Since everyone is interested in SaaS funding and valuations I thought it would be helpful to tell you about an interesting Cloud Computing investor panel I attended at the recent All About the Cloud conference in SF. The session was moderated by Jason Green from Emergence Capital Partners and was joined by Gary Hromadko from Crosslink Capital, Mark McNay from William Blair and Evangelos Simoudis from Trident Capital.

So what did they have to say?

The market has finally changed for the better

2009 was all about survival and the venture community did less than half the investments than in a typical year.

This year is now about growing again and current investments are more focused on companies that have weathered the economic downturn. Their investments are focused on changing the slope of these types of company’s growth curves, by concentrating more on sales and marketing.

SaaS and Cloud companies are leading the way

Consumers have been driving the adoption of easier to use Cloud-based solutions like eBay, iTunes, Facebook, Twitter and LinkedIn. They are viral and can reach critical mass very quickly because there are low barriers to adoption.

With SaaS, the recession has really pushed the advantages of a subscription business model and moving from CapEx to OpEx software investments. It’s like leasing your car rather than buying it.

Lean start-ups are definitely in. Almost all early stage software investments in 2009-10 are Cloud-based because it takes a fair amount of capital to fund SaaS firms and it takes a long time for them to reach profitability. One interesting comment was that later stage on-premise companies are now being asked about what their SaaS/Cloud strategy is for the future, because without it, they may find funding might be difficult.

What the VC’s are looking for

SaaS 1.0 focused on a company’s income statement, expenses and cash flows than GAAP reported financials. One important measurement is a company’s incremental contribution margins (gross margins), which is critical for SaaS. Companies needed to balance capital efficiency with building a business that can scale.

Investors are looking for unique business processes that can only be built or automated through SaaS or the Cloud. Emergence latest investments are pure Cloud-based companies that have viral qualities like YouSendit, the files sharing company and Yammer and the enterprise micro-blogging firm, both of these companies are viral enterprise solutions. Yammer has more than 70,000 customers with at least 1 user and is signing up between 7-10,000 users a month and 10% are turning into paying customers. Crosslink invested in Carbonite, a backup and recovery company, has high margins and is the only other independent player in the category with Mozy, who is owned by EMC. They felt that scarcity of competitors and their ability to manage Customer Acquisition Costs were important in establishing the company’s value.

The panelists also said they are looking for companies that have a rigorous focus on metrics like Customer Lifetime Value and Customer Acquisition Costs. In fact CAC appears to drive business value because it has a lot to do with capital efficiency and the company’s ability to grow their business.

Exits, IPO’s and Valuations

Economy has recovered and CEO’s are ready to start taking on more risk, and it’s a real change in psychology because we are at the beginning of a macro trend that will last more than 10 years.

This is evident by more than 100 M&A transactions last quarter including high profile deals like IBM buying CastIron, Salesforce buying Jigsaw for $142M, Successfactors buying CubeTree for $50M. The current environment is right for deals, especially as SaaS is gaining enterprise momentum with recent deals like SuccessFactors’ mega deal with Walmart for 1.6M users. Transactions like Jigsaw, CubeTree, and CA’s purchase of 3Tera and Nimsoft for $350M all indicate a return to a healthy M&A atmosphere, that will probably last for the next 12-18 months.

Oracle and SAP won’t be aggressive on the M&A front until they come to the realization that they can’t build Cloud solutions internally. Because many SaaS companies have now crossed the $25-30M in recurring revenues threshold, these firms may become quite attractive to these larger ISV’s looking to make the move to the SaaS business model.

But these acquirers don’t want to take on the burn associated with many start-ups so it will be important to stay close to breakeven and you may have to sacrifice growth for profitability. Since the access to capital is still tight, start-ups will have to try and collect cash upfront and continue to tune their business models to improve cash flows.

Companies that seem to own a category have perceived scarcity value which will result in a premium on any transaction, especially if they are perceived to own a segment franchise. VC’s and acquirers are looking for a minimum of 40% CAGR to get a premium valuation.

On the other side of the liquidity front, the IPO window for SaaS companies is beginning to open up and firms like SolarWinds and LogMeIn have now been joined by SPS Commerce and Convio. At least before the recent stock market downturn, these companies had traded up by 15% since their IPOs.

The panel seemed to believe that the market is definitely getting better and that is good news for SaaS and Cloud Computing companies looking for funding or an exit!

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.