Valuations and deal sizes for “hot start ups” are reaching lofty heights.

Just off the press is an article from Dan Primack, a journalist for Fortune magazine. In his article titled, “Venture capital shows sign of bubble” he writes the following:

Venture capitalists invested $5.87 billion in 736 U.S.-based companies during the first quarter of 2011, according to a new MoneyTree Report released by PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters. That works out to $7.98 million per deal, which is 18% larger than the average deal size during the prior quarter. It also is 21.6% higher than the average deal size in Q1 2010, and a whopping 47% larger than the average deal size in Q1 2009. Moreover, the average early-stage, expansion-stage and later-stage deal was larger in Q1 2011 than was the comparable deal in 2010. That’s important, because it indicates that this isn’t just reflective of VCs putting more of their eggs into less-risky, later-stage deals.

He goes on to cite the following statistics:

Overall, software companies continued to lead all industry sectors with $1.1 billion raised for 187 companies last quarter. This was followed by industrial/energy with $1.03 billion for 75 companies and biotech with $784 million for 85 companies. The quarter’s largest deal was a $201 million round for BrightSource Energy, an Oakland, Calif.-based thermal power plant developer, that raised $201 million. The rest of the top five was Plastic Logic ($200 million), Fisker Automotive ($111 million), Tabula ($108 million) and SoloPower ($78 million). Per usual, Silicon Valley led the nation with $2.49 billion invested in 212 companies. New England placed second with $639 million for 90 companies, and New York Metro snared $580 million for 69 companies.

So, the question currently being bandied about the proverbial watercooler is are we or are we not in a bubble? If we are in a bubble, are we in 1998 or 2000 (referring to the relative beginning and end of the last formally recognized bubble) and if we are in a bubble will this one end like the last one or will the ending be somehow different this time.

From my own perspective at InterWest, we are seeing more deals than ever in 2011. The weeks are literally jammed with back to back meetings with great entrepreneurs with great ideas. And, the deals that are getting done, for companies in a hot sector (e.g. consumer internet) and/or with a proven team are being fought for and won at valuations that may be hard for the entrepreneurs to live up to — and for the venture firms to generate a great return if anything goes wrong and the company takes longer and more capital to reach its goals.

That said, one observation made by Keval Desai, an early member of Google and VP at Digg, is that:

•  There are 7B people on the planet.
• 2/3rds of them don’t have Internet yet
• 95% without smartphones
• Facebook only has 10% share
• There is an entire new generation that is using mobile tablets, as infants, that will learn, socialize and play completely differently than anyone born prior to them.

In addition, the rapid rise of the mobile/cloud computing market is also driving a complete transformation and overhaul of back end systems thereby creating opportunity throughout the technology markets.

Given all this, it could be entirely possible that we see many years of growth in many, many different technology areas without the big bubble pop we saw last time. Companies started today that see early traction and growth - and revenue – have a good shot at not suffering the fate of the Bubble 1.0 companies like “pets.com” but instead could survive to become the new large incumbents that help to reshape the world in which we work and play.

Of course, this doesn’t factor in exogenous issues such as instability in the Middle East, natural disasters, etc. which could act as a countervailing dampener.

So, while hot start up valuations may appear to be “bubbly”, we may look back and feel they were actually fairly valued. The next few years should be pretty interesting…but hopefully “interesting” in a good way.

The report states, “13 public SaaS companies tracked by Pacific Crest Securities have increased in value 40% since the beginning of 2008. During that same period, the S&P index has yet to return to its pre-recession value.”

It goes on to say, “…not all public SaaS companies have performed equally well. To be a standout in this space, growth needs to be greater than 25% per annum, and the market opportunity needs to be significant (e.g. CRM, ERP, HCM, etc).”

They claim that growth dominates over profitability for a couple of reasons. The first is that the SaaS market is still immature with only a third of the entire software market spend. The second is that these companies have been able to demonstrate significant profitability after sales and marketing spend is cut back.

I’m not sure I necessarily buy into this last statement because I’ve yet to see any high growth SaaS companies that have cut back on their sales and marketing spend in favor of profitability. In fact, I remember a few years ago speaking with Phill Robinson, the then-current CMO of Salesforce. His comment to me was that he had not reached a point of diminishing return from his investments in Google Adwords – and Salesforce has continued to invest heavily in sales and marketing – mostly “brand” marketing v demand marketing surprisingly.

