TheFunded is filled with critical commentary by entrepreneurs about venture capitalists and cite real life examples that reinforce this stereotype.

However, now that I have sat on the venture capital side of the table for 4 years, I can also attest to the fact that entrepreneurs can be culpable of equally egregious behavior.

When I accept a meeting with an entrepreneur, I realize this is highly valuable time that he/she could be spending doing something else – meeting with a customer, another vc, employees, etc. Consequently, I try to ensure I am properly prepared to engage by doing some homework on the company, the team, and the market prior to the meeting so I can ask relevant questions. At a minimum, I try to find out about the background of the CEO and if I have any connections to him/her through my network.

On the other side, you would think that an entrepreneur who is looking to me and other members of my firm to invest millions of dollars into his/her company would also invest some time in advance to know who he/she is meeting with and learn about our backgrounds. However, I have discovered this is more the exception than the rule.

To give you a real example, last week one of my business partners and I had a phone conference with the CEO and the management team of a “cloud-computing” company looking for a Series A investment. It didn’t go well.

First, the CEO called in late and his team didn’t know where he was or why he was late – turned out he was talking to a customer (which is great) but he should have at least let his team know that he was tied up and why – we could have started later. No problem.

Second, based upon the content of his presentation it was fairly clear to me he  had not reviewed my nor my partner’s backgrounds prior to the meeting and he certainly didn’t bother to inquire about our backgrounds during the meeting. He proceeded to waste valuable presentation time explaining to us how cloud computing works, how Salesforce had pre-empted Siebel with cloud computing, and then schooled us on IBM’s go to market strategy for cloud computing.

Had he done some minimal investigating prior to our phone call, he would have known my and my partner’s backgrounds (me with Siebel and his with 30 years at IBM) and he could have tailored his presentation — and would have had far more time to dicuss his specfic business.

Yes, I could have cut him off early and explained our backgrounds but I felt it was better to let him just go through his canned pitch and see where it took us. Unfortunately, it only got worse (e.g. the financial slide showed profit would eventually exceed revenues). The CEO was looking for me to invest $5M into his company and he didn’t show up on time, know something about the people he was presenting to, nor check his slides to make sure they were accurate.

At the end of the call, I sent him an email  telling him I was passing but I included a write up on the issues I saw with respect to his business plan and some things he might want to consider to make his presentation better for the next firm he presented to – so far, no reply whatsoever.

If this were just an isolated incident, I would just write it off  and wouldn’t have  bothered blogging about it. However, this type of interaction has unfortunately been more often the rule than not.

I am far from perfect but I try to at least be prepared for my meetings, engaged during them and provide a cogent response afterward – even if I elect not to invest. I have had entrepreneurs disagree with my conclusions and get angry with me when I tell them why I have chosen not to invest, but I feel it is important I continue to provide this feedback out of respect for the time the entrepreneur spends with me – even at the expense of getting skewered on TheFunded.

If you are an entrepreneur and you want a venture firm to consider investing $M’s in to your company, I would propose that you treat your meetings as enterprise sales calls – where you are trying to sell a multi-million $$ deal. You should know in advance who you are meeting with, their backgrounds, and the firm’s background so you can ask questions that will help you determine if there is a fit between your company and the partners/firm (e.g. relevant investing/operating background).

Venture capitalists, too, need to get their act together. We need to pay attention and provide relevant and timely feedback – even if we aren’t going to invest in your deal.

In the end, we are all in this “game” together – venture capitalists and entrepreneurs. In this especially difficult economic climate, both venture capitalists and entrepreneurs need to step up their collective game – be prepared – or there won’t be a game for either of us to play.

• 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.

I really enjoyed working with Cary because he acted as a member of my management team; he first focused on the business objectives I wanted to accomplish and then applied law to help me accomplish those objectives. He also helped me negotiate through a minefield of sticky issues like Vendor Specific Objective Evidence (VSOE) for revenue recognition and managing SLA issues.

Cary now has his own legal practice, Platkin Law,  and one of his specialities is helping SaaS startups. I asked Cary if he wouldn’t mind addressing a number of common legal issues that SaaS companies are faced with and he was kind enough to oblige.

Bruce:  What key terms should a SaaS Agreement contain?

