• Credit
  • CFO.com | US

How the Cloud Will Be Capitalized

Cloud-based software and services will be the backbone of businesses, but can lenders and investors find a way to finance the providers?

In December, Google announced its launch into the public cloud as a direct assault on Amazon, IBM and Microsoft, betting it can be the systems infrastructure for corporations. Businesses of all kinds will be built on top of such computing power and storage capacity. But how are SaaS (software as a service) and IaaS (infrastructure as a service) vendors (other than the giants) going to be capitalized and financed to enable the next leap in cloud computing?

Relative to the enterprise software sellers of the past, SaaS companies require less upfront dollars to build infrastructure (e.g., servers). By some estimates, the application company of the past required 10x to 100x the capital to realize the same enterprise value. But SaaS companies confront greater working capital challenges. Those challenges come from client acquisition and on-boarding.

Recurring revenue business models are also uniquely measured. The metrics are committed monthly recurring revenue (CMRR), customer lifetime value (CLTV), customer acquisition cost (CAC) and customer churn. For a SaaS company, these distinct attributes help determine enterprise value and the likelihood for sustained growth in value over time.

Bergquist_ColumnistThe inherent “stickiness” of recurring (and committed) revenue yields a valuation premium over traditional enterprise license, or non-recurring, sales models. But financing such models requires working capital and growth capital structures that are nontraditional.

Capitalization Scenarios
Financing cloud-based businesses can be difficult through traditional means. That’s because recurring models make a trade-off at inception: a lower-priced perpetual revenue stream with higher long-term value, versus a traditional revenue stream with higher initial price but lower long-term value.

The recurring revenue model can be worth more over time and require less capital to fund. But fixed assets, front-loaded expenses associated with client acquisition, and on-boarding put demands on the internal cash flows, debt, and equity needed to support growth.

Cash Flow. A few cloud-based companies are able to capture sufficient cash flow to grow organically without institutional capital. Few can do so without the benefit of a cash-cow elsewhere in the business, though. In the SaaS model, there is an inherent mismatch between client acquisition expenses and subscription revenues. Client acquisition costs (CAC) can equal several months of revenue, putting enormous pressure on a fast-growth company to manage a positive working capital position. As growth rates are king for SaaS companies to stay competitive, it is difficult to pare back these sales and marketing expenses, and revenues will not flow until the software is successfully installed and integrated with existing systems — both are material, front-loaded expenses. Accordingly, fast organic growth exceeding 80 percent CAGR is rare, except for a company with a product that is “pulled” into a large market opportunity and is relatively self-serve for new clients to load and run.

Debt. Recurring revenue models, like cloud-based SaaS and IaaS, provide a strong platform for leverage with or without positive cash flow. A few bank and nonbank debt providers are delivering “recurring revenue lines of credit” (RRL) to address the strain that front-loaded client acquisition costs can put on working capital and precious equity. RRLs are a relatively new debt product. They require an untraditional underwriting approach, as the borrowers do not have adequate supporting assets (like accounts receivable) or cash flow.

4 thoughts on “How the Cloud Will Be Capitalized

  1. Excellent post that highlights the need to have granularity when it comes to complex sectors like this. One also needs to look at this from a ‘local’ use of capital as funding arrangements may vary by state, country, continent as tax, interest and cost of capital comes into account.

  2. Great analysis on the hard impact of cloud computing. There are many other soft impacts, such as the ability to be more agile and change the business rapidly vs needing significant investments in people and hardware. Another is the ability to “swim up steam” into your customers other business processes.

  3. Thank you for the article. It brought clarity to the financing arena for start up cloud based software companies for me. We have a product, Accountants’ Workflow Solutions, Inc. that provides a practice management, client relationship management, document management and task/project management solution for small firms. It is implementable in 7 to 10 business days with a fully populated database. When I moved from a server based product to a hosted product, I transitioned from the higher original purchase price plus implementation fees to a monthly subscription fee plus a smaller implementation fee. I knew it was going to be financially challenging to make this transition, but the best decision for the long term. Our onboarding costs are minimal and the costs are covered by our fees. You answered a lot of questions I had regarding the ability to obtain financing or funding. The flywheel is creeking over the first turn for the hosted product. We haven’t marketed other than social media while we complete the development of the SaaS version. This will be ready for release in late April 2014. The onboarding costs for the SaaS version will be significantly reduced and the feature/function will be greatly improved. We invested a lot to create the best technological platform for future development of significant applications for the accounting industry. Again, thanks for the thought provoking article.

Discuss

Your email address will not be published. Required fields are marked *