Why I Like B2B Software

B2B software, particularly SaaS, went through a frenzy that peaked in 2021. “B2B SaaS” became a buzzword among tech enthusiasts and venture capitalists. But beyond the excitement, B2B software has intrinsic advantages that make it one of the strongest types of businesses.

I’d like to believe that I don’t invest based on trends. I like B2B software for its core strengths, regardless of what’s popular in tech circles.

One framework I use to evaluate businesses is by analyzing its strengths and weaknesses at different stages of growth. It is useful to understand where a business faces friction and what makes it defensible. This perspective helps me evaluate strong investment candidates at different stages.

Compared to companies reliant on physical assets, software businesses (specifically mid-market and larger ones) offer the potential for strong strong growth and durable competitive advantages.

Disclaimer:

Not all software businesses share the advantages I highlight. Not all physical businesses are at a relative disadvantage with regard to software. There are exceptions to the rule.

Some software companies lack attractive traits like high margins and strong customer retention. Likewise, certain brick-and-mortar businesses thrive despite their physical constraints.

For example, LVMH, a luxury goods company, sells physical products. Yet, LVMH maintains exceptionally high gross margins that are better than some software companies. This proves that physical businesses can generate world-class financial results despite their limitations.

I make broad generalizations to highlight what makes a great business and why B2B software embodies many of these traits.

When talking about 'software', I’m referring to cloud-based software at the application (SaaS) and middleware (PaaS) layers.

This exercise aims to explain why B2B software is an attractive type of business.

Why I like software:

1)        Zero marginal cost of replication

Software scales effortlessly because adding new users costs almost nothing. The cost of duplication is virtually free. Once a company builds a product, it can serve millions or even billions of customers with minimal extra expense.

Microsoft only had to develop MS Office once before rolling it out to millions of customers. Software can be instantly replicated and distributed worldwide at near-zero cost.

In contrast, physical businesses face significant barriers to scaling. Expansion for traditional physical businesses requires factories, inventory, labor and transport. This makes growth slower and costlier.

2)        Agility

Software is like play-dough—it's highly malleable and easy to reshape. Features can be added, removed, or upgraded quickly, allowing businesses to adapt to customer needs in real-time.

In contrast, physical businesses face longer lead times and delays in product development. A software company can iterate and improve its product multiple times a week. Conversely, physical products can take months (or even years) to design, manufacture, and distribute. This agility gives software businesses a significant competitive edge.

This has several implications.

i.               Flexible offers and short feedback cycles

Software has built-in tracking capabilities that monitor user behavior. Because of this, software can be infinitely iterated in a given time frame. Software businesses can continuously refine their offering until they find a profitable and sustainable model.

(An offer is what businesses provide in exchange for money.)

If a software business operates sub-optimally, it can adjust its offer quickly. This can be done by tweaking its value proposition and price.

This helps software businesses identify which features and customer segments to prioritize. Software companies can split-test different features, prices, and interfaces to optimize conversions and retention.

This data-driven insight benefits software businesses and helps maximize revenue and customer retention. It allows companies to use dynamic pricing models (e.g., per seat, per use). It also allows companies to tailor offers based on customer needs.

Software businesses can also expand into new markets more efficiently. This is because of their ability to conduct multiple small-scale tests and make data-driven decisions. It can test new customer segments, upsell or cross-sell features, and scale geographically with minimal risk.

This adaptability allows software companies to increase their market size quickly and with less risk.

Physical businesses lack this flexibility. Manufacturers rely on various supplier contracts and fixed production or delivery cycles. Altering this complex system is costly, risky, and complicated.

ii.               Operational efficiency

Software businesses have less operational complexity since everything is distributed online. There’s no need for inventory, warehousing, or logistics. Cloud-based software is delivered instantly, with no shipping delays or logistical hurdles.

This efficiency allows small, highly skilled teams to build and scale massive businesses. Some of the highest revenue per employee businesses are software companies. Software is inherently more operationally efficient, making it among the most profitable and scalable businesses.

3)        Pricing power and recurring revenue

B2B software has strong pricing power. This is because of the high switching costs associated with B2B software customers. This is also because software typically represents a small fraction of a buyer's costs. This dynamic increases a software’s pricing power dramatically.