Here is the chart that SaaS Capital showed with the relative performance of each of the 13 public SaaS companies.

So, it’s true for public SaaS companies but does high growth spell high valuations for private SaaS companies?

The answer is a resounding “yes”. In fact, even more so. For fast growing private SaaS companies, valuations have recently been over the top. In the public markets, the high multiple ranges but is about 10x-12x annual revenues.

In the private markets, a high growth SaaS company with “only” a 12x multiple could be a great deal for an investor. One of the companies I looked at last year had less than $5M in revenue but the pre-money valuation of the round when it was completed was in the mid $100M range – all because its YoY growth rate and its pipeline had grown so fast and it was in a very large and addressable market.

In contrast, a low growth SaaS company is in a precarious position. The authors of the SaaS Capital report cite a private SaaS company they have been working with that generated $11M in revenues and is profitable but only growing somewhere north of 10% per annum. The company was unable to find any interested strategic investors and is hoping to get a financial buyer to pay 1.5x revenue this year. If they do, I think they should consider themselves fortunate.

So, if you want a successful outcome for your SaaS business, by defnition it needs to generate high growth. To do that, you need the capital to invest in sales and marketing. And, as I have written about in previous blogs, in a high volume SaaS model, lead generation not sales capacity, fuels growth. This is one reason why I believe we haven’t seen any leading SaaS companies emerge that haven’t been venture backed at some point to fuel growth.

So, by definition, if you’re a SaaS company it’s incumbent upon you to find marketing personnel who are experts at lead generation. I know this is one of the critical hires in each one of my SaaS portfolio companies and it is becoming increasingly more difficult to attract this highly sought after talent.

Given the importance of lead generation for the SaaS model and company valuations, I suspect over the next few years, that marketers with proven lead generation skills in the SaaS market may see base + variable compensation on the same level as sales personnel.

I try to attend Dreamforce each year because a) Marc is entertaining, b) there is always something interesting that he announces and c) it’s usually pretty relevant to the companies and markets I invest in. This year, as expected, he announced several new offerings; one  that I thought was an especially shrewd move is  Free Chatter (good idea since SuccessFactors is gunning to own the enteprise collaboration market with its CubeTree  acquisition earlier this year. I think Lars Daalgard, CEO of SuccessFactors, is one of the few current high tech CEOs who can go toe to toe with Marc for showmanship!).

Another major new offering according to Marc, to be delivered in 2011, is Database.com. This is a new SaaS-based noSQL database offering that developers can use to create a variety of new applications. It supports a multitude of programming languages which is a departure from Salesforce’s more proprietary approach in the past. 

During his explanation of Database.com, it dawned on me that what I was hearing was Marc essentially endorsing and bringing to market a client/server computing offering – client/server 2.0, if you will. This is the very person who eschewed and spurned the client/server computing architecture in favor of “internet/web-based computing” a mere decade ago. 

Think about it. One of the fastest growing areas for application development is for mobile computing on top of Android, iOS, and, dare I say it, Windows Phone 7. Each of these applications are downloaded to a client device and communicate through an API/protocol to a backend server/filesystem. That, my friends, is by definition client/server computing.

Yes, it’s a different time/space and it’s a different architecture that helps obviate many of the issues associated with client/server 1.0. But, nevertheless, it is client/server computing. I found this to be extremely ironic. I wonder if anyone else was thinking the same thing?

The overall show was impressive and my portfolio companies are all very happy with the amount of customer interaction they had in the Expo. Just one  small complaint; Marc, in case you’re out there reading this — don’t you guys think you ought to retire the “No Software” positioning. It served its purposes in its day but I think everyone has figured out that Salesforce is all about software — and now, apparently, client/server computing.

Some firms prefer to invest in early stage v late stage companies. Some must be assured at least 20% ownership before they will invest. Some want to lead an investment. Some only want to follow another lead investor. Some only want to follow Sequoia.

Some have large funds where they must put to work a lot of capital. Others have smaller funds where a modest success in the portolio can deliver reasonable multiples for their Limited Partners.

