BeyondVC

Startups and financial models for SAAS companies

The other day I met with an entrepreneur I was advising as he prepared to raise his next round of funding.  In the meeting, he wanted me to narrow in and focus on his financial model.  Financial models for startups are important from a big picture perspective, but I never like to get mired in the full details as things always change in the early stages.  So first and foremost, I let him know that while it was nice to have a well thought out spreadsheet, that the most important thing was getting the product developed and the right team in place.  I don't invest based on detailed spreadsheet models - getting comfortable with the team, the problem being solved, and the market opportunity are more important in the early days.  Secondly, what is most important for me to understand is the expenses and what milestones will be achieved with this first round of funding and whether or not it would be suitable enough to raise the next round of financing.  Finally from a big picture perspective, I like to understand the unit economics of the business - can this really scale, is the company capital efficient, and are there high or low gross margins.  While the revenue model may change as well, I like to at least understand going into the investment that the entrepreneur's head is in the right place and that the economics work right from the start.

Given my experience with SAAS based companies like GoToMyPC (Citrix Online now) and LivePerson (Nasdaq: LPSN), we also spent some time discussing key financial metrics for SAAS businesses that he should pay attention to as he ramped up his business.  Once again, no startup spreadsheet is going to accurately predict the future, but it is imperative to understand some of the key variables that will drive your business so you can prepare early on to have the right people in place and the right focus.  In my mind some of these key variables include new bookings, growth of deferred revenue, churn rate, cost of acquiring new customers, and obviously cash.  New bookings are a better indicator of sales growth for a SAAS company because typically contracts are signed for 1 year or more and the revenue is recognized monthly as the service is delivered.  So if a SAAS company signed up $1.2mm in bookings for December, it may only recognize $120k each month.  The remainder would go into deferred revenue.  Another area that is quite important is churn rate.  If your company churns or loses 5% of customers every month, then during the course of the year the company will have to replace a significant number of customers just to maintain status quo.  What this tells a company is that they while focused on adding new customers, they also have to make sure customer satisfaction is up to snuff and that they keep their existing customers happy.  Also if your cost of acquiring a new customer is high and breakeven is longer than the contract length, then your company will never be financially stable if you cannot keep your customers on board.  Finally cash is an important metric for all startups - watching the burn rate and being proactive about it can keep you fighting through the lean times and prepared for growth.  While many SAAS companies may collect cash monthly or quarterly, some collect annual fees by offering discounts by paying upfront.  This is a great way for SAAS companies to keep the cash coming in earlier so they can use it to fuel growth.

The Googlization of IT

Today I took a sales team from a portfolio company to meet with a couple of senior IT executives at a major retail company.  Towards the end of the meeting, it started to become quite clear to me the effect that Google and the web has had on IT to date and where it was going. In an oversimplified way, it seems that there have been 3 distinct phases to how the web and Google have impacted the enterprise, first starting at the app layer and increasingly diving deeper into the core infrastructure.

Phase 1 - Consumerization of IT - all internal corporate users are consumers first and then employees second.  we have all seen how consumers have gotten used to using browsers and SAAS-based applications and how successful startups have been able to provide web-based applications that users can pull into the enterprise environment starting at a department level rather than having to go out and sell and push technology into enterprises.

Phase 2 - Rise of open source - I would call Phase 2 the rise of open source software over the last 10 years - most of which is hardcore infrastructure type software such as databases, virtualization software, and the like.  IT folks leveraged the web and Google not just for applications but also to download core software to help run their internal operations.

Phase 3 - Googlization of IT - have as much of your infrastructure as you can run like Google's - distributed, commodity-based, and in the cloud on a private basis.

Phase 1 and 2 are ongoing and Phase 3 is where I see a few of the more forward-thinking IT departments I have met with over the last few months going.  I am not just talking about Google Apps (like email, etc) but about how companies can run their infrastructure internally like Google.  If Google can deliver a number of highly scalable web-based apps by clustering commodity servers, then how can enterprises do the same for themselves.  This is not about getting sucked into buzzwords on the cloud but really understanding the cost savings and performance benefits a company can get from transitioning some of their infrastructure to a Google-like model. 