Cary: SaaS agreements are typically subscription services agreements that address key customer concerns with service levels, security, privacy, and ultimately performance.   

More detailed SaaS-specific issues include: how mid-term add-on user subscriptions are handled; the details of the renewal process; whether support is bundled in or extra; what usage rules apply to your users; and how third party services are made available through your service.

There are many ways to address these issues depending on your particular business, but one thing is clear – SaaS providers need to ensure their hosting and other services vendors are providing “back-to-back” terms for the terms being offered to customers. 

If you use outside vendors to provision your service, it is critical that you secure the same or better terms from your hosting vendors than your customers will seek from you.   If your vendor doesn’t back you up on the commitments you’ll need to make, you’re really out on a limb.  On one hand, you might choose to manage your risk tightly by seeking a one-off exception from the hosting vendor, but this can slow the sales cycle.  On the other hand, you might choose to accept the risk, close your sale quickly, and make contract commitments that your hosting vendor cannot or will not back up.

Sometimes the risk is merely a matter of numbers that you can easily analyze.  For example, say your SLA is 99.9% with one day of credit for each one hour of downtime.  Your vendor has agreed to provide you the same basic SLA and credit, so you feel comfortable with that arrangement.  But what if a good handful of customers demand 99.99% and two days of credit for each one hour of downtime?  Your risk is merely the delta between the coverage you have from your vendor and the commitment your customers want you to make. 

Crunch the numbers and cross your fingers.

Sometimes the risk is more cut and dry.  For example, say your customer insists it must be permitted physical access to the hosting facilities and full access to the detailed SAS 70 Type II security audit reports on the hosting facilities.  If your hosting vendor limits physical access to its facilities and restricts your right to distribute the revealing audit reports (both common security measures), then promising these things to your customer is simply not possible without an exception from the hosting vendor.

So as you develop your contract terms early on, anticipate your customers’ demands, think through the details, and insist that your vendors get on board with your business and your customers’ needs.

Bruce: Speaking of SLAs, should a SaaS company offer a Service Level Agreement, and if so, what are the key terms they should spell out in the SLA?

Cary: Whether to provide an SLA or not is a business decision based on customer demands and competitive landscape.  Obviously, if you can avoid making a commitment, most lawyers will tell you that’s a good thing.

However,  I think SLAs are a critical element to successfully market a SaaS offering, and more and more, SLAs are required to adequately compete with both on-demand and on-premise alternatives.  If your SLA is world-class and you can make your current performance metrics constantly available to customers, your customers will appreciate it, even if your system goes down from time to time.

There are many types of SLAs, so the first question is what are you going to measure and commit to?  Support levels (response times for support tickets) and system availability are minimum requirements for today’s SaaS offerings.  You might also offer SLAs around reliability — number of outages or time between outages — or response time for your system’s ability to turn around input and output.  Beyond that, I think it can be a bit difficult to offer accessibility, performance or scalability SLAs because there are so many factors that contribute to these issues. 

In any event, most customers want the availability SLA and the performance warranty to run in parallel, so if the system is down for an extended period of time, the customer can max out its SLA credits, and still terminate the contract for breach of warranty if you are ultimately unable to fix the system.

When drafting your SLA, describe in great detail:

• the definition of metric being measured (availability, reliability, etc.); 
• how the SLA percentage is calculated;
• the permitted exclusions to performance, including scheduled maintenance, customer-caused problems, and other issues outside of your control; and
• how credits (or refunds) are calculated and applied to customer accounts.

One tip about credits:  don’t over-do it.  The biggest and best SaaS providers experience downtime events on a regular basis.  No one expects dial-tone availability, and you probably only marginally better than the customers’ own internal IT staff.  You don’t want one or two events to wipe out your business.  One day of credit for each hour of downtime is typical, but only after the system has already fallen below your target availability level and only for use with renewal terms.

Bruce: What terms do you feel should never be in SaaS Agreements?

Cary: I have been encouraging my clients to hold the line on accepting unlimited liability for confidentiality breaches. 

