Quick, look! A unicorn!
No, not the mythical creature from fairy tales – rather, to use the business meaning of the term, the rare company with a valuation exceeding $1B. In legal tech, the count is at least three; if one believes various pundits quoted in a recent piece in Legaltech News, the number is sure to rise, and the question is whether that is a good thing.
Some may question whether I qualify as a pundit but allow me to offer my thoughts.
In business, as in fairy tales, a unicorn is an elusive creature. That has not stopped many venture capitalists and private equity firms from claiming that a company they have funded is destined for unicorn status – even though the concept of unicorns rests on the premise that they are rare. Just as everyone cannot be above average, only a few companies will achieve unicorn status. It is fantastical to believe that legal tech – and CLM technology in particular -- will have a ton of (sustainable) unicorns.
A close look at the economics of legal tech and CLM reveals how unlikely it is for such a creature to become a unicorn. Valuations are a function of several variables: investors’ Internal Rates of Return (IRR) targets, per cent of fund deployed, timeframe remaining to deploy capital in the fund, supply of and demand for investable assets and companies, portfolio balancing, and general knowledge of an industry domain. While most PE firms emphasise profit and EBITDA in calculating valuations and VC firms concentrate on top-line growth, all investors invest based on growth expectations. And those expectations are what generate visions of CLM tech unicorns. The reality is that few CLM tech companies will achieve that status.
Every CLM tech company travels the same path. After raising money, it will invest in selling more because acquiring customers require putting in place and growing a business development team to rack up wins and have more company logos to showcase as customers. The CLM tech sector is still in its early stages: penetration remains relatively low, the market is far from saturated, and tons of logos remain for the taking. In these circumstances, Year One of any CLM tech company’s (post investment) existence is likely to be exciting and generate optimism.
Most CLM tech companies rely on a SaaS business model and present themselves as machines that generate recurring and predictable revenue: as the company grows, it gains more subscribers, which results in stable and predictable revenue. Or so these companies claim.
However, not all CLM tech companies (or their investors) will live happily ever after. The realities of the SaaS model make it inevitable that Year Two and beyond will be far more challenging. After a customer signs up for x licenses, it is likely to find that user adoption occurs much more slowly than hoped. Consequently, in Year Two, the customer may renew fewer licenses. When Year Three arrives, if the rollout has stalled at just a few workflows and there still is no single source-of-truth repository of all executed agreements, then things get worse. Users and executives blame the CLM technology, and the team responsible for implementation then issues an RFP for a replacement system. Note, there is a lot of CLM platform switching happening every day and the service provider ecosystem gains a lot of business by supporting these switches.
By this time, the list of CLM tech companies has grown – when a new and growing market begins to attract investors, new entrants abound (barrier to entry are low), and the competitive environment becomes noisy. In contrast to Year One, a CLM tech company finds itself fighting to hold onto existing customers and faces a fiercer fight to win new ones. Meantime, companies that support the implementation of CLM systems are giddy: the CLM tech switchover market is healthy, growing, and nowhere close to saturation.
For investors who invested tens (or hundreds) of millions in a CLM tech company whose valuation went north of $1 Billion, the challenge becomes meeting their IRR amid increasing customer churn. Getting to unicorn status is one thing; achieving your target IRR requires exiting through an IPO or sale to another financial or strategic investor for an even higher valuation within your IRR timeframe.
Target IRR is typically around 30% - meaning an investor needs to double their cash investment in that period. A CLM tech company must project a much higher (10x?) return in that timeframe. Why? Because the VC or growth equity investor must achieve an overall 30% IRR across its portfolio, not just one company. It is not enough for the CLM tech company to double the money the investor sunk into it; proceeds from its sale must also cover losses from investments in companies that failed to pan out.
This means the CLM tech company must acquire more customers as quickly and cheaply as possible. Meantime, all its competitors that received VC or PE/growth equity funding must also do so. Churn will continue to increase, and fewer and fewer CLM tech companies will rise above the fray.
Every potential CLM tech investor faces this fundamental quandary. How will their investment close the gap between valuation and target return amid these dynamics?
I don’t know the answer to this, but I am highly confident that within three to five years, we will see whether the investor community maintains its (current level of) excitement over the CLM tech sector.
The legal tech industry has seen a whirl of large investment rounds, product launches, and announcements of increased quarterly revenue, signaling, if nothing else, an active market that’s rapidly expanding. The market also already has a few companies that have reached unicorn status—those with a valuation of at least $1 billion.