As an entrepreneur, you would be best served by identifying up front what type of firm you’re meeting with and the fund they are investing from or you could be wasting your time. For example, firms investing out of a larger fund and focused on early stage deals  must find and invest in startups that have a reasonable chance of becoming larger companies so they can “move the needle” with respect to generating large returns.

You may have a great idea that addresses a legitimate market but if that idea is more of a single product idea or more of a “feature” v. a “company”, then a firm investing out of a large fund may elect to pass. It doesn’t mean you don’t have a great idea and a viable business opportunity but each investing partner only has a limited amount of time to devote to investing/managing their portfolio. They have to weigh the risk of making an investment of their time and money in a company that is more likely to generate a smaller return v a larger return.

What’s a large return? Well, again it depends upon the size of the firm/fund. For the larger brand name firms, we’re talking $100′s M/$1B’s. Big hits. For smaller funds, more modest returns are acceptable. If a firm investing out of a $100M+ fund can generate a 10x+ return from a $5M investment that will return half the fund. For a firm investing out of a $1B fund this return wouldn’t even begin to move the needle.

And, as a recent Silicon Valley Bank report stated, the data for the past 15 years shows that only 2 out of 10 VC-backed software start ups have been successful with a median multiple of 4x. There have been very, very few $1B+ outcomes over the past 10 years.

Another key concern for venture firms is liquidity — how long will it take for a company to grow to a reasonable size  so it can IPO and/or becomes interesting acquisition candidate?

With few exceptions, Limited Partners have seen little liquidity from the venture asset class over the past 10 years and are therefore putting tremendous pressure on the GPs of venture firms to deliver liquidity. Delivering liquidity sooner v later is critical to whether or not a venture firm can raise its next fund.

So, in addition to wanting to know how big a company you think you can create, entrepreneurs need to be prepared to discuss how they will grow their company as quickly as possible.

Here’s a good example of how this plays out. SaaS is currently an extremely hot business model. The top public SaaS companies get up to an 8x multiple (e.g. CRM, SFSF) v the top traditional software business model incumbents who get about a 3x multiple (e.g. ORCL, SAP, MSFT).

However, the data suggests that successful SaaS companies take at least 7 years - with 10 years not being unrealistic - before they are large enough to consider a liquidity event (e.g. IPO).  A venture firm needs to raise a new fund every 4-5 years. If a venture firm can’t show “realized liquidity” from its companies until after 7 years from initial investment, it may be tough to raise its next fund.

Also, a venture fund is typically formed and designed to wind down after 10 years. The GPs of the firm typically need to request permission to extend the fund (and to collect management fees from the fund) to manage portfolio companies beyond 10 years. If your company will be funded toward the end of a current fund and it’s going to take 7-10 years before you can expect liquidity (a typical SaaS company) then there could be pressure to liquidate earlier rather than later by your investors. So, you need to know whether or not your investor is going to hang in there with you to maximize the return of your hard work.

In summary, when you’re presenting your company to a venture firm, make sure in advance that you’re aligned with them in the following ways:

1. Your business opportunity (e.g size of market/potential size of company) fits with the investment profile of the venture firm.

2. You understand which fund the firm is investing out of; how big it is and how old it is.

As I have said before, raising money from a venture firm is an enterprise sales process. Know who you are selling to in advance of your meeting(s) and gain an understanding of what their motivations are. Don’t waste your time with firms whose funds don’t align with the goals/objectives of your company.

The general premise of the article is that SaaS point solutions or “best of breed” are going to eventually be replaced by suites – just as what happened with traditional enterprise software applications.

In the interview, Sino makes 5 significant points as they considered SaaS-based ERP solutions:

1. “The major problem with a best-of-breed ERP solution is integration.”
2. “If I’ve got three different best-of-breed applications supporting the process, how can I be sure the integrity of the data remains intact across all of them?”
3. “In essence, best-of-breed products would create a new set of integration challenges…”
4. “Support was another key consideration.. “
5. “Throughout the purchase process, cost was an overriding concern.”

Sounds pretty familiar doesn’t it? The issues that Sina outlines are identical to the issues that drove consolidation of traditional enterprise application point solutions.

His conclusion: “The overarching need for a business “truth” pushed us to a single suite solution that was capable of tying all master business data and processes together.”

Saugatuck Technology, a research firm, has also been predicting the arrival of SaaS suites sooner v later for some time. They predict that full SaaS suites become widespread toward the end of “SaaS Wave III” (2012-2013) and the beginning SaaS Wave IV (2013- ).