While security of the system and privacy of the customer data are critical customer concerns, you are not Fort Knox.  You can and should use the same type of security measures that other vendors in the industry use.  But if a hacker gets in despite these measures, is it really fair to hold you fully responsible for the damages?  If you said “yes,” then you agree that your monthly subscription fee is adequate to cover not only software and hosting services, but unlimited insurance against this common business risk.  Assuming you were able to buy insurance for this risk, how much do you think unlimited coverage would cost you?   Some multiplier of fees paid, up to a comfortable cap in the high 6 or low 7 figures, is probably adequate to close most transactions – why accept more and put your entire business at risk for something no one can absolutely guarantee?

You might be surprised to learn that other terms that might not be necessary in your SaaS subscription agreement are traditional software license terms.  If your offering is a pure multi-tenant hosted offering without any local client for the customer to use, then you are merely providing access and use of a service.  You are not licensing software in the manner most customers are accustomed to.  This is a subtle but important distinction for your template subscription agreement – SaaS is easier to sell when you continually reinforce the notion that this is not a software license plus associated hosting and managed services.  Rather, it’s a subscription service that is offered the same way to every subscriber.  There’s no delivery of software, no need for source code escrow, and most importantly for the multi-tenant solution, no custom hosting services terms often found in ASP or managed services agreements.  

Bruce: How should a SaaS company set up its Agreements from the beginning so it can avoid revenue recognition problems downstream?

Cary: I am not an accountant so I can only speak to the kinds of terms clients have told me are important to them.  First, SaaS providers know that revenue recognition is one of the great barriers-to-entry for publicly-traded enterprise software companies.  This is because subscription services revenue is recognized ratably over the life of the agreement as the services are performed, which runs contrary to the up-front revenue recognition model of traditional  software license deals.

Pure play SaaS providers build stable annual revenue streams that end up being more predictable.  So, the key to success with subscription agreements is to do all you can to keep the revenue flowing and renewing.    

Although revenue is recognized differently, accountants tend to care about the same issues that arise with standard software and services:  

• Acceptance terms should be avoided (the free 30-day trial and smaller up-front start-up costs have made this easier for customers to bear);
• Payment terms should not be extended too far into the future;
• SLAs should be achievable and warranties should be “documentation” based; 
• remedies for breach of these commitments should be credits on future services only, no refunds of fees paid;
• termination for any reason should result in refund of unused prepaid fees only, not fees for services rendered prior to the date of termination.
• future product commitments should be avoided. 

Bruce: What about multi-year Agreements? Should companies execute multi-year Agreements? If so, for how long?

Cary: Multi-year agreements are great for business — I haven’t met a person selling SaaS yet who preferred short-term subscriptions.  Multi-year contracts are typically procured through the use of higher discounts on fee that are paid annually in advance (or for unconvinced customers, quarterly in advance for the first year and annually thereafter). 

Customers being customers, they love discounts, but hate commitments.  So, I usually recommend terms that require the customer to pay the delta between the discounted multi-year rate and the higher short-term rate in the event it terminates the subscription mid-term or at the end of the shorter term.  SaaS providers with better leverage might even suggest some percentage of terminated subscription fees (up to 20%) as an early termination fee.

Bruce: If a SaaS company is planning to handle customers/data from the U.K./Europe/Asia, will they need make any special provisions?

Cary: This is a very complicated question that depends on many factors including where your company is incorporated, where your data centers and support staff are, where your customer is, where their end users are, what kind of customers they are, what kind of data they are uploading to your system, etc.

The easy answer is if you are a US company that has been selling to US customers, and you are suddenly selling into international markets, you should probably seek knowledgeable US or local counsel to work with your finance team to iron out required terms.

The most common issue that US SaaS providers face early on is Safe Harbor certification.  Many EU customers will not do business with a US company holding personally identifiable information unless it warrants that it complies with the UE-EU Safe Harbor framework.  Participation in this program requires annual self-certification that your company complies with security and privacy standards set forth by the US Department of Commerce at www.export.gov/safeharbor.  I do caution clients not to over-commit to the customer here – EU customers have their own requirements to comply with privacy regulations.  When you are holding and processing data on behalf of your EU customer, you can only really commit to security terms, but issues related to the direct relationship between your customer and its individual end customers can only be managed by your customer.  A simple example:  if privacy regulations provide that the individual should have the ability to “opt out” of marketing programs that use their personal information, only your customer can manage this obligation, so it is not likely that you are in a position to help or hurt their compliance with this regulation.

