Are software companies good businesses?

We’re back to talking about profitability.

A technology-finance podcast recently talked about software company valuations, the impact of interest rates, and just how profitable well-known tech companies can become.

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Riffing off a chart that showed the inverse relationship between rising interest rates and tech company revenue multiples, investor Chamath Palihapitiya said something interesting:

I think this chart is not that helpful, because this is all unprofitable software companies. So I think the more important thing is to look at the broad-based index. The thing with these companies is that even if rates are at 6% or 3% or 2% or 1%, that trick is over. These companies are not going to get out of this cul-de-sac until they figure out true product-market fit, how to eliminate churn, how to drive medium- to long-term profitability. And most of them, unfortunately, don’t have a clear path to that.

The problem is all of the old, legacy software companies, except Salesforce, have still not gotten to profitability. So, the ones that went public in the early teens are still sucking wind, losing money. So the idea that software businesses generate long-term profits is so far unfortunately a fallacy.

Here’s the chart in question:

As you can tell from the branding on the chart, it’s by Altimeter, so its founder Brad Gerstner joined the conversation after the podcast was aired, tweeting his own thoughts.

Gerstner had a more positive take: “Are software companies bad business models? So I asked the team to pull together a few charts. Of the 61 companies in the index only 6 have [negative free cash flow] margins.”

Gerstner went on to point out that the basket of companies has swapped growth and free cash flow margins in the last several quarters.

According to another chart (embedded below), that group of companies had median revenue growth of 26% and median free cash flow margins of 6% in 2022. Those metrics nearly switched places in 2023 — median growth rates declined to 19% and median free cash flow margins soared to 12%.

Gerstner argued that software companies also tend to generate more cash over time, so there’s reason to be optimistic about software companies. He did allow that share-based compensation should also be a factor to consider for tech companies’ profitability.