We’ve seen how this play turns out in the traditional software sector which is why it is fairly obvious why the market values SaaS companies CRM and SFSF at an 8X EV/Rev multiple.

• The investing environment / opportunities to sustain the growth and competitive advantage of the American economy
• The exit environment
• The capital raising environment for VCs
• The positive and negative impacts of rules and regulations on the venture community and its portfolio companies

I have my own agenda and it centers around the topic of liquidity. 

In my opinion, the root cause of all issues that are curently having the greatest negative impact on the venture business – and our collective ability to raise funds so we can invest in your companies - is tied to liquidity. Every regulation that gets in the way of supporting liquidity ultimately affects the economy, Limited Partners, portfolio companies,  and the venture community in general.  

In my mind, there are three things the SEC could do to make an immediate impact upon liquidity for small, private companies:

SarBox. According to my own experience and industry experts, companies can expect to pay at least $2M/year just to service SarBox expenses. Meeting SarBox requirements eats up a good portion of earnings and therefore makes it impractical to even consider an IPO unless you are a much bigger company. Proposal: Relax the reporting requirements for companies generating less than $250M annual revenue. The market will build in a discount to the stock price to account for the additional market risk. This risk can be socialized in the Prospectus.  

R&D Tax Credits. Proposal: Enable small companies to carry forward all R&D expenses generated as a private company as a future tax credit thereby enabling small companies that IPO to generate strong earnings as a nascent public company so that their balance sheets can successfully compete against the incumbents for investor support.

Employee Stock Options. In this unstable economy, small companies are finding it more difficult to attract employees from large relatively stable companies. And, with all the stock option scandals that surfaced earlier in the decade, it’s dampened the enthusiasm for companies to broadly disseminate stock options as a mechanism to entice employees to join/stay with a small company. Proposal: Allow all vested stock options to be treated as a capital gain, irrespective of the exercise/holding period.

Those are a few of my ideas. But, I am quite confident you will have even better ones. Why don’t you comment with your ideas and I will see if I can compile them into some sort of categorized/logical order and get them in front of the Commissioner.

Looking forward to hearing your suggestions.

While at the application level, it’s easy to view Salesforce.com as the star of that sector, it gets a little murky as you move to other functional areas of the front and back office as well as down the overall cloud ‘stack’. As with most nascent markets,  the market is highly fragmented: CoLo/Managed Services (e.g. Rackspace, OpSource, many others),  Infrastructure/Platform (e.g. Amazon, Salesforce.com, VMWare, many others), Tools (e.g. Salesforce.com, Corent, Serena, SAP/Coghead, many others), and some a mixture of 2 or more areas (e.g. Salesforce.com).

To make some sense of the trends, I attended a presentation last year by Bill McNee who is an industry analyst with Saugatech. I thought he did a particularly good job breaking the market down into sectors, segments and strategies. Here were some of his observations and predictions he shared with respect to the growth of cloud computing and SaaS at that time:

1. Core systems of record (e.g. Finance, HR and BI/EPM) are growing rapidly – both SMB & Enterprise are adopting.
2. International is beginning to grow.
3. Standalone applications is Wave 1, International is Wave 2, Workflow/Collaboration is Wave 3 and Measured/Monitored/Managed business processes are Wave 4.
4. Platforms are beginning to proliferate.
5. M&A will accelerate.
6. Customer satisfaction is generally quite high with high annual renewal rates.

Bill went on to say that their data showed that 70% of the companies with >100 employees would deploy at least 1 SaaS-based application by 2012. And, he believed that one of the biggest market opportunities would be SaaS-based BI/CPM which in 2008 represented about 17.3% market share and would grow to 40.7% by the end of 2010.

He also predicted that SaaS-enablement would lead to cloud development — which indeed is occurring. Salesforce.com’s announcement of Force.com last year and its latest quarter’s growth from that business is proving this out. In addition,  with acquisitions by companies such as SAP with Coghead last year and VMWare with SpringSource this quarter, we are now beginning to gain a sense for how this may play out.

