When a public company announces an acquisition, the press commonly judges an exit’s success by looking at the exit valuation as a simple multiple of dollars invested. If the startup raised $50 million in a prior venture investment, a $500 million exit generates a fantastic 10x multiple, whereas a $100 million exit generates a respectable 2x multiple. But what if the company gets sold for $47.5 million? (Hint: Remember this number.) Most of us know that this back-of-envelope calculation is not always precise, but it’s a fair way of judging relative capital efficiency of venture deals.
Sitting in the exit row
There are two ways to widen the spread between dollars invested and exit valuations: One, increase the exit valuations, or, two, decrease the dollars invested. Venture investors can pray for higher exit valuations until the cows come home, but at the end of the day they are subject to the exit valuations dictated by the current market.
While exit activity has increased in recent years, the technology IPO window remains tight as it’s become clear that Google’s IPO has not paved the way for other blockbuster public offerings. In 2005, there were only 41 venture-backed IPOs, down from 67 in 2004. The overhead of Sarbanes-Oxley compliance is a big reason the IPO market is stagnating.
On the M&A front, the median price paid for IT companies in 2005 was $47.5 million (there’s that number again), according to VentureOne. These numbers are indicative of strategic acquisitions where early stage startups were scooped up at lower prices. Acquisitions like Flickr (bought by Yahoo) and Keyhole (Google) were rumored to have been in the sub-$50 million range and predicated on buying technology rather than building it in-house.
Venture firms are employing a variety of strategies to achieve capital efficiency. Some firms have flown to India, China and Eastern Europe. Others (including Blueprint) fund spinouts that leverage prior investments from corporations, universities or the government. These tactical strategies help reduce the lifetime venture investment required for a portfolio company. However, venture firms that also focus on investment sectors with inherently low cost structures are best positioned to crack the capital efficiency frontier.
So what investment areas are most capital efficient? In our opinion, software in all flavors—except shrink-wrapped—tops the list. Hardware or semiconductor companies have difficulty competing with software’s low capital expenditure requirements and “write once, sell millions of times” high gross margins. Recent trends are making software startups even more capital efficient than they were just a few years ago. Specifically, the broad acceptance of open source software within IT organizations and the maturation of Software as a Service (SaaS) as a distribution model now make it easier to build profitable software businesses with significantly less invested capital.
The open source movement is changing the way people think about software. Users of open source realize many benefits over traditional proprietary software, including lower prices, improved code quality and reduced vendor lock-in. Open source has also grown in popularity as a business model among venture-backed startups. These startups typically offer a free download of the software for a starter application and generate revenue by charging customers for premium features (the so-called “dual license” model), additional licenses, maintenance, training and/or support. Open source startups are cost effective to build and operate because they realize savings in several ways:
Lower go-to-market costs. Open source startups typically post their source code and compiled versions for public distribution on sites such as SourceForge, allowing customers to download the products themselves, often free of charge. The open source community acts through word-of-mouth, leveraging guerilla marketing techniques and lowering marketing and lead generation expenses.
Lower product development and/or debugging costs. Open source leverages the talents of the public developer community to extend the code base. Some open source communities, such as Linux’s, accept code contributions from the community. Others, such as MySQL’s, get the benefits of rapid debugging in real world situations. External developers who add features or bug fixes to an open source project typically submit the new code to the company to maintain. An open source project can grow its feature set at minimal cost to the company, reducing its in-house development staffing requirements.
Thanks to their capital efficiency advantages, open source and SaaS startups should be able to achieve appreciable customer traction and cash flow break-even with less than $20 million in lifetime venture funding.
Bart Schachter, Blueprint Ventures
Fewer sales resources. “Try before you buy” is a key advantage not just for customers, but also for the company. Historically, almost 70 cents of every dollar of revenue in an enterprise software startup goes into sales and support. With open source, these costs can be drastically reduced. Potential customers can download the software and test it for as long as they want. Only after they have decided to upgrade to the paid software do they contact the company. This reduces the company’s sales cycle, since resources are invested once the customer is genuinely interested. Open source companies can hire smaller sales forces that focus less on trials and evangelism and more on closing deals.
SaaS is making waves thanks to the industry’s frustration with the traditional enterprise software sales model. Software buyers are shying away from monolithic applications with a large upfront license in favor of SaaS offerings, which can be purchased on a per-user, per-month basis. Customers appreciate paying only for what they use, receiving upgrades and support for the length of the contract, and avoiding vendor lock-in caused by the frontloaded payment. SaaS startups enjoy the predictable monthly revenue stream and lower barrier to customer adoption. They also have several cost advantages over traditional software startups:
Lower customization/integration costs. One of enterprise software’s biggest headaches is the complicated customization and integration process for each new customer. In contrast, SaaS startups publish a single Web-based offering that prevents per-customer customization by design. Also, customers integrate SaaS offerings via Web services APIs that are reused across the entire customer base. Venture dollars are spent building a common code base rather than on NRE work that is not highly leveraged.
Lower maintenance costs. SaaS startups can easily roll out new product releases because the software is hosted in their data centers. There is no need to distribute patches and assist customer IT departments. Bringing new software online is as easy as rebooting the application. Also, all SaaS customers run the most current version of the software. This eliminates the pain and cost of supporting customers who are running legacy versions.
No porting cost. Traditional software applications often must be ported to and tested on several operating systems (Linux, Windows XP, Solaris), application frameworks (J2EE, .NET), and databases (Oracle, MySQL, SQL Server). Because SaaS offerings are Web-based, SaaS startups control the entire back-end infrastructure and can standardize on a single software and hardware platform. This eliminates the overhead of porting and performing multi-platform quality assurance.
World has caught up
Open source is hardly a new phenomenon. Several of the biggest “bubble” IPOs were Linux-related, including Red Hat and VA Linux. And SaaS is a bit like the ASP (application service provider) model from the late 1990s, when every enterprise software startup had an ASP story. But we believe that the world has changed and that both of these trends are now real and great investment opportunities. Open source is now mainstream in IT organizations around the world—the open source geeks have succeeded in changing the world by co-opting the suits. And with the maturation of the Internet infrastructure and the proven model of companies like Salesforce.com, IT organizations are using SaaS for new application deployments or upgrades.
Thanks to their capital efficiency advantages, open source and SaaS startups should be able to achieve appreciable customer traction and cash flow break-even with less than $20 million in lifetime venture funding. These startups will be well positioned to generate solid returns in today’s exit environment and in the coming years.
Guest Article Bios
Bart Schachter is a managing director with Blueprint Ventures. He focuses on comm. and IT infrastructure, wireless technologies, nanoelectronics, software, and comm. semiconductors. Richard Yen is a Blueprint principal and a Kauffman Fellow. Yen focuses on infrastructure software, wireless technologies and consumer Internet deals. Schachter may be reached at email@example.com. Yen may be reached at firstname.lastname@example.org.