With Cornerstone OnDemand’s recent IPO (NASDAQ: CSOD) and their high valuation based on a negative EBIDTA, many are starting to ask if we are headed for a second Internet or SaaS Bubble?

I do agree that some of the valuations at this point are a lot higher than a reasonable person would expect, but this is probably just pent up interest in the technology sector. It doesn’t help that Facebook and LinkedIn has seriously pumped up the valuations for Internet/Social Media firms, but today’s SaaS companies are very different from the Dot Bombs of 1999/2000.

Remember these companies?

All of these companies were built on bad business models, too much money and expectations that were out of control. And by the way are all out of business.

But not all of the Internet companies that were formed during this period were bombs; in fact there are a number of firms that are now pillars of the technology industry including these firms:

It would be safe to say that each of these companies struggled during and after the Dot-Com collapse but they were able to modify their models to take advantage of the efficiencies that the Internet provided. Amazon has built a business that can effectively compete against the largest retailer in the world, Walmart, even though its sales are only 1/12^th their revenues.

All of these Internet Survivors had to develop a real business model that would deliver solid margins, profits and growth. They each had to assemble experienced management teams, learn how to deliver superior customer service and build trusted brands. Not easy to do, but they did it.

Fast-forward to today and we have a whole new set of Internet and Software-as-a-Service companies that have emerged and gone public including these firms:

(1) CSOD IPO: March 17, 2011

(2) SREV IPO: March 25, 2011

As you can see most of these companies were founded before the Internet Bubble burst and were forced to create real business models that could deliver profits.

At Montclair Advisors, we specialize in SaaS business advisory services and we know many of these firms quite well and they all have strong management teams, growing businesses and staying power. Unlike the Internet firms that went IPO in 1999 or 2000, most of these firms have had to build up their businesses over ten or more years and are based on some form of recurring revenues.

Major differences between the companies on this list versus the early Dot Bomb firms include:

• Proven Over Time. As you can see most of these firms are at least ten years old and have weathered the economic changes through the last two recessions.

• Businesses at Scale. Most of these companies are over $100M in annual revenues, which means they have been successful in selling into multiple markets and geographies.

• Recurring Revenue Streams. Anyone who has been involved with a company that has developed a subscription business can tell you how hard it is to create a meaningful recurring revenue stream. The advantages of being a SaaS software company based on subscriptions means that revenues remain consistent so there is a high degree of transparency and visibility.

• High Degree of Customer Satisfaction. All of these companies are dependent on satisfied customers that want to renew their annual subscription agreements and purchase more services. This is quite different than the ‘drive-by’ relationships many of the early Internet companies developed with their customers.

• Strong Management Teams. After the Dot Com crash it became much harder to file for an IPO and manage a company in the post Sarbanes-Oxley world. These next generation of Internet companies have attracted leading management expertise that knows how to innovate and rapidly scale viable businesses.

So are the valuations of companies like Cornerstone OnDemand and Servicesource, Facebook and LinkedIn too high? Are we beginning to see a SaaS Bubble? Maybe, but all of these companies have been built for the long term and will be around long after any correction, unlike their early Internet cousins Web Van or Kozmo.com.

By Kevin Dobbs

Montclair Advisors, LLC

Dreamforce 2010 was in San Francisco last week and there were a lot of announcements and it is only now that I am starting post my thoughts.   This post is going be around Force.com 2 and how Salesforce has rethought their approach, repackaged their platform and now have relaunced their PaaS.

This table provides a quick summary of how Salesforce has repackaged the Force.com 2 Platform.

What is interesting is that several of these offerings are just new packaging concepts and several are net-new products.  Let me walk you through the suite:

Appforce

This is basically the original Force platform using their proprietary 4GL, point-click-language APEX that has been repackaged as a departmental application platform.  What is interesting is that this environment is not just for departments, large enterprises like Japan Post and Thomson Reuters have done very large Cloud development projects using this platform.  I think that Salesforce realizes that due to its proprietary nature, most organizations will be attracted to Force.com but would prefer a more open and portable development environment.  Applications built with Appforce are also able to be easily integrated with Salesforce’s collaboration capability Chatter

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Siteforce

This is a development environment specifically designed for building websites without having to write code. There was a great demonstration of how you can build and modify websites, even for mobile devices, using their drag-and-drop interface.  This will be popular with firms that do a lot of campaigns and need to design a lot of landing pages which can be tied back to Salesforce.  Like the Appforce products, Siteforce can be linked to Chatter to add social and mobile features to websites.  This was an existing capability inside of Force.com that has now been exposed as a new offering.  The marketing materials we were given state that there have been more than 20,000 website built using Siteforce.

