Look at what's happening to public SaaS business efficiency
So it begins...
One of my big theories for 2025 is that public software names are going to get a LOT more efficient and will begin to generate significantly more cash. Two main reasons for this:
AI. While I don't see fully autonomous agents replacing human employees en masse (this year at least), many companies will be able to reduce hiring or keep headcount closer to flat, while asking those employees to become incrementally more productive with AI tooling. It seems reasonable that largest beneficiaries of consuming AI technologies (as opposed to selling AI functionality) would be software companies, for the obvious reason that building and implementing workflow tech is their modus operandi.
Sticky, growing, recurring revenue software companies are among the easiest to manage for greater efficiency (if so desired by management). Because nearly all costs come in the form of personnel1, a simple way to increase cash flows is to hire more slowly than ARR goes up.
I now direct your attention to the chart of ARR per employee (top of this post) and trailing 12mo free cash flow percentage (below). These are not all public SaaS companies, but a subset that I track in a personal workbook of mine.
The data is noisy and incomplete (not all companies publish quarterly headcount numbers, for example; and ones that do occasionally stop) but the direction is clear: Efficiency is up, cash flows are up too.
A lot of this is the natural consequence of the long-term post-ZIRP rebound and should not be surprising. But one thing you'll notice in both charts is a somewhat-pronounced positive inflection in the most recent quarter (Q4-24)2.
If I had to guess, I would say that Q4 is the first quarter for AI impact to show up in software companies' profitability. Barring a recession or an over-supply of capital rotating back into midcap software names, it’s tough to imagine this trend reversing anytime in 2025.
Is (virtually) every public SaaS business going to be a cash-generator by the end of the year? That would be quite the departure from fall 2022 when half of the online financial commentariat was calling SaaS companies “structurally unprofitable shitcos”.
Though this may be changing in the era of AI "wrapper" companies that have significant COGS in the form of LLM inference compute.
This may get muted once SentinelOne reports on Wednesday. Still, SentinelOne’s improvement in cash flows over the last 3 years has been profound, maybe the most impressive of any public SaaS business.