For traditional software companies in the fight for ‘cloud’ leadership, the overriding issue that remains is the hostile business model that SaaS/cloud computing presents. Wall Street measures these companies by in-quarter revenue growth and margins. Deferred revenue and in-quarter expense are antithetical to those models. With Salesforce.com, they have been successful in selling to the Line of Business and primarily SMB’s (that’s where 90%+ of their business still resides). Selling a Platform/Tools to IT and larger companies is a big departure from that success. However, they recently hired some big sales hitters from Siebel Systems to help address that issue.

Here is some other data Bill shared with us based upon their market research polls:

1. 40% of large enterprises will seriously consider SaaS-based ERP, HR, order management, and procurement solutions.
2. 30% will choose a new next gen SaaS solution provider
3. By 2012, only 20%-40% of software will be sold under traditional perpetual license model

In support of this data, I  think we are beginning to see SaaS break into the back office — initially in SMB — just as Salesforce.com did with its CRM applications. Companies such as Host Analytics, SmartTurn, and Adaptive Planning are beginning to make  progress in an area that has traditionally gone unserved by the large enterprise ERP suppliers such as SAP, Oracle and Manhattan Associates.

However, even though we are beginning to see where companies are picking their spots to compete in the cloud/SaaS space, identifying the future master brand(s) out of this fragmented market is challenging. I would say, though, that the comments I made in a blog I wrote early last year titled “Global Market Leadership” are still germane to becoming the next ‘master brand’.  It may be one of the existing competitors we know about today or, in fact, it may come from a new entrant we have not yet seen.

That’s what makes this market so exciting.

Investing in Enterprise SaaS

As a result, large software companies whose innovation/growth strategy has relied upon a steady stream of start-up company candidates to acquire may be faced with a shortage in the not-so-distant future. Consequently, companies that have traditionally relied upon their strategic software providers to deliver innovative new solutions to enable them to further optimize back office and front office operations will suffer. 

A Spin on the Spin In

Given the current issues associated with the traditional venture capital business model (e.g. lack of liquidity) and the fear to invest in enterprise software start ups, and the innovation/growth pressures that the large software brands are faced with I believe there is a unique opportunity for the venture community and the large software brands to come together.- using a modified version of the classic spin in.

For this discussion I am defining a spin in as a company formed with the explicit endorsement and investment – including personnel, cash and IP – by a large software company and venture investors. The express purpose of the spin in is to build strategic products and/or go after new markets with the ultimate objective that the large software company will acquire the spin in at some point in the future.

The concept is relatively straightforward and has been tried, tested and proven most successfully in high tech by Cisco but it has also been used by companies in other industries as well as the federal government. However, this approach has not typically been employed by software companies.

Why? Well, primarily because there hasn’t been any need. Large software companies have had the benefit for years of relying upon the venture community to finance a plethora of competitive software start-ups that identify new markets, create innovative technology, and secure customers.  Once some/most of the technical and business risk s are removed and the 2-3 leaders emerge, the large software companies have been able to approach these  ‘winners’ and acquire one of them either willingly or unwillingly. This process has been used successfully by many of the larger brands including, but not limited to: Computer Associates, IBM, McAfee, Microsoft, Oracle, SAP, and Symantec.

Another reason spin ins have not been utilized much by the software industry is due to the widespread ‘Not Invented Here’ (NIH) syndrome that most successful software companies express. The attitude is typically “we can do this better, faster, and cheaper ourselves.”

However, the facts tend to conflict with the attitude.  As companies grow, few really innovative products are started, completed, and successfully brought to market. Each year when the products organization and executive team sit down to consider all the proposed projects for the following year, there is a finite budget to distribute. A line is drawn and all the projects that fall below the line go unfunded. The projects that are usually funded are those that are the current mainstay of the company; the ones that are most likely to generate short-term product and maintenance revenue.

The dilemma is that those projects that fall below the funding line could very well be the innovation the company needs to thwart competition and secure and grow substantial future revenue streams. In addition, many of those proposed, unfunded projects may come from some of the most talented personnel in the company. When those projects don’t make the cut, the people associated with those projects can become extremely frustrated and threaten to, and often do, leave the company to ‘pursue other interests’. This can put a significant brain drain on the company.

The framework of the spin in structure I am proposing is different from the more traditional approach and it is my attempt to address the issues of each of the constituents involved: the large software company, the venture investor and the “spin in” management/employees. While there are some financial/structural problems associated with the spin in derivation I am proposing (there are no panaceas) I believe the benefits could far outweigh them.