Bruce: Are there simple things  a SaaS company can do develop a easy, scalable contracting process?

Cary: Perfecting the contracting process is often overlooked, but it can have such an important impact on close rates, cash flow, and customer satisfaction.  From a legal perspective, the easiest thing you can do to close contracts quickly is to use fair, industry standard terms that meet or exceed your customers’ expectations.  For each term in your subscription agreement, you should know not only the industry standard and your customers’ expectations, but also how much risk you are willing to tolerate.  Your law firm’s standard software or services agreement probably won’t do here.  You really need to think through each of the issues, or you’ll learn the hard way as customers begin to question certain provisions with each new deal.

 From an operational perspective, you’ll want to use an automated contract management system that integrates with all of your company’s workflows.  As such, you should solicit input from all of the company functions that touch this important process:  sales, sales operations, finance, legal, provisioning, and support.

If the offering is marketed to the low-end of the SMB market, then an online transaction system with a posted click-to-accept subscription agreement is ideal for an easy, scalable solution.  However, this is rarely sufficient for my clients – even if they can use an ecommerce system, there are always clients who want to negotiate terms or even use their own agreements.  So there has to be an exception process, and an 80-20 goal (or better) of closing as many deals as possible without business or legal exceptions.

I find that the best contracting structure for most SaaS companies is a simple page or two order form generated out of a sales order processing system.  The order form should contain all the applicable customer information, products and pricing being purchased, and a space for one-off terms applicable to the deal (future discount provisions, early termination rights, etc.).  And most importantly from a legal perspective, it should state that acceptance of the order form (by signing the form, emailing acceptance, or issuing a PO) constitutes acceptance of your posted subscription agreement (including the URL).  The posted subscription agreement can in turn reference other posted policies such as support policy, SLA, security policy, etc.  You should have a Word version of the subscription agreement and the related policies available for prospects that request the ability to redline.

Finally, your lawyer can help you minimize legal fees for negotiations by helping you prepare tools that empower non-lawyers to close deals with standard exceptions.  These tools may include:

• a list of regularly-used alternative business and legal terms,
• a “playbook” that describes the purpose of the various clauses in your contracts and provides alternatives,
• an approval matrix to ensure that the right people around the company are approving exceptions to standard terms.

* * *

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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.

• Object-oriented development environment for rapid prototyping and application development.
• “Out-of-the-cloud’ integration with other applications developed on the platform
• No need to invest in commodity operational infrastructure such as “ping, power, and pipe” and disaster recovery services which can be expensive to set up yet completely non-differentiating.

So, if you’re a SaaS application developer or investor, what’s not to like?

Well, first let’s talk about the SaaS business model.

One of the key drivers for this model to generate profits similar to traditional enterprise software companies is the ability to amortize the cost of the service over your customer base. As your base grows, the infrastucture costs/customer  or COGS/customer must be able to decline to a point where they represent just a few percentage points of gross margin.

If those variable costs remain relatively fixed at a high percentage of each user, then the SaaS model – which is already a difficult one to reach profitability quickly – is weakened substantially. I suspect the PaaS providers will ameliorate that with a discounted cost as your user counts grow.

So, while a critical issue, this isn’t the primary concern I have with PaaS providers who also sell their own applications. The real concern I have is the potential downstream conflict of interest.

What do I mean?

Let’s say you’re a developer and you see a big opportunity to build a solution for widget management. So, you build a widget management application using the tools/platform from your favorite PaaS vendor. Initially, everything is just great — you’re up and running quickly and you don’t have to hire a bunch of ops people to run your 24/7 widget managemet application software application.

You quickly begin to grow because your widget management application solves a legitimate business problem. At some point, your PaaS provider – who knows everything about your installed base because they manage your infrastructure – becomes aware of the growth you’re achieving in the widget management market and decides that they, too, want to enter the this market. “Overnight” they are no longer your “friend/partner”, they are now your chief competitor.

And, unlike Microsoft, which both partners and competes with its development community, your PaaS vendor knows everything about your customers – who they are, usage rates, adoption rates, etc. And, they can decide to “work less cooperatively” with you. You no longer get return phone calls to your support issues. You don’t get active cooperation with the product organization. Etc, etc.

