What a difference a few years can make. For about a decade, software companies had been riding a wave of growth. Between 2011 and 2018, the global software industry’s market capitalization increased at double the rate of the overall market, according to previous McKinsey analysis. With the pandemic accelerating digital transformations, software valuations and growth reached a crescendo in 2021.
In recent years, however, the software industry has been facing major headwinds, as enterprises have slowed their spending on IT. This deceleration in technology investment led to slower growth for software companies. At the same time, rising interest rates meant that software customers faced increasing cash flow headwinds, exacerbating the pressure to cut back on software spend. As a result, software valuations experienced substantial multiple compression, and growth efficiency declined significantly, dropping roughly 50 percent between 2021 and 2023—with some signals in the first half of 2024 indicating that this trend may persist, according to our estimates.
Amid these flagging fortunes, high-performing software players, spurred by investors, sought to preserve their valuations by turning to the lever most in their control—margins —at a degree not seen in decades. While industry leaders understandably wanted to protect valuations, prioritizing margins at the expense of growth has left significant money on the table, a new McKinsey analysis reveals. As much as $500 billion in incremental enterprise value could be at stake.
To learn why software companies made this historic shift to margins, McKinsey conducted a comprehensive review of 116 public software companies based in North America. We found that to protect valuations in a bear market, software companies were justified in focusing on margin expansion, as players that effectively improved their cash flows were rewarded with higher valuations. However, the magnitude of the pivot to margins was an overcorrection, McKinsey analysis shows.
What we found was clear: for software businesses, the path forward lies in an approach we call “efficient growth”—one that seeks to pursue maximal growth alongside a healthy margin. Our hope is that this information helps software executives over the next 24 months and beyond, as they aim to create long-term value for shareholders, investors, and their companies.
More expensive growth
In 2022 and 2023, software companies faced serious headwinds as global IT spending decelerated. In the United States, the growth rate for IT spending contracted to 5.7 percent between 2022 to 2023, roughly half what it was between 2020 and 2022, according to McKinsey analysis. A recent report found that finance chiefs urged IT leaders to decrease spending on software tools by as much as 30 percent in 2023.
Although software companies continued to invest in growth, they were notably less efficient at generating new revenue. A McKinsey study of 116 publicly listed software companies reveals that between 2021 and 2023, median growth efficiency declined by more than 50 percent (Exhibit 1).
This decrease in growth efficiency was experienced by nearly all companies across the software landscape, including those with the highest valuation multiples. Among the software companies with at least $500 million in revenues, more than 90 percent fell below a growth efficiency of one in 2023. This means that each incremental dollar of growth investment yielded less than a dollar of new recurring revenue.
Protecting valuations through margin
As a result of these challenges, many software companies have veered off their well-charted growth trajectories into largely uncharted territory, shifting from a “growth at all costs” mindset to one anchored in margins. While companies in the top quartile for valuation multiples had previously achieved superior performance through higher revenue growth, in 2022 and 2023, they focused on improving free cash flow (FCF) margins. From 2018 to 2021, FCF margins for top-quartile and median companies were within a two-percentage-point range. In 2022 and 2023, however, companies with top-quartile valuation multiples achieved six to eight percentage points higher FCF margins, on average, than median companies (Exhibit 2). (In fact, top-quartile software companies more than doubled their margins between 2018 and 2023.) The markets rewarded the players that focused on margins, which were a greater differentiator between top-quartile and median companies than growth was in 2023.
Software companies’ overcorrection to margins
The focus on margins to preserve valuations was sensible, but software leaders ultimately made a bigger pivot to margins than was optimal, cutting costs at the expense of making sound investments in growth. In the past, market expectations for growth for a top-quartile software company (implied by valuation multiple, discount rate, and margins) lined up with companies’ actual growth rates, yet in 2023, actual growth exceeded growth expectations by four to eight percentage points (Exhibit 3). This outcome suggests that the growth levels implied by software valuations (a function of growth outlook, margins, and cost of capital) fell short of the growth that was realized, suggesting that players could have focused less on margins and invested in additional growth throughout 2023.
Our analysis suggests that these actions left significant value on the table. Even in a trying macroeconomic environment, software companies could have expanded their businesses more than they actually did. In fact, despite the challenges of rising interest rates and dropping growth efficiency, top-quartile software companies would have been better off keeping margins where they were in 2021, at 23 percent, instead of expanding them to 29 percent. Had companies reinvested six percentage points of margin into growth, even at a lower growth efficiency, this could have yielded about a 9 percent uplift in enterprise value (Exhibit 4).