Product Selection

The key to selecting a specific project/product as a candidate for a spin in is to ensure the product is strategic to the success of the large software company and that the market opportunity is large enough to support an independent entity.  A product idea that is just a feature of a larger product suite is not a suitable spin in candidate. Think of it this way, if it won’t pass a venture capital firm’s due diligence as a sizeable, standalone firm it isn’t a viable candidate as a spin in.   

Financial Structure

There are several important elements required to make a spin in a viable financial structure for the large software company, the investors, and the employees. Below is my proposed framework for such a structure.

Ownership

The first objective is to ensure the spin in’s financials are kept off the large software company’s books and preventing it from diluting the large software company’s earnings while the spin in grows to profitability. To achieve this, the large software company must pass an outside auditor’s scrutiny demonstrating it doesn’t possess a majority and/or controlling interest. Practically, this means the company must own less than 20% of the spin in and cannot have a formal seat on the Board of Directors.

This is why the large software company needs the venture community as a strategic partner. The large software company can own at most up to 20% so it cannot execute this on its own. The venture community is the ideal partner because it brings money and expertise in building start ups.  

For some large companies, the lack of majority control makes a spin in a non-starter because they don’t have formal control. However, ultimate control comes from the fact the spin in is going to be highly dependent upon working with the large company to gain access to its marketing and distribution channels.  Doing anything to jeopardize that is not in the financial interest of the spin in’s management team and venture investors.

To attract a world-class management team and employees, the spin in will need to allocate a minimum of 20%-25%.

Therefore, simple math suggests venture investors will own up to 60% of the spin in at its onset and may need to provide up to 100% of the forecasted cash requirements. The large software company can contribute any one or all of the following: IP, key employees, marketing programs, a ready-made distribution channel, and even cash to account for its percentage ownership position.

Collar

The primary difference between the spin in structure I am proposing and a traditional spin in is the use of a financial “collar”. It is this collar that can ensure the large software company, the venture investors and the management team are incented to make the spin in become a successful business.

The terms of the collar I am suggesting gives the large software company a call option. This option includes a “first right of refusal” to purchase the company at a pre-determined multiple of revenue for a pre-determined period of time, thereby protecting the large software company from having to compete to buy the spin in on the open market.  This is only fair since the spin in will require the large software company to provide a significant amount of marketing and distribution support.

To ensure the large software company remains interested in the success of the new entity over the long term, irrespective of potential market and regime changes, the venture investors hold a put option to sell the spin in back to the large software company at a certain point in time at a certain multiple of paid in capital.

The collar can be structured such that the management team and employees are incented to drive a range of increased valuation outcomes tied directly to revenue and expense objectives. For example, the call and put options can be set such that they don’t begin to run until year 5. This gives the management team the ability to drive the company’s revenues as high as they can to drive a higher multiple if the call option is executed. If the put option is executed, the management team and employees only receive 50% of their equity ownership which incents them to make the business as successful as they can. Both options can expire at the beginning of year 8 so that if the large software company or the venture investors don’t execute their option, the management team is free to operate thereafter.

Although it is beyond the scope of this article, I have put together a set of terms and models with a variety of outcomes that show how this modified spin in approach is financially attractive to the large software company, the venture investors and the management team.

Summary

Software innovation is still needed by the large software companies and enterprises. For all the reasons discussed, large software companies are not able to do much real innovation internally. For at least the past 5 years, the venture community with few exceptions hasn’t been willing to fund new start ups focused on traditional enterprise software. And, due to current macro-economic conditions, the venture community is struggling with its business model.  As a result, I believe the enterprise software innovation engine could slowly grind to a halt if the status quo remains. I believe there is a unique opportunity for both of these communities to partner using a modified spin in approach. While clearly requiring compromise by all parties involved the spin in could solve a number of key issues that could enable the enterprise software innovation cycle to thrive.

The potential benefits of a spin in approach for large software companies are:

• Strategic projects that might not be funded because they are below the line are able to get funded.
• The cost of development is carried off the parent company’s balance sheet until such point the product is in the market and generating revenue so it is potentially non-dilutive to corporate earnings.
• The parent company is able to effectively retain key personnel by enabling them to exercise their entrepreneurial spirit.
• The spin in retains some of the parent company ‘DNA’ so cultural issues that affect most acquisitions are minimized.
•  The products that are developed can be managed such that they are architecturally consistent with the parent company’s products so there is little overhead integrating the “spin in” products.

