“Every generation a chaotic event occurs reordering the players and their equity value.”

Jim Armstrong, Managing Director, Clearstone Venture Partners on SaaS

Justin Perreault of Commonwealth Capital Ventures says SaaS, along with developments in mobility and other corners of the cloud market are driving a renaissance in venture capital.

Forward thinking investors and boards wanting to capitalize on the higher valuation for SaaS companies are investing in new SaaS companies and moving their on-premise companies to pure SaaS or Hybrid on-premise/SaaS models.  Venture Capitalists have shifted funding from on-premise software companies to  SaaS, Big Data, and Mobile software.  Private Equity groups are seeing major opportunities to fund traditional on-premise software companies to move to a SaaS model and reap heightened valuations.  Financial firms are getting comfortable monetizing SaaS subscription revenue stream helping SaaS companies reduce their working capital requirements.

This “sea change” in the investment community’s attitude in embracing SaaS has occurred due to numerous SaaS company successes, improved understanding of working SaaS business models, and the lust for high investment returns from successful SaaS companies

Top 5 reasons why Investors and Boards are driving to SaaS

1)  SaaS Company Valuations average 2.25 times higher P/R ratio

SaaS companies’ Price to Revenue ratio on exit is 2.25 times that of on-premise companies according to the Software Equity’s M&A report.  This understates the relative value of SaaS companies to on-premise software companies as SaaS companies are rapidly being acquired by large software companies to accelerate their transition to SaaS while traditional software companies are less likely to be acquired at any price.  Even if the transition to SaaS resulted in a revenue decline of 30%, the greater P/R ratio on exit would yield a 58% greater valuation.

2)  Private Equity is flowing into software companies transitioning to SaaS

Many software equity firms are aggressively pursuing a strategy of seeking software companies with good fundamentals, making significant investments to fund the development of new SaaS offerings for the company and to provide the working capital to cover the cash flow decline during their transition to SaaS.  The conversion of an established on-premise software company to SaaS can result in a large increase in valuation with a moderate investment.

3)  Investor are getting comfortable with SaaS business models

Certainty of the SaaS business model has been a barrier to Software companies adopting a SaaS model.  Most early SaaS companies had a negative EBITDA and consumed cash for years.  The successful SaaS business model is much better understood today both from the perspective of being better able to project the long term profitability and cashflow, and understanding of the key factors in obtaining this profitability.  Investors now have the historical records of successful SaaS companies enabling them to better assess the potential of new investments.

a) Cost of Sales as a multiple of the number of months of Contribution Margin

b) Weighted Attrition expressed as the percent of lost revenue for the period

c) GP% of Subscription Revenue (World Class cost of providing SaaS services is 10%)

d) Growth in Revenue under Contract

e) Growth in MRR (Monthly Reoccurring Revenue)

Investors that rigorously track the crucial SaaS KPIs (in addition to the standard software business KPIs such as the sales pipeline) will have good visibility into the health and potential of the SaaS business, and allow them to intervene if the company needs help.  The improved certainty of the SaaS business model and the superior exit valuations of SaaS companies are driving many more SaaS investments.

4)  Finance institutions are beginning to finance SaaS revenue streams

One of the greatest obstacles to the adoption of the SaaS model by software companies has been the inability to finance the negative cash flow resulting from the deferred receipt of subscription revenue.  Banks and other financial institutions routinely financed receivables, but had not been willing to finance contract revenue streams.  With a better understanding of the risks of SaaS reoccurring revenue streams, finance institutions are now beginning to allow companies to monetize their contractually assured subscriptions helping reduce the working capital requirements of SaaS companies.

5)  VC software investments have moved from on-premise to SaaS companies

Investments in traditional on-premise software companies have become scarce as VC investments shift to the Cloud. These investments are resulting in a new crop of SaaS companies creating new products that are now entering the market.  As Leo Spiegel of Mission Ventures stated, “SaaS offers a whole new generation of competitors — SaaS will become dominant”.   These new offerings are greatly expanding the range of available SaaS products providing a SaaS alternative to on-premise software in nearly every segment of the software market.

