How efficient growth can fuel enduring value creation in software
Key takeaway
- For entrepreneurs: Pursuing efficient growth by optimally balancing growth and margins can help software companies create the greatest long-term value and better endure market volatility.
- For investors: Software companies that overcorrected towards margins in 2022-2023 left significant value on the table, and those that reinvest in growth while maintaining healthy margins are poised for success.
Summary
McKinsey's analysis reveals that software companies overcorrected towards margins in 2022-2023, leaving up to $500 billion in potential value on the table. The article advocates for an "efficient growth" approach, which optimally balances growth and margins based on each company's unique circumstances. They provide a framework for determining the ideal growth-to-margin ratio and urge software leaders to take a long-term view, reinvest margin in growth, and push the boundaries on growth efficiency.
Insights
- The software industry experienced a major shift from growth-focused strategies to margin-centric approaches due to economic challenges and rising interest rates. Growth efficiency declined by more than 50% between 2021-2023.
- Top-performing software companies increased their free cash flow (FCF) margins significantly more than median companies in 2022 and 2023, which the market rewarded in the short term.
- Many software companies overcorrected by focusing too heavily on margins, potentially missing out on substantial growth opportunities. Actual growth rates of software companies exceeded market expectations by 4-8 percentage points in 2023 and up to 50% of software companies could have benefited from investing more in growth rather than focusing on margins.
- The optimal growth-to-margin ratio for a typical Rule of 40 software company is roughly 2.1 to 1.2. An optimal ratio depends on factors such as baseline growth and margin, cost of capital, growth efficiency, and industry growth headroom.
- Analysts expect software companies to continue overemphasizing margins in 2024-2025, potentially leaving value on the table. Only 19% of software companies are forecasted to invest in growth in 2024 and 2025, while 64% are expected to focus on increasing FCF margins.
Implications
- Software companies need to reassess their strategies to find the right balance between growth and margins.
- Investors should advocate for balanced growth strategies that consider both immediate financial health and long-term potential.
- Reinvesting margin in growth and improving growth efficiency through strategies like pricing optimization and AI adoption can help companies achieve efficient growth.
- The current trend of overemphasizing margins may lead to missed opportunities and reduced long-term value creation.
- The potential for unlocking $500 billion in additional value underscores the importance of optimizing growth-to-margin ratios.
- Taking a long-term, through-cycle view of growth can help software companies create strategic distance from competitors.