When Luca Pacioli first recorded the method of double-entry bookkeeping in the fifteenth century, he may not have anticipated the impact he would have on the modern world. He is certainly unlikely to have anticipated the pain felt by countless small business owners today - who find themselves managing cash flow challenges from day to day, and reconciling shoeboxes of receipts and invoices at year-end.
Now, given the pressure exerted by COVID-19, these financial challenges are more acute than ever. It's a precarious time to run a small business, calling for policy interventions such as the UK's Coronavirus Business Interruption Loan Scheme.
There are approximately 25 million small- and medium-sized enterprises (SMEs) in Europe, accounting for two thirds of European employment. Every one of these needs to manage its finances, but few are currently served by a good way of doing so. Accounting is rarely a core competency for SME owners, who typically rely on spreadsheets and/or local accounting firms. This yields a user experience that is operationally inefficient, and often expensive. We believe there's a meaningful SaaS opportunity hiding in plain sight here, with a potential TAM on the order of ~$5B.
It's no secret that SME SaaS behaves very differently from enterprise SaaS. In large enterprises, we have seen multiple waves of software driving efficiency in the finance function, from the rise of megalithic ERP systems in the 1980s to the proliferation of SaaS vendors in the last decade. Conversely, the SME segment has been underserved - at least in Europe. We have seen Intuit gain substantial market share among US SMEs, but Europe has no comparable dominant incumbent. While Sage, Intuit and Xero have made significant gains in various parts of the continent, we believe that ~90% of the potential market remains unpenetrated. In other words, the real market leader today is Excel.
Things are starting to change, and the unbundling of Excel is well under way. We have seen a crop of promising European startups that promise to make SME owners' lives easier by automating an overhead which they widely loathe. We've met a number of exciting startups in the space: Bokio, Candis, CountingUp, to name a few. All of these share in a vision of better-run businesses across the continent. As these companies build scale, SMEs can expect to waste less time on non-core work, spend less on local accountants and advisers, enjoy greater visibility and control of their day-to-day finances; and make fewer reporting errors (thereby avoiding the costs of non-compliance).
There are also regulatory catalysts for adoption of accounting SaaS. As electronic reporting becomes mandatory, we expect this software category to be robust in the face of the current pandemic. In the UK, the Making Tax Digital initiative came into effect in August 2019, requiring quarterly electronic tax reporting. This has been a secular driver for adoption of accounting software among SMEs. As Morgan Stanley puts it:
The UK market stands at a tipping point for accounting software penetration. We believe the UK's 'Making Tax Digital' (MTD) initiative could start driving penetration of accounting software in the UK from ~20% of SMEs to rates closer to those in Australia and New Zealand (ANZ) - 75-80%. Over one million business are affected by this regulatory change, yet historically, only an estimated 10-15% of these firms have filed directly via software. To comply with the new MTD initiative, these businesses will need to switch to a software accounting solution.
Across the continent, there are similar trends, albeit at different stages of advancement. The first countries to require electronic tax reporting include Spain, Italy, Poland, and Czechia. We expect the digitalisation of tax authorities to continue across Europe, given the loss prevention opportunity it presents at diminishing cost over time.
Our fundamental thesis, then, is:
Building a best-in-class product is a key hurdle to overcome - but we believe that distribution is the challenge that will separate great companies from good ones in this space. SME SaaS companies sell into an inherently fragmented market, targeting a high volume of customers with much lower ARPCs than their enterprise counterparts. This can lead to challenging unit economics. The most effective SME SaaS companies forgo the expensive, top-down enterprise sales model, and instead pursue product-market fit through consumer-like routes to market. These include effective content marketing via direct channels, but also elegant niches of network-driven distribution that bring down CAC. One example is partnering with local accounting firms to gain an insertion point into their customer bases, as Xero has notably done. We're excited to meet entrepreneurs with inventive approaches to the challenge of low-cost customer acquisition.
Great SME SaaS enables entrepreneurs to focus on the things that matter most: spending their time with their customers and running their core business. At Mosaic, we're excited to back great founders working towards this goal. Accounting is a near-universal pain point that's near-universally unsolved, and we have conviction that there's large untapped potential here.
If you're building a company in this space with an elegant business model, we're excited to hear from you. Please get in touch!