Now you are really stuck. You’ve built your application using their development environment and their platform. What do you do? Your only option is to rewrite the application and get it moved onto another PaaS provider that doesn’t also sell applications — as fast as possible. This could be a very onerous undertaking and potentially not survivable.

So, unless you’re a company that is going to build applications for small markets, I would have to think long and hard about tying myself so closely to a company that might end up being my biggest competitor.

I would want to understand the warrantees, the SLA, the financial remuneration policies available to me before I embarked down this path. I’m sure this isn’t what Salesforce or NetSuite want to hear but it is definitely an issue that needs to be addressed head on if they want to achieve their PaaS objectives.

I had an opportunity to meet and get to know Sarah in 2004 because she did a long story about me and Siebel’s entrance into the OnDemand market.  I have a lot of respect for her and her opinion. However, I take issue with a few of the conclusions one might reach by simply reading this article and taking it at face value.

On Demand or SaaS isn’t a panacea, it’s a business model. Companies won’t succeed simply because they are SaaS-based. You still have to build a compelling application that solves a real business problem that people will really use and pay money for.  However, what the SaaS model has done is to give customers the ability to try a few seats and then “walk away” with relatively few sunk costs when a vendor fails to deliver real business value. Under the traditional enterprise model most customers needed months/years to do a pilot — which seldom gave them a complete picture - and once they committed they were committed forever because of the psychological and financial investment. So big projects like Oracle, PeopleSoft, Siebel, etc. rolled on even when it was clear that the customer wasn’t happy with the expense or the value.

What I can say as a former traditional enterprise software executive who had to be “retooled” for SaaS, is that SaaS companies need to sell, market and support differently than traditional enterprise software; this is where a lot of firms are getting into trouble. Many don’t have executives who are experienced with SaaS and they attempt to do it the way they’ve always done it (hence the reference to getting on planes in the article — you can’t afford to do that with most SaaS models). Instead, you need to couple a strong direct inside sales program with a product that can have a somewhat viral element or a strong partner program that helps to substantially reduce the cost of sales and marketing over time. And, a customer success team that is compensated to ensure people use the service and are happy with it.

By my count, there are 27 public SaaS companies that have figured out how to build a compelling application and deliver it profitably via a SaaS model — and they didn’t each take $100M of capital to get there.  As Sarah reported, there are a lot more that haven’t and probably won’t.

Venture Capitalist Gives Entrepreneurs Advice

Top Ten Questions:
1. Tell us about your Venture Capital Company.
InterWest Partners was established in 1979 and is a leading diversified venture capital firm currently investing InterWest IX, a $600 million fund. With more than $2B in capital under management, we take a long-term, collaborative approach to venture funding, providing early-stage and ongoing capital, management development and access to a broad network of resources.

InterWest is the lead investor in more than 70% of the investments we make, reflecting our ability to marshal resources and organize financings on behalf of our portfolio companies. We maintain relationships with our portfolio companies for an average of 5 years and in some cases for 10 years or more. An InterWest general partner serves as a director for 85% of the companies in our portfolio, often continuing to serve even after the partnership’s investment in the company has been returned.

2. What is its focus?
Our partnership invests in Life Sciences and Information Technology companies. Within the Life Sciences market, we invest in pharmaceuticals, biotechnology and medical devices. Within the Information Technology market, we invest in multiple sectors such as: semiconductors, telecommunications, consumer and enterprise software, infrastructure and wireless/mobile.

3. What is your minimum and maximum investment?
We invest in companies at all stages depending upon the circumstances. Where we have a strong relationship with the management team and/or know the market very well, we have made early stage seed round investments of $500K or less. InterWest, though, typically expects to invest an average of about $7 – 15 million over the span of our involvement with each company in our portfolio. We invest in companies through the full range of venture investment stages, and investments may be staged over several rounds of financing. Although we generally begin our involvement in the early stages of a company’s development, we pursue attractive opportunities based on their individual merits rather than their investment stage.