One company in my portfolio that is leading the charge in the data warehousing space is Greenplum.  A customer can buy our data warehouse, cluster commodity servers like Google, and get petabyte scale and much better performance for less than the cost of maintenance of many existing solutions on the market today.  In addition, large global companies can have these nodes accessible to anyone anywhere in what we call the Enterprise Data Cloud.  One of our large customers said that data was a strategic weapon and that he wanted to make the cost of a running a new query zero.  In today's world and without the enterprise data cloud initiative I can tell you that running new queries in a global organization is an expensive and time consuming task of replicating data, creating data marts, running the processes, etc that can take months to get going and days to run reports.  Another company in which I am an angel investor is called Eucalyptus Systems whose tagline is your hardware, your data, your cloud. Eucalyptus is an open-source system for implementing on-premise private and hybrid clouds using the hardware and software infrastructure that is in place, without modification.  Eucalyptus adds capabilities such as end-user customization, self-service provisioning, and legacy application support to data center virtualization features, making IT customer service easier, more fully featured, and less expensive.  Yes there are public clouds like Amazon EC2 which is now also offering virtualized private clouds.  But the reality is that many large IT organizations want to control their own data, find ways to make it more easily accessible to everyone, significantly reduce infrastructure costs, and be able to launch new apps or services quickly and cheaply.  This is where I believe many IT organizations will be headed in the next 5 to 10 years creating private and hybrid clouds for existing and new applications, a phase which I call the Googlization of IT.

I want it NOW, I want it REAL TIME

I was recently asked by a friend if he should get his son the new Nintendo DSi.  This would be an upgrade from the current DS and also add the photo capability.  As I thought about my own son's usage of the device, I said no.  Once my son got an IPod Touch for music and now games, he never looked back.  While he loves the music, the real reason is because of the App Store and ability to instantly download any game for free instantaneously.  While the DSi does have a Wi-Fi connection, the IPod Touch is just so easy and frictionless.  And as evidenced by the rise of the Internet and the ability to download movies, music, and games instantaneously, it got me thinking more and more about the fact that we live in the "Now" or "Real Time" Generation.  Yes, it has been happening for awhile but we finally have the broadband speeds and ubiquitous connectivity that we craved for the last 10 years.  We also have better pricing and better products to be able to download those movies and games anywhere and on any device.  In addition, you can just see the rise of Twitter as another example of this new culture of real time.  People no longer want to wait for anything any more - if you have something to say, say it on Twitter or Facebook.  Products and friends are just a click away.

Sure, we can clearly see the impact of the Now Generation on consumers and new web applications.  A substitue product or application is just a click away.  If you don't like the user interface, if the product loads too slowly, or if the registration process is too burdensome, you can do another Google search and instantly find a substitute.  But what does it mean for the enterprise, for the corporate IT professional and startups selling into these companies.  I have always believed that the old way of selling enterprise software products with expensive sales forces and complicated installations is dying.  Buyers no longer want you to push software that they may or may not need.  They are empowered and can easily do their own Google search and download open source software or fill out a short registration form to trial a web-based app.  They, like my own son and his friends, are increasingly seeking instant gratification.  They are not just consumers but prosumers who are pulling new products into their departments and potentially into their enterprise.  I wrote about this instant gratification in 2006 and it is happening faster than ever.  The kids who were in college 5 years ago are the very same ones in the IT department tasked with coding new products.  They are used to doing more for themselves, doing their own research, and being able to trial new applications in real time.  If you are an entrepreneur selling into an enterprise and don't see this trend now, you will be toast in the future.