VMforce

This platform is a result of a partnership with VMware, that opens up the Force.com platform to more than 6 million Java developers.  Using VMforce, developers can now run their Java-based applications on the Force.com platform, similar to what they would do it they were using Amazon EC2.  Developers can also use Java IDE’s like Spring or Eclipse as well as other open standards.  With my clients, this is a popular approach, it provides some leverage with existing Java-based apps as well as professional developers prefer to develop in this type of environment, rather than using a 4GL point-and-click product.   VMforce is currently in beta and will be ready for general availability in 2011.

Heroku

In a really interesting move, Salesforce went out an purchased a leading provider of Ruby-on-Rails for $212M in cash, $27M in stock and another $10M for un-vested employee shares.  Like VMforce, Heroku will offer developers a way to write applications using Ruby and then run them on Force.com.  The rumor was that VMware had made a run at the firm several months ago, but wanted to remain independent.  Marc Benioff in his keynote indicated that Heroku would remain independent from Salesforce, I am assuming in the way VMware has remained independent from EMC.  Several benifits for Heroku as part of Salesforce will be access to their 87,000 customers as well as their technology stack including Chatter.  Today, there are more than 100,000 websites and applications written using their platform including BestBuy and FlightCaster.

ISVforce

In another re-packaging move Salesforce has taken the Force.com platform and created a new program to help larger ISV’s to build their next generation applications on top of their PaaS.  This is a program that contains services and tools to help Independent Software Vendors to move their apps to the Cloud. Salesforce provides development services, trails and provisioning, connections to AppExchange and application monitoring along with their multi-tenant Infrastructure-as-a-Service.  Some early adopter ISV’s include Blackboard (who did a quick little demo), BMC (RemedyForce) and CA (Agile Vision).

AppExchange

Salesforce continues to promote their on-line application marketplace, which is similar to what Apple offers with their App Market, and how has over 1,000 applications available. Some interesting facts provided by Salesforce about the AppExchange include there have been more than 360,000 application test drives through the AppExchange, nearly 700,000 application installs and more than $1B invested in companies who are on the AppExchange.

Database.com

Another interesting announcement is that Salesforce has gone into the database business.  When I first heard this, I thought it wasn’t necessarily a good idea, but then I read that they were just repackaging a gigantic Cloud-based version of Oracle and selling the database by-the-slice.  Apparently Oracle thinks this is not a secure approach to selling databases, but let’s see how this all works out.  Amazon has something similar with their RDS offering.

The result is that Salesforce now has a suite of offerings that are designed to meet the needs to enterprise customers, software companies, professional and casual developers.  The strategic benefit of all of these offerings is to open up several new revenue streams for the company and continue their leadership momentum in the Cloud.

There were a number of keynotes at last week’s All About the Cloud conference that focused on Public and Private Clouds and the market. What was interesting is that the typical hype associated with Cloud Computing appears to be calming down. It seems like it is no longer necessary to justify or explain the Cloud, or at least for the audience at that conference. According to Gartner the Cloud Computing market will be $150B in IT spend by 2013 as compared to $56B in 2009 and is the #1 Strategic Technology for CIO’s in 2010

The new Cloud attitude appears to be more about ‘when’ and ‘how’ enterprises will be utilizing Cloud solutions rather than ‘if’.

Coexistence is ‘In’

The other interesting change, which I first noticed at the end of last year at both OracleWorld and Dreamforce, was that everyone seemed to be talking about co-existence or hybrid uses of the Cloud with on-premise assets. This more reasoned approach is going to make more sense to CIO’s and business executives to who have spend millions building out their infrastructure over the past 10 years. Cloud can be complimentary. Starting with fringe or edge applications and then over time becoming more useful for mission critical functions.

