By: Cindy Padnos
And you thought SaaS wasn’t sexy. Well, you’re wrong. I’ve been investing in the “uncool” business-to-business space, and it’s taught me not to doubt its potential.
Now is the time for founders of enterprise-oriented start-ups to leverage the winds of change: It takes less initial capital than ever before to build business application software. Not only that, but the market size is huge–and still growing rapidly. Exit opportunities are strong. All of this cements the opportunity for both larger and more rapid outcomes in the enterprise software world.
Recent examples abound: SlideShare, the San Francisco-based maker of a PowerPoint competitor, raised just $3 million before it sold to LinkedIn for $119 million. Demandforce, which created an application for companies to handle their marketing and communications, was acquired by Intuit for $424 million. It had raised less than $12 million. Both of those exits came within three years of the initial financing rounds.
Here’s my evidence as to why it’s a perfect storm for enterprise start-ups:
1. It requires less capital up front. In the past, enterprise-oriented companies required more upfront capital to launch and had less potential for a rapid outcome than consumer Internet companies. The positive impact of public cloud computing–dramatically reducing start-up capital requirements–showed up earlier in consumer start-ups, with small teams bootstrapping companies to rapid growth. More recently, however, many enterprise start-ups, including several in our own portfolio, have shown that developing business software can be just as capital-efficient in the early years as a consumer play, and they offer several other advantages. Companies like BrightEdge Technologies, built leveraging public cloud platforms like Amazon Web Services, offer the proof: They have grown from zero to tens of millions of dollars in recurring revenue in just a few years, while having deployed a fraction of that amount of capital to get there. The level of early capital efficiency enables entrepreneurs to retain significant ownership.
2. Enterprise cloud software is a higher-growth market. Cloud computing has ushered in a period of robust enterprise software activity, as many businesses are switching to a software-as-a-service model for their IT investments. The forecast for growth in IT spending through 2014 is four times as high for SaaS solutions as for traditional on-premise offerings (a 15.6 percent compound annual growth rate versus only 3.4 percent). Cloud-based solutions and their associated pay-as-you-go subscription revenue models have also enabled market expansion in the enterprise world. New sectors of sales opportunity, such as small to medium-size businesses, are now possible to target. Talk about market expansion. There are 50 times as many small and midsize businesses as large enterprises needing software solutions.
3. It has better sales efficiency. Because SaaS solutions most often don’t require expensive upfront costs for integration and offer monthly subscriptions versus one-time large payment models, the sales cycles are shorter and expensive outside sales teams are often no longer required. SaaS companies can expand their businesses faster and with lower capital requirements than ever before. For example, one of our Illuminate Ventures portfolio companies, using only inside sales teams, in three years has grown from zero to more than 2,000 global brands using its product. Sales cycles average 90 days or fewer, and their reach is global. These new sales models for cloud-based enterprise software companies are the wave of the future.
4. There’s lower risk involved. Enterprise start-ups have lower failure rates and better outcomes overall than their consumer Internet peers. The lower risk and outcome outperformance in the enterprise category are probably the result of three factors:
•Enterprise start-ups generally have more stable revenue streams because of their subscription-based recurring-revenue models.
•Typically more than one company in a given category can gain a good outcome, because business buyers demand choice.
•Even lower-performing companies can find a good acquisition with a large corporate acquirer, because they probably have core technology that is of interest.
The consumer Internet is much more of a hit-based world, where the winner takes all and other would-be competitors die on the vine. There is, for example, really just one Facebook. Failure risk in an enterprise start-up is lower for entrepreneur and investor alike, and the upside potential is twice that of a typical consumer company.
5. Enterprise software companies have better merger, acquisition, and IPO outcomes. Large-scale acquisitions of enterprise companies have become increasingly common, and that trend is unlikely to end anytime soon. Of the 10 most active acquirers in software in the past five years, eight are enterprise companies, not consumer. And of the acquirers with the highest cash-equivalent balances as a percentage of assets, the majority are also enterprise companies.
IPO performance in the enterprise world follows a similar curve of higher performance. In recent years, enterprise software companies have consistently outperformed consumer Internet companies, with typically a 50 percentage point difference between the post-IPO market cap performance of an enterprise software company versus a company in the consumer sectors. In fact, the consumer companies are, on average, sitting well below their initial public offering price while enterprise companies are well above theirs. This is particularly important for founders and investors, who are generally locked up for several months after the public offering, thus profoundly impacted by the post-IPO performance of a stock.
Of course, there are still interesting opportunities in the consumer world, but it is clearly a hit-based sector, in which both entrepreneurs and investors need to understand the risk-reward stakes they are taking on. We’re entering a period of tremendous potential for cloud-based enterprise software–for entrepreneurs and investors, it’s now increasingly being seen as the place to be.