Pioneers get arrows in their backs

Pioneers get arrows in their backs - I have experienced it firsthand from an active investor's viewpoint and written about it in the past.  Being early in a market is great but being too early can be deadly.  Just like the settlers in the westward migration, entrepreneurs who are too early will get arrows in their back.  It doesn't matter if you have a rock star CEO (Bill Coleman who founded BEA) and $100mm of funding from some great investors.  If you are too early and have to spend lots of money educating a market and get engaged in long protracted sales cycles and pilots, you are not going to be able to spend your way to success.

That is what it seems like is happening to Cassat Software. Forbes has an article about Cassat nearing the end.  On the surface it seems like the company was built for the right place at the right time helping enterprises save tons of money and run their internal data center like a cloud.  However the first funding went in 6 years ago and has totaled around $100mm since then.  Here is a quote from their founder and CEO:

For many years, Coleman acted as something of a prophet for cheap computing via the cloud, but he also thought it would mean a sharp drop in pricing with which the big companies would not be able to compete.

"The big guys copied my story," says Coleman. Cassatt, he adds, was upended by a slowing economy and by customers skittish about closing big orders or changing existing ways.

"What frustrates me is my own naivete," Coleman told Forbes. "I thought I could give companies something radical that had a proven return on investment, and they would be willing to change all their companies' computer policies and procedures to get that. Right now, it's hard to get people to get beyond proof-of-concept tests or a data center energy analysis."

He will be right eventually but will not have a lot to show for it.  A couple points to make - raising too much money too early can be harmful as it puts huge expectations on a company before it has proven itself and selling million dollar plus licenses into enterprises has gone the way of the dinosaur as only the biggest companies can afford to do this and it is extremely expensive to do.  Remember some of my old posts about frictionless sales and leveraging the web for sales/marketing and inside sales?  Having just participated as an angel in the recent Eucalyptus funding led by Benchmark, we are hoping to avoid this fate leveraging free download model which has generated over 14 thousand users, many of whom are corporate customers.  In addition, we have signed partnerships and are bundled in the Sun cloud computing initiative and the new Ubuntu enterprise Linux release.  Got to love leveraging partners and downloads to drive sales leads and sales.

Hybrid clouds are coming

Amazon has taken off with its cloud compute infrastructure but there still have been some limitations from an enterprise perspective.  Mainly, some enterprises are concerned about keeping their data private, about reliability, and storage costs over time.  Any enterprise looking at potentially leveraging the cloud would love to have a hybrid solution which allows them to manage their own internal cloud and then burst over to a public cloud for either automated failover, extra storage, or to port an application over after using an internal platform for development.  Sun seems to get it as evidenced by their announcement today to offer their own cloud computing platform.  Key here is that it will be interoperable with Amazon S3 and its platform.

"Sun anticipates that the cloud scene will feature many clouds, both public and private, that are interoperable and driven by different application types. Applications eyed for deployment on Sun Cloud include Web 2.0 applications, social networking systems, gaming applications, and anything that needs the scale of the Web, said Tucker. Departmental applications are envisioned as well.

"What we're introducing in New York here is we're talking about our public cloud," for developers, Tucker said. Sun has seen a lot of interest in cloud computing from enterprises, he said. "It’s getting very rapid uptake at least in the large enterprises today," said Tucker.

What is interesting is that their is a little known startup with great open source technology called Eucalyptus which is helping drive some of this initiative. Eucalyptus will be the software that will allow the Sun cloud to interoperate with other platforms and services.  With this open source platform, companies can now deploy apps on their own cloud and use Amazon or other cloud services for high availabilty or extra storage without vendor lockin.  Congratulations to Rich Wolski and team as they have made tremendous strides during the last 6 months.  I was just with them in New York yesterday and believe they are on to something big.

Cloud computing for SMBs

Cloud this, Cloud that - the word cloud is clearly an overhyped word and reminds me of the beginning of the hype around hosted models and ASPs (application service providers) in the late 90s and the term SAAS today.  Anyway, as I look at announcement after announcement released about cloud computing platforms, one thing is pretty clear to me from an investment perspective.  First, I am not going to invest in the next hot cloud computing infrastructure service that will compete against Amazon, Rackspace, Microsoft, and every other large tech vendor in the world.  This is suicide and far from capital efficient.  Secondly, while everyone looks in the consumer space, I want to look at how software companies can deploy new enterprise-based applications in the cloud, particularly for small/medium sized businesses.  In other words, show me the arms merchants with a recurring revenue model and frictionless sale and I will definitely be interested.

