A call for founders to shelter in the cloud
Tech’s path to economic recovery will require an increased focus on efficient growth and product innovation in the cloud.
Years from now, people will look back on the COVID-19 pandemic as a watershed moment for society and the global economy. Wearing a mask might be as common as owning a phone; telework, telemedicine, and online education will be more of a norm than a backup plan, and for the global economy, the cloud will have transformed the underlying infrastructure of businesses and entire industries.
COVID-19 is a turning point for the cloud and cloud company founders. For its computing power and as a delivery model of software, the cloud has been embraced as a solution to many challenges that businesses face during today’s economic downturn and recovery. Not only is the cloud industry more resilient than other industries, but the cloud model offers businesses a promising future in the age of social distancing and beyond. We believe that once founders find shelter in the cloud, they’ll never go back.
Over the past decade, there’s been a massive market shift from on-premises to cloud, as 94% of enterprises use at least one cloud service today. 2020 was already a milestone year for the cloud industry, as aggregate SaaS and IaaS run-rate revenue each crossed $100 billion, and the BVP Nasdaq Emerging Cloud Index (^EMCLOUD) market cap crossed $1 trillion in early February. Yet in a matter of days, as the COVID-19 pandemic spread, fear tore through financial markets.
In early March, public markets experienced the steepest crash in history with volatility we haven’t seen since the Great Recession. The cloud index market cap dropped to \~$750MM and cloud multiples returned close to their historical averages of \~7x while the VIX volatility index spiked to the mid-80s. Both at global highs in February 2020, the ^EMCLOUD and the S&P 500 traded off by roughly 35% by mid-March. Over the next two months, though, the ^EMCLOUD recouped those losses, charging to a new all-time high on May 7. The cloud index has continued its rise since then, and as of the close on May 11 has a market cap above $1.2Tr and has returned to the lofty 12x forward run rate revenue multiples from 2019. Similar to Adobe in 2012, we expect many enterprises to transition over to the cloud model, and the index will continue to expand. As we predicted in this year’s State of the Cloud 2020, by 2025 we expect the cloud to penetrate 50% of enterprise software.
No sector is immune to the economic impact of this pandemic; however, the cloud’s relatively quick rebound highlights the industry’s resiliency compared to others, especially after witnessing the public cloud markets reach an all-time high. For founders, weathering this economic crisis will require honing the operating features that make cloud businesses more resilient while also staying alert to the factors that expose certain businesses to more risk.
If we look under the hood of the cloud business model, we can spot the features that help businesses endure despite economic downturns:
- Recurring revenue with annual to multi-year contracts, often with upfront cash collections, high renewal rates, and low churn dynamics;
- Cost structures consisting mostly of operational expenses, resulting in high gross and operating margins;
- Balance sheet health, often with low leverage and positive net cash positions.
Combined, these elements support a business’ flexibility to adjust operations as sales slow down and market conditions change.
Cloud adoption has escalated over the years, and shifting IT spend to the cloud has proven to be especially beneficial during downturns because the cloud business model yields consistent market resiliency, cost-savings, and ease of implementation. These three benefits will be coveted byproducts of the cloud business model as the world works and lives in a remote-first and socially distanced society.
Some cloud companies are fortunate to ride unprecedented tailwinds. Cloud computing providers, such as AWS, Azure, and GCP are seeing increased usage as they help organizations to store and to process information; key applications that support cloud infrastructure are also seeing a boost, such as Auth0 for authentication. As people and businesses transition to the fully remote-first world, Zoom for video conferencing, DocuSign for e-Signatures, 2U for online education, and online fitness and gaming companies running on the cloud are also seeing significant upticks in usage.
Unfortunately, the negative impact of this downturn will disproportionately fall on the cloud businesses that are most exposed to risk from their geography, industry vertical, functional vertical, or target customer segment. Broadly, we encourage cloud companies to be even more disciplined in tracking and maintaining their core cloud metrics, the 6 C’s of Cloud Finance, as they ride out this disruption and continue to get more information about their businesses. Capital efficiency and cash preservation should be the north stars during this period of uncertainty in which visibility into consumer demand and access to capital are both obfuscated.
Despite the relative advantages that cloud companies possess, the COVID-19 induced economic downturn has been the first real test to date in the cloud industry’s twenty-year history. The last 11 years of a bull market—which happened to coincide with the proliferation of cloud—came to a crashing halt in March. $40Bn of public cloud market cap turned into $1Tr in that time, and COVID-19 put it all at risk.
So far, the cloud has passed the test. ^EMCLOUD has traded up almost +65% from its March lows as the market internalized the cloud’s resiliency. And while the current market is turbulent and uncertain, there is still a meaningful opportunity now for cloud founders to hone the fundamentals of their businesses, invest in product innovation, and build a cost-effective go-to-market strategy. With focus, these efforts will help vault well-positioned businesses to market leadership when the economy enters its recovery, likely propelled by a scarcer competitive landscape as non-market leaders die out due to lack of demand or funding.
As a cloud founder, it is important to note that innovation can come of disruption. Some of today’s most profitable cloud businesses weathered similar storms a decade ago in the 2007-2009 recession. At that time, Shopify was a nine-person team in Ottawa, Canada, only earning enough revenue to pay salaries. When the stock market crashed, Shopify focused entirely on the fundamentals of their business proposition; everything they built for their e-commerce tools platform would serve aspiring entrepreneurs and SMBs to build online stores and increase revenue streams.
“A major market disruption is like the shaking of a tree and seeing what fruit falls off,” Tobi Lutke, founder and CEO of Shopify, told us recently. Despite the challenges they faced serving SMBs and entrepreneurs, Shopify has had a long history of growth since the Great Recession, and today they stand with a market capitalization of roughly $90 billion.
Beyond Shopify, companies including Twilio, Venmo, Uber, Slack, Pinterest, and Square were all founded during the Great Recession— an uncertain time, much like today, which required adapting to an ever-changing environment and yet in which rapid innovation was possible. These world-shaping businesses were born during a market disruption. We believe that the next generation of transformative cloud companies will emerge even faster as a result of the new normal created by COVID-19.