4. What do you typically look for when assessing a Business Plan?
At the macro level, we look at the following key criteria.
• Total Addressable Market – is the market large and growing and if so, can it be reached in a capital-efficient way?
• Technology – does the company have unique and defensible intellectual property?
• Management Team – has the management team worked and won together previously?
• Distribution – does the company have a powerful and compelling strategy for rising above the competition to become the recognized global market leader?

5. What do you typically look for when assessing a team?
• Is each member of the management team an expert in their functional area?
• Is the CEO credible and in command of the facts of her/his business?
• Do you have a credible financial model that shows you’ve really thought about the revenues/expenses of the business beyond plug and crank formulas?

6. How long does it typically take to go through the investment assessment process?
If we are very knowledgeable about the market and have a prior relationship with the management team, the process can take as little as two weeks. If we need to do a deep dive on the technology, the market and the team, it can take up to 60 days. Many times, we may elect to pass on the current opportunity to invest but stay involved and help the team for a year or more while they make progress against their plans only to invest once some of the more critical milestones have been achieved

7. How does your VC firm support its portfolio companies and founders?
The answer to this question depends upon the specific partner in our firm and her/his particular investment strategy and/or background. Many of us are former CEOs and/or senior operating executives and therefore are available to help our portfolio companies identify and hire key executives, compose strategic product and marketing plans, attract key board members, structure future financing rounds, etc. In all cases, we work as a team across our entire portfolio and can solicit advice and advisors in areas outside any one of our individual core competencies.

8. What is the best way to get your attention and stand out from the crowd?
Deliver a presentation that answers the questions I proposed in Answer 4 above and a demo (if applicable) in less than 1 hour. Read Guy Kawasaki’s blog titled “10, 20, 30”. He does a masterful job telling you how to pitch a potential investor.

9. Any advice for entrepreneurs relating to getting VC funding and support?
What follows is a long answer, and may be repetitive to some, but I hope it provides you with better insight into what drives the venture community. As an operating executive for the previous 27 years, it wasn’t until I joined a venture firm and had the opportunity to learn the business model that I fully understood what motivates most venture firms and partners.

First, when you meet with a venture capital firm, you need to remember it is nothing more – or less – than a high level sales call. Only in this case, the product you are selling is yourselves. As a result, just as you would prepare for an important prospect visit, it is equally important for you to do research on the firm you are presenting to: each firm is different and you need to understand their history, track record, the partners in general and the specific partners you are meeting with so you can adjust your presentation accordingly.

Unlike one of your typical prospect sales calls, however, where there is always someone who is “the decision maker”, partnerships are different. With few, but notable exceptions, there is no one “in charge” or who is the decision maker. In almost all cases, all the partners are equal in status – although informally some partners are more equal than others due to the fact they have been around longer and may have a longer list of successful investments. As a result, while one of the partners may decide she wants to invest in your company, she must convince the rest of her partners to vote favorably before the investment can be made. To do that, she needs to do due diligence and in many firms involve one or more of her partners in the process so that they are sympathetic and supportive of the investment. Each partner has a financial interest in the overall profits of the fund – called “carry” – that motivates them to be interested in any and all investments each partner makes. Therefore, each partner evaluates every investment opportunity brought into the firm and must weigh that opportunity against others the firm might make before voting positively to make the investment. Again, there are exceptions to this structure but by and large this is how it works. You should attempt to discover the firm’s investment/decision making process in your first meeting or as early as possible.

The one thing that is universally true among virtually all venture firms is that that they must answer to their Limited Partners. Limited Partners provide venture firms with the capital to invest, pay management fees, and run the firm. Limited Partners include entities such as large pension funds, family trusts, banks and other financial institutions and wealthy individuals. Limited Partners consider venture capital one of many asset classes they can invest in and, unsurprisingly, are seeking only the firms with the best investment records; while venture firms seldom share information about their results beyond their Limited Partners, Limited Partners have no qualms about sharing the results of their venture firm fund investments and generally make these available to the financial community at large. A venture capital firm’s track record against other investment asset classes and against other venture capital firms will dictate whether or not it can raise its next fund and survive. Most Limited Partners seek to invest in venture capital firms that are in the upper quartile of returns against all other venture capital firms – as measured by multiples of capital invested and Internal Rate of Return (IRR). Generally, Limited Partners want to invest in venture capital firms that have a sustained and successful investment track record with partners who they have met and known for many years. Partner turnover is a negative. Partners without a long, successful investment record is another negative and works against the firm’s ability to raise its next fund.