Some of the companies that fit this parameter include Rightscale (founded by Thorsten von Eicken, a cofounder of former portfolio company GoToMyPC) and one that I am looking at in the email archiving and compliance space which has a number of OEM partners reselling its service. Rightscale is an on-ramp to Amazon EC2 and other clouds and provides automate systems management.  It kind of reminds me of a next generation Tivoli or Openview.  The beauty is that the whole sales cycle is quite frictionless and all web-based which means an oppotunity to scale quickly.  There are a number of other recent players I have seen including one for BI in the cloud (not exactly sure what the killer app here is yet) and many others.  Of course the trick here is not to get enamored with the word "cloud" but to really understand the business problem that is being solved and why leveraging a cloud computing platform offers better economics, scale, and competitive advantages.  As I dig deeper into some of these companies, it is clear to me that software purpose-built from the ground up to live in a cloud has a huge advantage since it is hard to retrofit off-the-shelf software to leverage all of the benefits offered by Amazon, Rackspace, and the like.  Secondly, many of the better companies have built some slick tools and services to solve difficult problems like how to make customers feel like they have their own privated, dedicated systems while still keeping costs low.  Finally, from a go-to-market perspective, a number of the companies I have spoken with have not gotten the question of whether or not they could scale as they quickly point to their backend provider and move to the next objection.  So, if you have an application targeted at the SMB market that is taking advantage of cloud economics, please feel free to contact me.

Selling to large enterprises costs big dollars no matter how frictionless your sale is

I have written a number of times about frictionless sales and how on-demand companies have a huge opportunity to reduce their sales and marketing costs and subsequently scale their business more efficiently.  Here is an excerpt from a prior post:

Frictionless sales means reducing the pain for customers to adopt and use a service/product and consequently reducing the cost of sales and marketing to get a customer and generate revenue.  As I mention in an earlier post, "The less friction you have in your sales and delivery model, the easier it is to scale. The easier it is to scale the faster and more efficiently you can grow." The lowest friction sale can be a user clicking on a web page and the content owner getting paid for it.  The highest friction sale is spending lots of money on marketing and trade shows and having a large, direct sales force of expensive reps pounding the pavement for months trying to close a large deal with an enterprise customer.  Follow that with a 3 month implementation process to get the customer happy.  There are various grades of friction between these two extreme points like open source business models, software as a service, and reseller/OEM-type models as other forms of packaging and delivering a product/service.  And of course, each of these models requires a different methodology and way of marketing and selling to a customer. Ultimately what you want is sales leverage where every $1 you spend on sales and marketing equals multiples of that in terms of revenue.

The perception that it is much easier to scale definitely holds true if you are selling to consumers, small businesses, and workgroups within large organizations.  However, it seems that many public on-demand vendors are feeling the pressure to deliver growth and ultimately need to feed the revenue machine by going after larger customers.  And what many companies are learning is that no matter how on-demand your software is, if you are selling to huge enterprises you are going to have to spend huge dollars in sales and marketing.  Sales cycles are long no matter how you slice it and even if there is no massive hardware and software installation, many large companies want to have their service customized and integrated, even lightly, with other systems.  in other words, many of these high flying on-demand vendors are starting to look more like the old software companies they are trying to replace.  As per a Wall Street Journal article today, it seems that many of these public on-demand companies are finding out the hard way that no matter how frictionless your sales process is, the bigger the company you sell to, the more it is going to cost you. 

There is nothing to install, so workers can start using online software without the aid of the tech department. That makes it easier for companies that sell online software to get into a business than their on-premises competitors.

