Chapter 1: The Rise of Invisible Technology

In the words of Steve Jobs, "Great technology is invisible." This sentiment became particularly evident in 2020 as the Covid-19 pandemic shifted work and social interactions to online platforms. As a result, software took center stage, facilitating countless conversations, transactions, and work processes—often without us realizing it. For instance, that DoorDash notification about your dim sum delivery was enabled by Twilio, and the coffee you ordered from a local roaster was facilitated through Shopify.

Software is no longer limited to large enterprises; it has infiltrated a variety of sectors, including construction (Procore), automotive repair (Shopmonkey), and even barbershops (Squire). A prime example of this shift is Zapier, a no-code automation platform that allows users to streamline repetitive tasks with minimal effort, while the underlying software performs complex functions invisibly.

Bessemer Venture Partners (BVP), known for its successful investments in software companies like Shopify, Twilio, and Wix, annually releases its State of the Cloud report, which outlines key trends in the industry. BVP asserts that:

Cloud computing is increasingly dominating the landscape of software, hardware, and services, positioning it as a pivotal mega-trend in technology that will significantly influence global GDP in the years ahead.

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Chapter 2: A Year of Exponential Growth

The year 2020 was monumental for cloud software, characterized by unprecedented growth rates and access to capital. While the software's role became less visible, the expansion of the industry and the performance of its stocks could not be overlooked.

In 2019, no public cloud company surpassed a valuation of $200 billion. However, by 2020, three companies—Adobe, PayPal, and Salesforce—achieved this milestone, collectively pushing the market capitalization of public cloud companies over $1 trillion. Deal activity surged, setting records in both IPOs and mergers and acquisitions. Snowflake, a cloud data-warehousing firm, made headlines with the largest cloud IPO valued at $34 billion, eclipsing VMware's previous record from 2007.

BVP noted a concerning trend:

More IPOs last year experienced a doubling in value on their opening days than at any time since 1999.

In a similar vein, Salesforce's acquisition of Slack, a chat platform, was executed at an astonishing 35x forward revenue multiple. This means Salesforce paid $35 for every projected $1 in sales for Slack in the following year, marking a lucrative outcome for Slack's early investors. However, for Salesforce to reap the rewards, Slack must achieve substantial growth and profitability.

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In this transformed landscape, the pandemic accelerated existing trends, pulling the future closer. This is evident in the valuation of both public and private cloud entities. Sales multiples, which indicate how much an investor is willing to pay for future revenue, have soared. According to BVP, the forward sales multiples for public cloud companies rose from 5x in 2010 to 20x in 2020, while private markets also saw significant expansion, with the average multiple in BVP's Cloud 100 index jumping over 150% from 9x ARR in 2016 to 23x ARR in 2020.

The fundamental outlook for cloud software remains optimistic, fueled by high growth rates and ample capital. The CEOs of Amazon and Microsoft, both former leaders in cloud services, exemplify the significance of this market. Since their public offerings, cloud revenue growth has consistently exceeded Wall Street's expectations, with private cloud companies experiencing accelerated growth.

Despite the promising outlook, the reality of mean reversion looms over valuations in the long term. While the expanding Total Addressable Market (TAM) supports higher multiples compared to 2010, there will inevitably be a pullback on the currently inflated 20x revenue multiples.

Chapter 3: The Maturation of Cloud Infrastructure

The Infrastructure as a Service (IaaS) segment represents the most developed aspect of the cloud ecosystem, offering insights into how other cloud markets might evolve. Amazon Web Services (AWS), launched in 2006, commands approximately 33% of the IaaS market, while Microsoft Azure and Google Cloud are gaining ground, albeit at a faster pace.

This trend of increasing concentration is not limited to IaaS; it is a broader phenomenon across the tech industry, with major players in advertising and video streaming capturing more market share at the expense of smaller competitors. According to an analysis by The Economist, many incumbents have seen their market shares plateau.

As a result, the spoils are disproportionately awarded to leading players. In this context, the ability to identify winning investments becomes critically important, given that rising valuations elevate the risks associated with poor investment choices.

In 2020, private software companies attracted a record $186 billion in investments, but only a handful will evolve into industry leaders, while many may falter. Just as software has transformed industries, some companies may ultimately vanish from the scene.

For further insights into BVP's investment strategies, explore their memos on LinkedIn, Pinterest, and Shopify.

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