Next — Part VII, “Conclusion: Why 2013 is the year of the SaaS Explosion”

The post The SaaS Explosion of 2013: Part VI – Investors and Boards Get on Board appeared first on .

Software vendors see their growth opportunities in SaaS.  New software companies are based on SaaS, mobile, or big data — not on-premise software.  These new companies such as Salesforce, NetSuite, and Workday are the darlings of the software business by virtue of their technology, high growth, and rapid innovation .  They will erode the market share of their on-premise competitors until the legacy vendors strike back with superior SaaS products.   While it is hard to make the transition from an on-premise to a SaaS model as discussed in Bruce Cleveland’s blog, the innovative ISVs will make the transition.

Top 5 reasons why Software Vendors are moving to SaaS

1) Market benefits drive software vendors to SaaS

In competitive markets, SaaS vendors enjoy better market positioning.  As discussed in my prior post, customers are moving vendors to providing cloud solutions.

• SaaS opens new sales opportunities to prospects with SaaS requirements
• SaaS has “buzz” and positions the company as an innovator, not a laggard
• SaaS provides the ability to expand with new channel partners looking to jump on the SaaS bandwagon
• SaaS vendors are much closer to their customers than on-premise vendors since they are an integral part of their customers’ daily operation allowing the ability to continually market to them.

2) The business benefits of SaaS are compelling

• The win ratio for new business is higher for SaaS companies — NetSuite and Salesforce both have higher close ratios than their on-premise competitors
• The sales cycles for selling SaaS is generally half of an on-premise solution since the customer commitment is less and they are looking at a shorter implementation time
• Development cycles are shorter for SaaS companies enhancing the company’s ability to deliver market leading products before their on-premise competitors
• The overhead to support prior software revisions are eliminated for pure-play SaaS companies reducing development costs

3)  Big software companies now get it

• The traditional software vendors such as Microsoft, Oracle, and Sage see the SaaS imperative and are investing heavily to support SaaS products.  These companies see their greatest growth coming from the cloud and are investing commensurately.   .
• These large companies are investing in SaaS growth with their ISV partner community by acquisition and by marketing/co-marketing spending.  Some Microsoft products have a co-marketing budget of five times their on-premise products per dollar of revenue.  There is a big opportunity for ISVs to leverage the Cloud investments of the software behemoths.

4)  We finally understand how the SaaS model (should) work

While many SaaS companies have had a tough time reaching profitability and becoming cash flow positive, the elements to make a SaaS company financially solid are becoming better understood.  The promise of SaaS is to build the flywheel of a reoccurring revenue stream while keeping the upfront costs (sales) low enough to generate sufficient operating margin to pay the company’s operating expenses.

We know the essential four KPIs to make the enterprise SaaS companies viable:

1. Cost of Sales expressed as the number of months of contribution margin for the deal
2. Gross Profit of the Monthly Reoccurring Revenue (MRR) (after cost of service)
3. Attrition
4. Monthly growth in MRR & Contracted Revenue

If you show me these four metrics and their trends, I can tell a lot about the viability of the business.

There are a huge number of other important factors including other fixed cost (like development costs) and cash flow both which can sink a company.  Joel York provides a good reference to the most critical SaaS metrics.  David Skok provides an excellent guide to SaaS financial goals.

This is a very complex topic, but there is much less risk today in SaaS businesses because we understand how we need to perform to make them successful.

5) Avoiding death is a good thing

While people can debate the timing, the software industry is moving to the Cloud.  The speed of the transition will vary greatly depending on the specific market and size of companies served.  Clearly there will be long term requirements for on-premise software just like there is still a market for mainframe software years after its peak.  I’m not so sure there will be any real activity in client/server systems by the end of the decade beyond sustaining efforts (after all, COBOL and RPG still exists).

I just wouldn’t want to be running those legacy businesses.

Coming Next — Part V, “VARs and System Integrators get on board”

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