Friday, June 20, 2008

The auditor’s view: Software company valuation

By James M. Connolly

The rules are changing for how software companies raise money and how investors value them. While some growing companies hit a gap where they have trouble attracting investors, there are ways to spot value. Watching both aspects are consulting, tax and audit companies such as Deloitte & Touche LLP. Stephen W. Ingram, partner in life sciences and technology, and Stephen Zamierowski, director of the company’s Tech Venture Center in Waltham, discussed software company investments and valuations with Mass High Tech associate editor James M. Connolly.

MHT: Given the changing nature of software technology, how do investors view software startups today?

Ingram: I still think the investors look at size of market and pain or need in that market.

Zamierowski: That’s first thing they look at: What is the market opportunity, and how big is it? Then they look at the team, and then they look at the product, in that order. As far as valuing those companies, once they are convinced that there is a big market opportunity, they want to know that the team is the right team. Even if it’s not a full team, especially at Series A, they want the CEO or the leader or the founder to be a strong person. Then, it’s that the product they developed has some uniqueness in the market, some competitive advantage. Then, the value of the company at Series A typically is twice what they need. In other words, for 50 percent of the company, someone will give you $2 million and the post is $4 million. It doesn’t sound scientific, but that’s the way it is right now.

MHT: How do things change with software as a service (SaaS) and open-source software?

Ingram: There’s lower capital in, so you can maybe give a higher valuation, especially for serial entrepreneurs. And we’ve seen companies that have been bootstrapped to the first customer or to a really good beta, and at that point they are going to drive a higher value for the VCs. They may need two or three or five or six million, but they will get a value of $20, $18 or $15 million — pick your number — so they are going to sell only a third of the company. I’ve seen that quite a bit.

The SaaS model allows a company to take less capital, and in some cases show customers quicker because, I would submit, it’s a lot easier to get a $50,000 renewable contract than it is to get a $500,000 site license. A lot of the strategy on the channel partnering and building the company is: If you can get into a large enterprises and you can hook one, two or three onto one of these renewable SaaS arrangements, I think a lot of investment capitalists look at that as an easier way to build a sales channel and predictability of the revenue stream.

MHT: Does SaaS allow a company to be quicker to market?

Zamierowski: Developing software today is a lot cheaper because of the platforms out there and the shareware you can use. Whether it’s going to be delivered as SaaS or delivered in a box doesn’t matter. The cost of building all those is lower. The thing about SaaS is that you can get customer acquisition faster because there is no capital expense for the customer. People can try it out, they can see if it works, and they can build with it. Then the challenge becomes that, instead of the traditional hockey-stick model, where you plod along and then your revenue ramps fast, it’s more of a steady incline on a SaaS model. But then it’s predictable. What do a lot of investors really like? It’s predictability and the fact that you have an annuity to some degree.

Ingram: That’s what investment bankers like when you go public and what acquiring companies like in an M&A. They like predictability. But the SaaS model only works in certain applications. The other thing about the SaaS model, especially early on in the company, the bookings are really what matters not so much the revenue, you need to find out how many new customers you are signing up every month, which will lead to the revenue. The whole idea of bookings and what the sales people are doing is a much better measure of how the company is doing and its chance for success.