 The benefits to the venture investors are:

• They can be certain the technology and business being created are interesting to the large software company from the onset, so they can invest with some confidence that the start up will ultimately have value v the typical 9 out of 10 failure rate they normally experience.
• While the upside will be capped, it his highly likely there will be a reasonably positive return within 5-8 years and therefore the investment will be accretive to the fund’s multiple and IRR.

The benefits to the entrepreneurs are:

• You will be funded!
• Lack of sales and marketing, not technology, is what typically kills most enterprise software companies. With a strategic investor/partner that is motivated to give you access to its customer base with a relevant offering this issue is mitigated.

I have shared this modified spin in concept with some executives at a few large software companies and I think I’ve heard all the reasons why it won’t work. However, as a former senior executive of a large software company, I haven’t yet heard anything to date that, with some work and compromise, makes the concept a non-starter.

So, I’m putting out a challenge to all those large enterprise software company CEOs and senior executives. Find that innovative project you’ve wanted get to market but for some reason just can’t get off the ground. I will share with you the full overview of this modified spin in model and why I believe it will work.

Wachovia Securities issued a report in May 2008 on the state of the SaaS market. On page 25, it shows amount of capital paid in prior to an IPO for 18 out of the 28 public SaaS companies. Here is that list below:

Blackboard                     $100.7M
Concur Technologies     $  30.2M
Constant Contact           $  37.3M
DealerTrack                    $  48.0M
DemandTrack                 $  42.0M
HireRight                        $  29.2M
Kenexa                            $  54.5M
LivePerson                      $  41.6M
NetSuite                          $  84.9M
Omniture                        $  66.9M
RightNow Technologies  $  32.2M
Salary.com                      $    5.7M
Salesforce.com               $  64.5M
Solera                              $   5.7M
SuccessFactors               $  54.5M
Taleo                               $ 36.9M
Ultimate Software            $ 25.1M
Vocus                              $ 26.4M

Mean                               $43.5M
Median                            $39.5M

So, it doesn’t really take $100M but the data seems to suggest it is still an expensive proposition. Let’s call it $40M — this is still 2-3X the amount of capital required for a traditional model software company to reach profitability/IPO.

However, this is where the details matter. It turns out that these public SaaS companies, on average, raised about $25M at strong valuation mark ups and invested this amount primarily on sales and marketing in the year prior to going public. For example, Salesforce.com raised $47M in November 1999 at a 224% step up in valuation and IPO’d just five months later in March 2000.

This makes sense when the data shows that Wall Street gives much better valuations (multiples that are possibly 2x-3x greater) to those SaaS companies able to demonstrate strong revenue and subscriber growth rates.

Consequently, if you eliminated this average $25M investment from the paid in capital, SaaS companies don’t look that much different from traditional software companies in terms of total capital required to either reach a liquidation event (e.g. IPO) and/or profitability.

All that said, SaaS companies do need to aggressively monitor and manage their customer acquisition costs (CAC). If Annual Contract Value (ACV is the expected annual stream of cash flows expected from each subscriber) is relatively low against the cost to initially acquire the customer, then the SaaS company can quickly get into cash trouble.

This is why I like my portfolio companies to constantly monitor and manage their customer acquisition to ACV ratio. A good target ratio to strive for is 1 or less — far less being the goal. That is, when you divide the total customer acquistion costs by the first year ACV, the resultant should be a number equal or less than 1. Customer acquisition costs should include: all direct and indirect marketing costs, commissions, and T&E.

In order for the SaaS business model to work, it’s critical to keep sales and marketing costs as low as possible. This means highly leveraged marketing programs that make the product as “viral” as possible — enabling current customers to easily tell others about the success they are having. And, sales costs must be kept down by using the website to answer as many questions as practicable, using customer video testimonials, self-service demos and web conferencing instead of travel for sales meetings.

In fact, if you’re a SaaS CEO, for 2009 I suggest you consider compensating your sales and marketing executives based upon achieving a pre-determined CAC/ACV ratio. This will force your sales and marketing organizations to work far more closely together — what a concept.