The Consumer Cloud

Tuesday’s press panel with [insert names] focused mostly on the use of the Cloud for consumer applications like Facebook, Google, Amazon, eBay and future offerings like iTunes LIVE and Microsoft Office 2010 (launched on May 12^th). Cloud is everywhere but the average consumer doesn’t even know they are in the Cloud. With the advent of ubiquitous broadband access, smart devices and massive data centers, there are all sorts of Cloud based consumer services emerging. But the market is still evolving because the Generation X’ers are plugged into the Cloud but as Kevin O’Brien from Oracle said in his session, ‘My mom still doesn’t know what the Cloud is’, and she is probably isn’t alone.

Private Clouds

There were many sessions that discussed how there is money to be made in the Private Cloud market. You can have many of the advantages of the Public Cloud without the security and control issues. IDC projects that by 2014, $11.8B will be spend on servers to create Private Clouds, considering overall IT spend in the US is approximately $1T, that’s not big percentage today, but it will be in the future.

Scared of the Cloud

Are CIO’s scared of the Cloud because of their potential for loss of control, security issues and resource impacts? Several sessions touched on this aspect of the Cloud Computing market including CIO’s creating hurdles to adoption.

Given the cost and scalability advantages why wouldn’t organizations like the State of California quickly adopt Cloud based solutions? What about the switching costs like decommissioning your own data centers, software and restructuring personnel. If you already own PeopleSoft and it is working, will you really be open to a Workday ‘rip and replace’ scenario? Enterprise organizations are warming up to the idea, just ask Flextronics.

One panelist cited a recent Google Docs deal that went sideways at UC Davis where they scrapped their trial for several thousand users. Maybe there were other considerations than the Cloud but most of the sessions agreed that the benefits of the Cloud outweigh the risks and CIO’s are starting to think in terms of intelligent trade-offs instead of just being against the Cloud. This is probably smart, given the recent economic conditions and every CEO is looking to optimize their IT spend.

Cloud 2010 and Beyond

Cloud is just the new thing. According to Bill McNee at Saugatuck Technologies, their most recent Cloud Computing survey indicated that 86% of the respondents thought that the Cloud would be part of mainstream IT by 2014.

There appears to be reasonable optimism that Cloud Computing is not a fad and its going to happen, it’s just going to be the way people are operating today in the future. The Google Docs business is adding 3,000 new companies a day, that doesn’t seem like a fad. According to Gartner, their Hype Curve for Cloud Computing showed that July 2009 was the peak and it really appears that the market is maturing about the Cloud.

Venture Capital firms are only funding Cloud-based start-ups and large technology companies like Cisco, CA and IBM are buying SaaS and Cloud based companies (like CastIron Systems) because they realize they need to overcome the ‘Innovators Dilemma’ around the Cloud. There will be an increase in successful SaaS and Cloud companies as the market continues to mature, as well as a lot more M&A activity.

As one speaker so aptly described the current market situation for many companies when evaluating Cloud Computing, ‘When a piano falling from the sky, you should be worried more about will it hit you not where it is while it is falling.’

As Zach Nelson kicked off last week’s Netsuite’s Partner and Developer Conference – SuiteCloud 2010 in San Francisco, there was a real focus on the importance of their platform as a way for partners to play a critical part in helping to take his company to the next level.

They kicked of the special launch event that featured a video of some of their key partners including TrueCloud, InsideView (who has been profiled in this blog), Aria, Hein & Associates, PaceJet, RootStock Software and Demand Solutions Group.

I think it is great with companies are building their business around their partners and creating a cool ecosystem where everyone can make money… more on that in a minute.

Zach then covered some Cloud Computing trends;

· Fake SaaS – He compared the NetSuite offerings, which are Cloud-based to Microsoft’s GreatPlains offering which is just a hosted version of their same on-premise offering. Still single tenant, version locked and requires Citrix to make it work like a true SaaS application. These types of business models will find it almost impossible to make money using a Fake SaaS. Other vendors mentioned here were Lawson and SAP.