Additionally, software naturally lends itself to the recurring revenue model. Recurring revenues create predictable cash flow and make growth more sustainable. Recurring revenues are the golden geese of revenue types — they make it easier to scale and they’re more stable.

(I’ve written more about recurring revenue here.)

4)        High operating leverage

Software businesses enjoy high operating leverage. Operating leverage allows profit to grow at a faster rate than revenue. This is because fixed costs stay relatively unchanged as revenues grow. You only have to develop a software product once before serving thousands or even millions of customers with minimal additional cost.

In contrast, physical businesses require higher operating and capital expenditures to expand. A physical business would need more inventory, facilities, and staff for the same number of customers compared to a software company.

Software companies benefit from operating leverage on three fronts. First, they can rapidly acquire new customers with minimal costs of servicing those customers. Second, they can expand revenue per customer by upselling or cross-selling higher-tier services. Third, they can increase pricing with relatively little friction. All this has a disproportionate impact on the bottom line.

5) Falling cost of computing power

The cost of computing power keeps falling while computing capabilities grow exponentially.

Meanwhile, physical businesses struggle with inflation as raw materials, components, and labor costs continue to rise. This puts pressure on their margins, especially since many can’t easily pass these costs onto customers.

In contrast, software businesses aren’t dependent on physical inputs, making them far more resilient to inflation. Their low variable costs and ability to flexibly adjust pricing give them a strong advantage over asset-heavy industries.

Although newer high-performance chips are expensive at launch, prices stabilize within a few years.

Additionally, public cloud providers help smooth out these costs by renting out computing power on a pay-per-use basis. This allows cloud-based software companies to avoid large upfront infrastructure costs and scale efficiently, even during periods of rising hardware prices.

This phenomenon has two effects on software businesses:

i.               Lower barriers to entry

Cheaper computing makes it easier for startups to enter the market and increases the threat of competition from new entrants.

This is generally bad for existing software providers. Established players with strong value propositions and captive customers don’t need to worry about new entrants.

ii.               Higher margins for established players

Mid-market and larger software companies with strong value propositions will benefit from lower computing costs. They will likely see operating costs decline over time, improving gross margins.

Additionally, advances in AI and automation are making software developers dramatically more productive. The rise of the "10x developer" means companies can achieve much higher output with fewer engineers. This significantly reduces R&D expenses, a major cost driver in software businesses.

6)        Unique competitive advantages

Software companies have three key competitive advantages: switching costs, economies of scale, and learning curve effects.

i.               Switching costs

Switching costs are particularly strong in software. Once a business adopts a system, moving to a competitor is costly and disruptive.

Data lock-in makes migration difficult, especially for mission-critical software. Some software uses algorithms, AI, or automation, that make it more valuable the more it is used. Moving away from these solutions means losing valuable insights and starting from scratch.

User familiarity and workflow customization also increase switching costs. Employees adapt to a system with time, and retraining takes time and is costly.

ii.               Economies of scale

Economies of scale gives software companies a major advantage. Once developed, software can be sold to millions with little additional cost.

Incumbent firms who have invested heavily in R&D and Sales & Marketing (S&M) for many years have an advantage. They provide a larger number of more valuable features to a large and growing user base.

A new entrant must outspend incumbents on R&D and S&M to build the right features and to convince customers to switch. This would be a challenging and costly endeavor. Incumbents benefit from years of customer feedback, making their functionality hard to replicate.

Incumbents make more revenue per customer. This means that they can spend a smaller percentage of revenue to service those customers. The incumbent's higher margins give them greater flexibility to respond to competition. This makes them better able to retaliate using prices, product improvements, or better customer service.

In software, the Minimum Efficient Scale (MES) is not fixed but is shaped by a company’s business model and strategy. While physical businesses hit capacity constraints, software can scale almost infinitely. This is because cloud infrastructure allows companies to grow efficiently without the same capacity constraints traditional industries face.

iii.               Learning curve effects.

