Examining The Cloud Software And Consolidation Landscape

July 3, 2019 8:00 AM EDT

By Jack McDonald
Forbes Business Development Council

A new batch of Silicon Valley cloud unicorns going public is attracting attention. But these big IPOs represent only a fraction of venture-capital-financed companies. There’s another crop of cloud companies that aren’t household names, but can have big value -- under the right business model.

It’s only natural that these two groups of cloud software companies developed. As the CEO of a cloud consolidation company, I know that a powerful new product category like enterprise application cloud software attracts attention and investment. Soon after, a million flowers bloom. There are some big winners and those that fail. And then there’s a group of smaller, successful companies with great technology that could be candidates for consolidation. We saw it in mainframe applications, desktop applications and client-server applications. And now we're seeing consolidation in cloud software.

With the cloud, companies can implement applications quickly and make them globally available. Cloud software is often easy to integrate with other third-party applications. That’s all very powerful from a user perspective. We owe thanks to the entrepreneurs who started these cloud companies and the VCs that financed them. Together, they have created a new era in enterprise software.

The venture model launches some cloud software startups into the stratosphere, with big strategic exits or IPOs. For example, Qualtrics last year was set to exit via its $8 billion acquisition by SAP. And Dropbox went public in March 2018 and was reportedly set to return between $2 and $3 billion to Sequoia Capital on its initial investments. Meanwhile, some cloud startups go out of business, and others become “orphan” companies.

When these smaller providers become VC orphans, the “problem” -- when there is one -- is not generally that they lack great cloud solutions, customers or people. Many of them may have award-winning products used by blue-chip companies. These cloud software companies may also have very talented personnel.

What makes these companies orphans, in my experience, is their inability to generate the outsized returns venture capitalists tend to seek. VCs naturally want their investments to grow at high, sustained organic growth rates until they’re $100 million businesses and beyond. While this makes complete sense in the context of a VC portfolio investment model, in the real world it can be very difficult to do.

Cloud software providers with less revenue face another challenge as well. Their limited resources can make it tough for large enterprise customers to do business with them. In my experience, enterprise customers need suppliers that can provide global, around-the-clock support and long-term product road maps. Small vendors may not be able to afford the secure infrastructure needed to provide that support. They may need to focus on winning new business rather than catering to existing enterprise customers. And their product road maps tend to be geared more to new features than scaling and stabilizing existing products. Big customers may also want to know that the companies with which they do business will be around for the long term.

Different Types Of Cloud Consolidators Offer Solutions

Consolidators such as Constellation Software, Descartes Systems Group and my company buy small enterprise software companies. While some cloud consolidators integrate the acquired companies and technology into their existing operations, other businesses set up their acquisitions as separate subsidiaries. Those businesses take a more federated approach by leaving management in place to run their operation and focusing corporate efforts on efficient capital allocation. Other cloud consolidators take a more centralized approach by fully integrating products and teams to drive operating synergies across shared service organizations. The federated approach has the benefit of added autonomy at the subsidiary level. The centralized approach has the advantage of critical mass and benefits from scaled shared service organizations that can serve large enterprise customers.

The Benefits Of Consolidation

Consolidation in cloud or other industries can enable small companies to obtain the resources, scale and balance sheets they need to achieve long-term success. That’s especially important for small enterprise cloud software suppliers, because there are a lot of them -- and more will likely come.

In its 2018 "Planet of the Apps" report, BTIG estimates that 38% of the enterprise applications are cloud-based and values the 2019 application software market at $211.96 billion. That’s a massive opportunity for consolidators and cloud companies alike. And it could, in turn, create more venture capital investment and more opportunities for cloud software consolidators to snap up valuable companies with sticky products and big customers.

Cloud consolidators can transform companies very quickly. Through acquisition by cloud consolidators, money-losing products can be repositioned for long-term, sustainable growth. Cloud companies can benefit from the larger company’s resources and strong balance sheet. It’s also beneficial for the businesses that use their cloud software, as they can get more stable, secure and scalable solutions than they might otherwise.

The Drawbacks To Consolidation

Of course, any time a business is acquired, there is disruption, particularly when the company is transforming or integrating its business model into a larger organization. Such disruption can lead to customer churn and loss of key employees, which may make consolidation too much of a risk for some companies.

And consolidation might not be a fit when the acquiree’s business is highly verticalized and requires specialized end-user industry knowledge and service offerings to effectively service customers. It also may not be a fit if the acquiree is small and the acquirer is very large because the people and product from the smaller company might get lost inside the larger entity. (That risk could be lower when the acquirer has a culture of consolidation and is proportional in size to those it acquires.) Personal services businesses might not benefit from scale economics and core function centralization due to the personalized nature of their offerings.

In my next article, I’ll talk about what today’s great consolidators and other business leaders are doing to build value by employing efficient capital allocation and repeatable processes that scale and ensure that acquisitions are both strategic and accretive to cash flow per share.

Jack McDonald is the founder, chairman, and CEO of Upland Software (NASDAQ: UPLD), a leader in cloud-based enterprise work management software. A serial entrepreneur, McDonald has built four successful technology companies, led two successful Nasdaq Global Market IPOs, and created more than $2 billion in shareholder enterprise value. He’s a leading consolidator of technology businesses with less than $25 million revenue, having successfully completed more than 41 such acquisitions in the last 20 years.