· SaaS-based Financial Systems Are Popular. He showed a Gartner market slide (from 2008) that showed NetSuite as the fastest growing FMS provider.

· Traditional License Software Firms Are Hurting – This is nothing new because Saugatuck Technologies, Ray Wang from Altimeter and Montclair Advisors have all written about this but this slide says it all…

Customers are moving away from the old software model.

· The Cloud can now handle complex business processes. This has been demonstrated by vendors like NetSuite, Workday (Flextronics), Amazon AWS and SuccessFactors (Siemens) servicing very large and complex clients.

· Customization is no longer the Achilles heel of Cloud applications. In fact, it was argued that customization with NetSuite is now a killer feature of their Cloud offerings.

· Channels are emerging as an important component of a successful Cloud business model.

· The Cloud is getting social. With applications like Twitter, Facebook, LinkedIn, blogs, Fluid, Mzinga, InsideView, applications are more focused on communities and content than ever before.

There was a funny segment that discussed the complexity associated with the development of years of on-premise software, which he called an infrastructure hairball. It is much more cost effective to manage a single architecture, database and system of record. He mentioned that the cost of managing an SAP system (ala hairball) was approximately 3% of a company’s revenues, while operating their system was only 0.1%.

Then Zach got back to the partners and referenced a number of applications that are being built on top of the NetSuite platform – SuiteCloud , like RootStock Software’s MRP application. Other providers who have integrated into SuiteCloud include Amazon Web Services, Google, InsideView and HostAnalytics.

I thought the most interesting part of this session was when they brought IRON Solutions and NewHolland on stage to discuss the vertical application they had built on top of SuiteCloud.

New Holland has approximately 9,800 customers and they wanted to automate and enhance their relationship with their partners/distributors. They started working with NetSuite in 2007.

IRON Solutions is the Kelly Blue Book of agricultural equipment and offered a very complex product configurator along with CRM capabilities that allowed distributors better create and manage pricing and leads. They launched their new products built on NetSuite, IRON HQ for new product promotions, IRON Builder for pricing and lead management, IRON Guides for appraisal and trade and IRON Search for promotion and sales.

New Holland wanted to balance both the science and art of their business to move more of their customers to the web. Darwin Melnyk, CEO from IRON Solutions and David Greenberg from NewHolland whipped out their iPads and demonstrated their new applications.

Increasingly these type of vertical partner applications are going to be popular with customers looking for more tailored solutions for their specific businesses. NetSuite has more than 200 channel partners and sales through their channel has grown by 40% on a compounded annual basis. Which is quite healthy given our recent recession.

New partner announcements included;

· ISV/OEM’s – JCurve Solutions

· Systems Integrators – Hein & Associates (a Top 50 CPA firm), Fujitsu that is forming a strategic relationship for Japan with NetSuite and WIPRO who is building a practice around NetSuite OneWorld.

· BPO – GenPact is building an ERP Outsourcing business on NetSuite

I mentioned at the beginning why working with partners like NetSuite can be really profitable and with their new SP100 program, channel partners can get 100% of their first years revenue when they move older client/server applications to NetSuite.

Overall, it is nice to see major players embrace their partners and give them an opportunity to build their business and help their partner - a real win-win for everyone.

In Charles Darwin’s landmark work on the Theory of Evolution, he stated that “…Natural selection acts only by taking advantage of slight successive variations; it can never take a great and sudden leap, but must advance by short and sure, though slow steps.” Based on what has been happening with our economy over the past six months, the Human Capital Management software world is going to be forced to do a quick evolution.

Times are tough; just consider the global economic slowdown over the past three years. In 2007 it was the sub-prime mortgage crisis, in 2008 it was the Banking crisis and in 2009 we are beginning to see the Human Resources crisis.

This is very different environment for HR professionals than the old War for Talent era that was discussed by industry experts over the past five years; this current crisis is more related to a dramatic reduction in jobs in the economy and unemployment approaching 10%. Human Resources related budgets and headcount have been cut way back in an effort to stem the financial tide. Unfortunately most companies were not ready to eliminate anywhere from 5-30% of their workforces overnight. Not only were they not prepared for this change but they probably don’t completely understand what the future impact of their actions will be for their workforces. These dramatic changes have left HR in a precarious position looking forward because they have little in the way of staff or resources but their charter remains the same.