Software also benefits from learning curve effects. The longer a company operates, the more efficient it becomes. Engineering teams optimize code, which cuts costs and increases product usage over time. Intimate knowledge of customers through years of user feedback helps refine products. This creates a cycle of continuous improvement that is difficult to replicate.

These advantages make software sticky, scalable, and highly profitable.

Why I like B2B:

1) Easy to identify and communicate with customers

Business customers are easy to find and target. They operate in specific industries, are listed in directories, and have a clear online and physical presence. It is easier to contact them, learn about them and communicate with them.

Businesses can be categorized and segmented based on what they do and where they operate. This makes it easier to identify ideal customers and customize marketing and sales strategies. With access to structured data, B2B companies can run more targeted campaigns and optimize lead generation. The customer acquisition process can be far more efficient and predictable than in B2C.

2) Rational customer purchase criteria

B2B customers are profit-driven, so their purchase decisions are rational and predictable. Because consumer preferences and behaviors are less predictable and rational, B2C markets are more likely to be influenced by fads or trends. B2B businesses are less likely to fail due to a sudden shift in customer preferences.

A rational purchase criterion benefits stakeholders because the value of purchases becomes clear and measurable. Stakeholders can objectively assess the value being delivered. They can compare offers between sellers and pinpoint why and by how much a B2B seller is ‘underperforming’ its peers. This ROI-driven buying process makes B2B software businesses more predictable, stable, and resilient over the long term.

When businesses purchase something to solve a real and pressing problem, they are more likely to use that solution regularly.

3) High contract values

Businesses have a greater capacity to spend than individuals. As businesses grow, so do their budgets. This allows B2B businesses to generate more revenue per customer.

Businesses pain points and solutions can be quantified. The difference between the value of a problem and the benefits of a solution is how much a business is willing to spend to solve that problem. This difference can be in multiple millions or billions of dollars for large companies.

Unlike consumers, who are limited by personal finances, businesses can justify large expenses if those expenses deliver a return on investment (ROI). This ROI can come from increased revenue, improved productivity, or cost reductions.

4) High gross margins

B2B software companies often achieve exceptionally high gross margins, typically 80% or more. This results from a combination of high average order values (AOVs) and insignificant servicing costs.

Physical businesses require inventory, logistics, and labor to service customers, which is a drag on gross margins.

Higher gross margins allow companies to grow quickly and with relative ease. They also have an outsized impact on the bottom line.

(For a deeper dive, read my post on gross margins here.)

5) High LTGP/CAC ratios

B2B software companies benefit from high average order values (AOV), strong customer retention, and long recurring revenue contracts. This combination results in high customer lifetime gross profit* (LTGP). Because B2B cloud software solutions can have high switching costs, customers tend to stay for years. This makes each acquired customer far more valuable over time.

Established B2B software companies typically experience LTGPs that are significantly higher than customer acquisition costs (CAC). This dynamic allows software companies to scale rapidly and profitably.

During a software's hypergrowth phase, the main bottlenecks are often found in sales and marketing. Many software businesses raise capital specifically to fuel customer acquisition. They know that their high LTGP/CAC ratios will generate strong long-term cash flows and use external funding to grow as fast as possible.

As technology continues to advance, the upside for well-positioned software businesses will only increase.

B2B software can be a fundamentally strong and high-leverage business model that is rewarding to investors.

But not all areas within B2B software are the same.

Some use cases and verticals are more compelling than others.

There are specific areas of software that I find particularly interesting. I plan to publish a follow-up outlining where I see a lot of opportunity.

If you’re as excited about the power of B2B software as I am, let’s connect.

Whether you're building, investing, or just exploring the space, I’d love to hear your thoughts. Drop a comment, reach out, or share this with someone who would find it valuable!

*Lifetime Value (LTV) is the total revenue a business expects to generate from a customer over the course of their relationship. It helps companies understand customer profitability and justify acquisition costs.

However, Lifetime Gross Profit (LTGP) is a better metric because it accounts for gross margins, providing a clearer picture of actual profitability. Two companies may have the same LTV, but if one has higher costs to service customers, its actual profit is lower.

LTGP ensures businesses focus on truly profitable customer relationships. It is a more accurate and meaningful measure for profitable long-term growth.