Seizing on this, investors bought into online-software companies in a big way. During the first 10 months of 2007, shares of 15 online-software companies tracked by Thomas Weisel Partners increased in value 61%. Since then, however, these companies have lost about a third of their value.

Wall Street has realized that it isn’t enough to simply offer online software—you have to have a sales strategy that can make your offering a corporate standard. It is possible to get individuals, project teams or small businesses to buy online software through word-of-mouth marketing, but it is hard to make money from these groups—at least the kind of money necessary to become a billion-dollar company.

In order to get there, they can’t operate like an Internet start-up, letting their technology spread virally as end users hear about it. They need to sell to the same executives and information-technology professionals who made purchasing decisions before online software was an option. Businesses have a lot riding on the decision to use one product or another. And while having pockets of workers advocate for a particular piece of software is a plus, the execs who sign the big checks still want to see demos, vet the seller and do all the things they have always done when they buy software.

So if you are an on-demand vendor, either stick to your focus of scaling with SMBs and consumers which requires a completely different sales and marketing approach more rooted in traditional online budgets and telesales or be prepared to spend some real dollars if you truly want to go after the big guys. 

Need homework help - try Tutor.com

I got an email from George Cigale, CEO of Tutor.com, yesterday to check out the New York Times article on his company's service (full disclosure-my fund is an investor in Tutor.com and my partner Dan is on the board).  The article, "On Demand, On Time and for a Fee, an Army of Tutors Appears," highlights Michelle Slatalla's experience with Tutor.com's service where her two daughters were able to get instant homework help by going to Tutor.com, logging in, and clicking on their grade level and subject matter to find a qualified instructor.  Thankfully Michelle had a pretty positive experience as we have had time to hone the service and continue to find great tutors as we currently complete thousands of sessions each day.  Anyway, next time your child asks you for help on Algebra, you may want to visit Tutor.com and try another method.  From a thematic point of view, this is another example of how companies can leverage the power of the Internet to offer an on-demand service leveraging a distributed and free agent workforce.  I just love those types of models!

Do you believe in the Red Shift theory?

The first time I heard the term Red Shift was from my portfolio company, Greenplum.  Greenplum has used red shift to characterize the nature of the existing database market where exponential data growth driven by network computing and internet applications have outstripped the capacity of existing mainstream vendors.  Hence, a new approach was needed (our database software running on commodity clusters) which would allow companies to load and query terabytes of data at 10-100x performance and scale over traditional vendors.  Ok-enough of the sales pitch.  Moving on, it is clear that red shift data requirements are only a fraction of what's necessary to meet this exponential growth as it will put tremendous strain on the existing IT infrastructure consuming ever-increasing amounts of CPU cycles, energy, storage, and more.  If you want to read more about this red shift theory, I suggest checking out a great article by Richard Martin in Information Week.  Martin neatly summarizes Red Shift as defined by Sun's Greg Papadopoulos to be:

• Red Shift refers to companies experiencing exponential growth in demand for raw computing power
• Red-shift companies tend to be Web 2.0 focused like YouTube and MySpace, or big financial, energy, or pharmaceutical companies
• Those companies, Sun CTO Greg Papadopoulos says, will experience similarly high levels of growth in users, revenue, etc., while blue-shift companies will grow relative to GDP
• Along with the cost of powering and cooling in-house data centers, the red shift is driving a surge in utility computing and software as a service

Based on my experience with both consumer Internet and companies selling infrastructure, I can say that this all feels right to me.  It is also no wonder that virtualization which helps IT consolidate servers and increase capacity utilization and utility computing are top of mind again.  Think about Amazon's S3 and EC2 which I have written about before as utility storage and processing for the masses. I am definitely meeting more and more startups which are starting to offload some of their computing requirements to these services.  And of course, while Greg Papadopoulos is pushing this vision of the red shift, he has put Sun in a great spot to execute on this with new platforms and ways of keeping up with this exponential demand.  The only question as Mark Anderson points out in the article is not if there will be an exponential increase in servers sold but how many of them will be Sun servers running Solaris versus open systems.  Either way, it looks like the stock market has been voting with its feet as Sun has been performing quite well as of late.  And as a VC whether you believe in the red shift or not, we would all like to find companies experiencing hypergrowth where one of the main uses of capital will be for scaling the infrastructure to meet demand.  That is what I call a good problem to have.