HR’s Rapid Evolution

As someone who sold HCM software for the last 12 years, it was always part of the sales pitch that the HR organization is always expected to do more with less. Now that the environment has really changed, when senior executives now say to HR, ‘do more with less,’ they really mean it.

Just like in natural selection, the HR survivors need to evolve. So in this brave new world, you no longer have the level of resources that that you have taken for granted for years. Resources like IT support, capital dollars in your annual budget, a team of people to work on projects and time. You may ask, how do I evolve? With dramatically less people, budget and basically the same responsibilities, you need to automate as much of your workload as well as your personal interactions. In this new world, the human touch is going to be at a real premium when it comes to HR.

Well - now that you are completely depressed, let’s review some ideas on how you can be an HR survivor. Did you know that most companies have up to 200 different HR suppliers, depending on the size of your company? Do you really need all of them? Since you are now in a zero sum budget exercise, start looking at your operating expenses as one big pot of money and start determining what is essential and what is optional. As you start your process, you need to free up budget to fund critical automation projects that can enable HR to continue to push along its strategic objectives. This may actually be a process that your IT business partners might actually be willing to help you with, since they are feeling HR’s pain like never before.

Natural Selection

So as you start thinking about your natural selection budget project, you should start to build out your game plan by trading out your old software for new software. My general conclusion about software is simple, old software is bad and new software is good.

Let me explain…

Many of the current Human Capital Management software providers evolved from PeopleSoft. PeopleSoft was the leading HR software provider in the market for nearly twenty years and spawned a complete suite of Enterprise Resource Planning applications including benefits administration, payroll and other HR applications. When PeopleSoft was purchased by Oracle in 2005, Oracle became the dominant provider but they appear to have no clear future plans for their HR software. So you need to continue to pay maintenance for old software, which keeps getting older.

When thinking about natural selection for HR software, think about the clear disadvantages in the current environment for your old school software provider:

• Software requires a large capital investment. This might be really difficult to get funded in our current environment, no matter how critical the software is to your company’s objectives.

• Implementation projects are both long and complex. Lots of investment to support customization and an expensive team of consultants who will live on-site for months or years. The consultants have to install your software in your data center, which will require a significant investment in hardware and infrastructure.

• Massive software upgrades. Whether it is moving from PeopleSoft 8 to PeopleSoft ? or to the latest version of SAP, these upgrades are expensive and require a lot of internal support resources and a big hardware investment.

• Lack of flexibility. The older software providers typically have rigid products, which make it tough to make even basic changes to features, reports or anything else. This is also a big disadvantage of buying all your HR software from a single vendor, like Oracle or SAP.

• Don’t play well with others. Ideally all of the software works together to make it easier to configure workflows, data elements, reports, and analytics because your data is sitting in a lot of different systems. If your software isn’t open to working with other systems, it can get really expensive, and you don’t have any budget to glue everything together.

Now you can see why old software is bad… and why they may be going the way of the dinosaur in the next 5-10 years. That’s right, even Oracle and SAP. Remember MSA and McCormick & Dodge!

What attributes should you be looking for in your future surviving HCM software suppliers?

These survivors have these clear market advantages:

• Software-as-a-Service. You have probably heard this term but it is simply when the software company rents you the software and you subscribe to their service the next 3-5 years. Because of this approach to delivering software as a service, SaaS firms are forced to be more cost-efficient because they get paid over time. SaaS software is delivered to your users through the Internet, which means your IT department doesn’t have to have to buy or support any software or hardware – this can save your company a lot of money.

• Long-term relationships. Because you rent the software, your SaaS provider has a vested interest in keeping you happy because you will want to continue to renew your subscription to the their software. Unlike old software firms who would sell you their software and disappear, SaaS firms are encouraged to stay close their clients and listen to your input.

• Incremental changes. It was not only the expense but also the tremendous organizational disruption associated with large software upgrades that customers really dislike about the old software model. SaaS clients enjoy a ongoing stream of transparent upgrades, that fix bugs, add features and their software literally evolves over time.