To further illustrate the extent of the sector’s margin overcorrection, consider the trajectory of 116 large software companies between 2021 and 2023. A more granular analysis of companies’ individual performance shows that, going into 2022, investment in growth was the optimal strategy for creating long-term value for 50 percent of players (Exhibit 5). However, in reality, only 23 percent of software companies invested in growth in 2022 and 2023, while more than half doubled down on margins. And while the economic environment meant that achieving software growth in 2022 and 2023 was undoubtedly more difficult than in prior years, we find that more than 90 percent of companies that should have invested more in growth could in fact have done so, based on their subsector’s growth headroom.
Getting the growth formula right
Valuation theory suggests that there is an optimal balance between margin and growth for every company. As an example, for an illustrative Rule of 40 software company, the ideal growth-to-margin ratio is roughly 2.1 times to 1.2 times (Exhibit 6). That balance, over time, enables the company to maximize its long-term value. However, the optimum ratio between growth and FCF margin is different for all software companies, as it depends on the business environment and companies’ individual circumstances. Getting this balance right can make all the difference.
For software companies, the path forward lies in an efficient approach that seeks to maximize growth while maintaining healthy margins. To chart their approach to creating enduring value, software companies should search for their optimal growth-to-margin ratio by following an “efficient growth formula.” The formula should be tailored to each company’s circumstances, as baseline growth and margin, cost of capital, growth efficiency, and industry growth headroom can all affect a software company’s ideal growth formula (Exhibit 7).
As an example, a typical Rule of 40 software company with $1 billion in revenue and a growth efficiency of 0.4 would be generating the most long-term value at a growth-to-margin ratio of 0.8 times—that is, 22 percent FCF margin and 18 percent growth. That same company at a growth efficiency of 0.7 would maximize long-term value at a growth-to-margin ratio of 2.1 times, or 13 percent FCF margin and 27 percent growth. Companies with growth tailwinds (for example, because of a booming market) will naturally experience higher growth efficiency, and their threshold for optimal margin will be lower. The opposite is also true: companies with limited growth headroom will have lower growth efficiency, and the threshold for optimal margin should increase. Growth efficiency, in other words, is not a static number. There are multiple levers players can deploy to improve growth efficiency and unlock the ROI of their growth investments, such as refreshed pricing strategies, product-led practices to shorten sales cycles, and more relevant vertical sales capabilities, among others.
The $500 billion efficient growth opportunity
Our analysis finds that if all 116 software companies had followed their efficient growth formula—in other words, their optimal growth-to-margin ratio—in 2022 and 2023, they could have theoretically unleashed an additional $500 billion in incremental value. In 2023, the actual enterprise value for 116 software companies (representing more than 95 percent of the total enterprise value of the US software market) totaled $7.9 trillion. But if each company reached their optimal formula for efficient growth, the combined enterprise value for these software companies would have instead reached $8.4 trillion that same year.
Strategies to boost value in 2024 and 2025
Given how many software players have over-rotated to margins in the past two years, what mix of growth and margin should software companies pursue over the next couple of years? A McKinsey study of equity analysts’ forecasts suggests that most software companies are expected to stay the course, increasing margin and underinvesting in growth in 2024 and 2025 (Exhibit 8). As the past two years have shown, this overly cautious behavior will likely result in software businesses leaving a considerable amount of revenue and value creation on the table.
Based on each company’s efficient growth formula, we find that to create enduring value, 46 percent of software companies should actually be investing in growth going into 2024, while only 34 percent should be trying to increase their margins. Yet based on analysts’ forecasts, only 19 percent of software companies will have invested in growth in 2024 and 2025, with the biggest group of companies, 64 percent, still aiming to increase FCF margins.
In our work with software executives, we have seen that companies effectively deploying the efficient growth formula can experience a dramatic improvement in performance on both sides of the ledger. In our experience, software companies have seen a 40 percent increase in annual contract value and a doubling of FCF margins within a period of 18 months (or six quarters). Similar results can be achieved by launching efficient growth programs that can help industry leaders in the following ways:
- Take a longer-term, through-cycle view of growth. While growth may have gotten more expensive, as other software companies overpivot to margins, doubling down on efficient growth can be a once-in-a-decade opportunity to create strategic distance from competitors.
- Reinvest margin in growth. Cost discipline is critical, and achieving a baseline level of margin is necessary. However, software leaders should likely view expanding margins as an opportunity to reinvest in growth.
- Push the boundaries on growth efficiency. Software leaders can begin to increase growth efficiency by improving sales productivity and pricing. They can also accelerate growth efficiency by adopting AI at scale in sales and marketing and R&D.
Similar to enterprises in many sectors, software companies are encountering macroeconomic pressures that may make them more focused on expanding margins and cash flow than investing in growing their businesses. But for software companies to thrive in the long term, our analysis suggests that leaders should no longer overprioritize margins at the expense of growth. Instead, pursuing an approach to efficient growth that optimally balances both growth and margins should help software companies to better endure the market’s volatility, better serve their customers, and create the greatest long-term value for all stakeholders.