Do it yourself (DIY) in the enterprise (continued)

Last year I wrote about the newfound productivity of the prosumer, the consumer who is bringing technologies into the workplace in a DIY (do it yourself) fashion.  If IT can't or won't get something done, users can simply check the Internet for the latest web-based service or software download to help them solve their problem.  In this month's CIO Magazine which landed on my desk somehow, the cover article is titled "Users Who Know Too Much and the CIOs Who Fear Them."  The subtitle is "They're smart, productive and using IT you didn't provide.  How to manage the modern user."  I think we are at the very beginning stages now of IT's recognition that the world is changing and like Jeff Nolan says the balance on the continuum of systems and people should move more towards a people-centric vision of technology.  What do the people want and how do we provide them the ability to get things done while at the same time balancing our need to keep a safe and secure environment?  Sometimes these issues are directly competing with one another.  It is still quite early in the CIO's recognition of a user-centric IT world but the fact that CIO magazine is focusing on this means that it is becoming more critical to its readers.

Over the next couple of years, it will be interesting to watch how the battle between top-down, conservative IT and bottom-up DIY employees gets resolved.  IT wants control, security, and compliance while users just want to get things done.  As the article advocates, the smart CIOs will figure out how to balance the needs of their users and the role of IT.

This will require CIOs to reexamine the way they relate to users and to come to terms with the fact that their IT department will no longer be the exclusive provider of technology within an organization.  This, says Smith (Gartner analyst) is the only way to stay relevant and responsive.  CIOs who ignore the benefits of consumer IT, who wage war against the shadow IT department, will be viewed as obstructionist, not to mention out of touch.  And once that happens, they will be ignored and any semblance of control will fly out the window.

Whether or not CIOs get it, does not really concern me as the nature of sales for many of these DIY apps and services should be focused around the end user vs. centralized IT.  Given this, the sale should be much different, less costly, and with much less friction.  If a user wants to track his sales force productivity, they can go online and sign up for Salesforce.com or create their own through a SugarCRM download.  There is no on-site installation as the web helps deliver the product efficiently.  From a sales perspective, as these companies grow over time, much of their sales can be done over the telephone or through a WebX or GoToMeeting session with only the large accounts reserved for an expensive direct sales rep.  Given this bottom-up, web-based model of selling and delivering software, it will be interesting to see how the incumbent vendors respond.  For example will users adopt a collaboarion platform from IBM that IT has pushed down on them or would it be better for CIOs to figure out what their workers are using and standardize on that?  Does this mean that the smarter incumbent software vendors look to buy startups that already have bottom-up traction versus building their technology from scratch?  As I was writing this post, I just noticed that IBM just signed a deal to pipe Google gadgets through its Websphere portal. 

"These sites are not just valuable to consumers. Businesses want the same content. Why would we keep these two universes separate?" said Larry Bowden, vice president of the IBM Lotus division for portals and Web services.

While Internet access, and thereby Google Gadgets, may be easily available to consumers, many businesses restrict access to the latest Web applications for security reasons, to make network management easier and to limit employee distractions.

By allowing Google Gadgets to work within its WebSphere Portal, IBM is making it easier for companies to give employees access to popular Web applications while keeping control over how they are used. Companies can decide which Google Gadgets they can see.

"The end user decides: We no longer need to go off and call a technician," Bowden said. "The power has been turned over to the people who know best. You know best."

It looks like IBM gets it and is trying to help its IT customers strike the delicate balance between control and giving users what they want.  All I can say is that the intersection of the enterprise and the web-based platform will be an interesting space to watch over the next few years and it is clearly heating up.