• Less extra costs. Since SaaS providers host their software in their own data centers, your company doesn’t need any IT staff to support their software or infrastructure (servers, firewalls and security) typically required to run HR applications.

• Configuration. SaaS firms offer more flexibility in the way they set up your software. Unlike the older software firms that bring a cast of thousands to customize and install your software, SaaS companies can set up an initial version of your software in minutes or hours rather than in months. Then once they understand your business needs, the software can be configured without custom programming. This approach saves you both time and money.

• Open for business. In this new world it will be difficult for any company to purchase every type of HR software from a single provider, so it is important for software to communicate and share information with many different software packages. This sharing will enable you to automate as many HR tasks as possible, allowing you to do more with fewer resources over time.

Slow Evolution of HCM Software

A little known fact is that the original Software-as-a-Service provider is Automatic Data Processing. They have been delivering payroll and HR services as a service, for nearly fifty years. Their offerings started out as a basic payroll service and their internal software just helped them to deliver their service more efficiently to their clients.

In the 1990’s, the next generation of on-line solutions appeared - where on-premise software was transitioned to being hosted in providers’ data centers (commonly referred to as Application Service Providers). A number of HR ASP software providers emerged including: Employease, PeopleSoft eCenter, and Workscape.

Then about ten years later, the conversation evolved from just hosting traditional software and a new model emerged - on-demand software, that provided a pay-as-you-go pricing model along with streamlined upgrades and new support processes. Some of these on-demand providers included: Authoria, Kenexa, SumTotal, Stepstone and Ultimate Software.

Then just a few years ago SaaS providers started to gain momentum. These firms really looked at delivering their software truly as a service and never delivered it on premise, sold in the traditional way. The HR SaaS providers always delivered their software over the Internet, with a modest amount of services, no upgrades, per-employee-month pricing and self-service support. Many better known HR SaaS providers include SuccessFactors, Taleo and Workday.

The next generation of HCM software might be based on Cloud Computing, where the SaaS providers no longer own their data centers and use providers like Google or Amazon.com to deliver world-class infrastructure support at on a pay-per-transaction fee. This approach could drive down costs, complexity and make a wide range of traditionally expensive HCM software much more affordable for small and medium-sized businesses.

Darwin Speaks

The HCM software market has undergone a number of wide ranging transformations over the last thirty years. We come back to the premise of old software is bad and new software is good. Old software is bad because it is expensive to maintain, modify and upgrade. Software teams that have the experience of working on traditional software but now working at new companies where they are using modern techniques might find it difficult to make their software better, faster and cheaper.

As you think of your portfolio of HCM software providers, maybe Darwin could help. And if Darwin were alive today, and knew about Human Capital Management software, I think he could put many of your company’s providers into these categories:

• Endangered – they are doing some of the right things to turn themselves into survivors but haven’t turned the corner just yet. These are the providers you need to keep a close eye on, just in case they become extinct.

• Extinct – those providers who are on the downside of innovation, living off of your precious maintenance, old architectures, delivered on premise and probably won’t be around for the long term.

• Survivors – those software firms who are worthy of your investment and will be in the market for the long term.

I listened to an interesting panel discussion at the Opsource, SaaS Summit a few days ago and I thought I would share what I heard.

Venture capital panelists were from Intel Capital, Emergence Capital Partners, CrossLink Capital and Hummer Winblad Venture Partners and Merrill Lynch.

New Investments

Seems like there was no agreement from the panel about what stage of investment was the most popular given the downturn.   There were several Series A and Seed investments that were mentioned including Crowd Factory and Zuberance.  One bright spot for investors was the fact that OpenTable has filed for an IPO, which would be a good step in the right direction given 2008’s anemic IPO performance.

Zombie Venture Capitalists

Most of the panelists had done some investments in the past six months but it is clear that SaaS entrepreneurs need to be on the look out for Zombie VC’s, who are still operating but are no longer making investments.  These walking dead  have their lights on, they have websites, and cash to support existing investments but no longer have enough cash to add new portfolio companies.  In writing this post I even discovered that peHUB publishes a list of these Zombie VC’s.  If they haven’t made any new investments during 2008, then I would be careful about wasting any time with these firms.