Partners are measured by their peers inside the firm and by the fund’s Limited Partners for the quality of investments they’ve made. Unfortunately, it usually takes at least 5 years before a new partner’s deals will mature to a point where the firm will know whether or not those investments are successful. As a result of this and the fact that partner turnover is viewed negatively, firms are very conservative about who they hire, who they fire and when.

Against this backdrop and at the very macro level, here is what the partner who is sitting across the table from you is considering. First, she knows that for the majority of successful venture capitalists, 8 out 10 of their investments will fail – are you 1 of those 8? She also knows that 1 out of 10 will just return capital – is that your company? She also knows for her firm to successfully raise its next fund, the overall fund must return at least a 2-3X multiple ($500M fund must generate $1B-$1.5B) and at least a 15% IRR (this is a rate of interest over time so the faster you return capital, the better your IRR – great companies that take many years to liquidate [e.g. IPO or merger] may have a great multiple but compromise IRR).

If each company, over time, requires an average of $10M of invested capital and 8 of them fail and 1 just returns capital here is how the model breaks out: $80M in 8 companies that are complete losses = net loss of $80M, $10M invested and $10M returned from 1 company = $0, and $10M in the 1 remaining investment. To that, the fund must also cover her yearly management fee (e.g. salary), overhead and expenses. So, assuming $10M for the remaining investment, this one investment must return the $90M+ to cover all previous investments/expenses/management fees and then generate approximately another $90M+ just to produce her share of a fund that returns 2X capital. By the way, a 2x fund depending upon the year it was started may not be in the upper quartile. And, all of this has to happen within 7-10 years of the original investment to generate a good IRR.

So, if the 1 remaining investment you own is 20% of a company that IPO’s with a market cap of $1B within 5-7 years, you will generate an overall 2x multiple of your 10 company investment portfolio with a nice IRR. Although it’s finally getting better in 2007, the problem with the IT market for the past 6 years is that only a handful of companies met this criteria (e.g. Google, Salesforce.com, Riverbed, Skype and a few others). Most failed outright and those that managed to hang on had no IPO opportunity to liquidate and few M&A opportunities to capitalize upon. Ouch. With few exceptions, only those venture firms that were diversified outside IT have managed to do well with their 1999-2002 vintage year funds.

This is why most top tier venture capital firms won’t/can’t invest in just any company/idea – even if it’s a reasonably good one. Our business model compels us to invest only in those companies we truly believe can be large (e.g. at least a $500M market capitalization) and/or where we can have significant ownership. For example, a company that becomes $500M in value but where we only own 5% doesn’t really help the fund/firm. This is why many firms won’t invest if they can’t have at least 20% ownership or if the company can’t achieve at least $250M in market capitalization – even if it’s a great idea, in a great market, with a great management team.

And, sometimes, even if you’ve got a great idea, team, market, it may just not be an area that is interesting to the specific partner you’re presenting to. If they pass, ask for an honest answer as to why (if they just didn’t like you/team, you will seldom get an honest answer), and move on.

So, now that you have a better appreciation of the business model and characteristics of how partnerships work, take a long look at your presentation/business plan and see if you’re covering off the issues that the partner you’re meeting with is facing.

10. Any advice for entrepreneurs with their startups or early stage companies?
1. Focus on executing against one thing. Get the entire company behind that one thing.
2. If you are a technology company, spend a significant amount of time thinking about your marketing and distribution strategy – nearly all technology companies can build a product that works but most don’t have a clue how to create a marketing and distribution strategy that compels companies to buy from them – ask yourself, “how will we rise above the rest of the industry to become the acknowledged global market leader.” Clue: the answer isn’t Google adwords.
3. If you feel you need venture capital, only seek out firms and partners that align with your business/management philosophy. If you fail to attract any firms that meet your criteria to invest, re-read my Answers 4 and 9 above and modify your presentation and try again. Don’t just move down to a lower tier of firms – you may get the money but you will more than likely fail because you didn’t really get the formula right.