Flat is the New Up

One phrase that was uttered more than once is that ‘Flat is the New Up’.  Although when it comes to Software as a Service…  it appears that ‘Up is still Up’.  Even in 2008, most publicly traded SaaS companies have bounced back from their lows by an aggregate of 20%, which is much better than the S&P 500.  Apparently Wall Street likes SaaS companies and now are valuing them at 3 to 3.5 times their recurring revenues, unfortunately at the beginning of 2008 that number was closer to 8x.  Keep in mind that this is better than a lot of public firms that are currently trading at their cash values.  Other Wall Street analysts are valuing SaaS firms at 12x their cash flow but it is difficult to understand if there is a consistent valuation metric that firms or investors should be using.

Another interesting development is that Venture firms are now forced to value their private portfolio the same way they would value a portfolio of publicly traded stocks due to new accounting regulations (FASB 157).  Based on the discussion this new regulation, it will only create more company valuation compression on top an already tough market for portfolio companies.

What Does a Good Investment Look Like?

So what are the VC’s looking for in an attractive investment in this market?  Apparently the same things they were looking for in the past; a game changing idea, the team, the product and a big market.   If you are a software company you better be offering a real SaaS solution or be leveraging the Cloud Computing to even be considered.

They are also looking for new portfolio companies to be more conservative about spending their precious cash.  There is now an overt trade-off between the rapid growth rates of the last five years and capital efficiency to provide a longer runway for portfolio companies.  The panelists indicated that they would like to see their new Series A companies, for example those who might raise $4 million, to survive at least for 18-24 months before going out for their next round!  With the difficult market dynamics it is important for SaaS firms to form a strong syndicate when raising capital because your next round will be an insider round.

The panel indicated that they are looking for operating executives who know how to manage cash and scrub expenses.  Another observation was that many of the early stage companies that they are seeing now are much more mature and well run than they were just a few years ago.

There also won’t be any more Salary.com (NASDAQ: SLRY) IPO’s of $15 million companies.  IPO candidates will need to be $50 to $70 million in revenues and ideally profitable before filing their S-1.

For public SaaS companies you are going to see a slow down in the rapid growth rates we were seeing from companies like Salesforce.com (NYSE: CRM) and SuccessFactors (NASDAQ: SFSF).  Public markets want to see profitability first and growth now comes second.  Momentum stocks, those with high growth rates were trading at 8-9 times revenues, like Salesforce and SuccessFactors, are giving way to slower growth companies that are profitable and are given a multiple on cash flows.

Customer Acquisition Costs

When building your SaaS business model, it is important to assume that for every dollar of recurring revenue you will probably need to invest $.50 to $1.00 in your Customer Acquisition Costs (CAC). It is important than ever to have an active program of testing various CAC channels and tactics to maximize your investments.  Then you need to have a smart statistical framework that you can explain to your investors.

Smart firms like EchoSign and YouSendIt are creating leads virally by infecting their customers and they are finding that they are finding 1/3 to 1/2 of all of their leads are generated organically.   It is also important to leverage distribution channels, especially companies that have access to large customer bases like Salesforce.com, Google, and Intuit.  Take more of a focused approach to your customer acquisition efforts by targeting a vertical market and use the power of your customer referrals because ‘word of mouth’ is the least expensive and most effective lead generation engine.  Keep in mind that your sales process needs to be as easy as possible, in other words it needs to be ‘friction-less’.  When your prospects sign up for a trial, it only takes a few minutes and weeks and they can do it without any involvement from your company.  Give them a free trial, a sandbox a free version.

So I came away from this panel discussion with the following advice for companies looking for funding in this environment:

1. You need to still need to have a great idea, product and team but you might need to have reduced risk for your potential investors.
2. Demonstrate your company knows how to stretch a dollar as far as possible.  Fewer employees is better… think Craigslist.
3. Show traction.  Number of transactions, members, customers, revenues, profits.
4. Shop carefully for your potential investors and don’t waste time with Zombies.