Cloud

How Cloud Computing Changes Startup Investing

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The cloud has changed almost every aspect of how software companies are built. Entrepreneurs require less capital than ever before to deliver their initial product and gain their first users – and investors are rewarded with lower early-stage risk.

In 1998, I was the founder and CEO of Vivant, a services procurement software company delivered as a service. In those days before the public cloud, the first $250,000 we raised, and maybe more, bought servers, database licenses, software development tools and other equipment we needed before we could write a single line of code or validate that customers wanted what we were building.

Ten years ago, when cloud computing was emerging, startups faced technological and business model adoption risks as they cobbled together the first open source technologies and began using new pricing and subscription models to deliver products as services. In those days, there was also greater “team risk” for investors because a startup team typically had only worked together for a short time before they were forced to seek money.

Today, cloud and open stack technologies are well established and businesses that leverage these capabilities take much less capital to build, at least in the beginning. Bootstrapping or angel-funded startups can go well beyond launching a product to actually vetting their business model and target market segments. From an investor perspective that means that technology and product risks are somewhat mitigated and initial customer/user validation is underway.

Additionally, teams reaching this point have typically worked together for at least six to 12 months before they seek institutional funding. As a result, the team risk for investors is also reduced.

Once an initial product is launched, cloud-based startups typically need an infusion of outside capital to build a successful business — to complete more rigorous market validation, build a sales and marketing organization, polish the user interface, file for intellectual property protection and start extending their architecture to ensure scalability. It still requires substantial capital to do these things well.

Preserving outcome flexibility

Our firm, Illuminate Ventures, invests in the sweet spot that likely would not exist without cloud computing. We make investments in the gap that has grown between the traditional angel round of financing ($250,000 – $1 million) and the typical large-scale series A round ($4-$10 million).

The $1-$3 million dollar equity financing round has long been a no-man’s land in terms of finding an ideal investor, but it turns out frequently to be the right amount of “next step” capital for a bootstrapped or angel-financed cloud-based business. It is an amount large enough for the team to take the “next steps” necessary to find out if they have something that can scale into a big company, but small enough that it allows them to preserve the opportunity for a reasonable outcome if that does not prove to be the case.

This new space filled by micro VCs like Illuminate creates a win-win opportunity for investors and founders. The smaller financing rounds create less risk for investors, reduce dilution for the founders and preserve the flexibility of outcomes for both parties. Once large amounts of capital are invested, flexibility in terms of finding an exit that can generate a reasonable return are greatly reduced.

Venture capital investors typically seek at least a 3-4X return on invested capital across a portfolio. Early stage investors typically target even higher returns for individual investments because they expect some of the startups to fail. With non-strategic acquisitions of $30 million or less, a startup that has already taken $10 million or more in funding leaves a deficit to fill for the investor – even if the outcome is marginally profitable. Likewise, between transaction expenses, preferred stock liquidation preferences, warrants, payables, severance and other factors – entrepreneurs will gain insufficient return for their efforts.

If, on the other hand, the company had taken in only $2-3M of outside capital before it is acquired – that same $30 million outcome can be lucrative to all parties.

Applied appropriately, the first $2-$3 million of financing can enable a startup to make huge progress. If the company succeeds in gaining customer/user traction that offers solid evidence of a large market with significant growth potential, these proof points can provide the leverage needed to gain a large financing round with favorable terms. By going slowly enough to listen to and incorporate customer feedback, identifying the best strategies to scale the business and showing their ability to execute against a plan, the team is now ready to put the pedal to the metal – and investors will come flocking.

Of our 13 early-stage investments only one has failed to return capital. This unusually high success rate is enabled by the fact that even when we discover that a company is unlikely to scale to a large business, there is still an opportunity to exit with a reasonable return. These companies can still achieve good outcomes because the founding team had built something of value and because they had not taken more capital than their company’s growth-stage needed.

Entrepreneurs starting up a new company should carefully consider how much venture backing to seek. There is a perception, especially in Silicon Valley, that if you don’t gain venture funding up front, you can’t build a credible business. That’s just not true any longer. Many smart entrepreneurs have learned that the best time to seek significant outside capital for their startup is when they are fairly sure that it is time to accelerate scaling.

Understanding investor strategies

Micro VC, super angels and large venture firms all have different early-stage investment strategies. Entrepreneurs should assess which of these investors are the best fit for their needs at each stage in the life of their company.

Super angels have been great accelerators of innovation in investing strategy. They move quickly, are great collaborators – syndicating investments rapidly with people they know and trust – and frequently have good contacts and connections to share. Many individual super angels make small commitments to a significant number of new companies every year (as many as 20-40). Because of the smaller amounts of capital they typically commit, there are frequently numerous co-investors in a single deal, leading to being nicknamed “club” deals. Crowd-sourced financings share this breadth of investor element but have other nuances and complexities that are important to consider

In the current environment, many of the large-scale VC firms that primarily focus on growth-stage investments also have seed funds or allow each partner to make one to two small “bets” out of each fund. These investments are too small to have meaningful impact on their fund unless they choose to lead a larger follow-on round of investment in the future but are done as a means of keeping an eye on interesting companies for exactly that purpose. The expectation from the outset is that only a portion of them will be compelling enough for the large follow-on financing. As a result, this type of investment is known as an “option” deal.

In contrast, micro VC firms like Illuminate Ventures typically do two to four new early-stage investments a year per partner and consider every investment to be important to the portfolio. They take board seats and reserve capital for follow-on funding for the entire portfolio – at least initially. Because they invest in so few companies each year, their due diligence is particularly thorough: they look carefully at the team, the technology, the market, and at every aspect of the company that can impact its success.

With a growing number of investment options to choose from, selecting the best type of backing has become an increasingly complex and strategic decision for entrepreneurs. It’s not just about gaining the biggest “name” or the largest fund as an investor – it’s about finding investors whose interests are well aligned with their own at each step of the way.

Cindy Padnos is founder and managing partner of Illuminate Ventures, an early-stage Micro VC firm focused on cloud computing. Current investments include BrightEdge, CalmSea, Hoopla, and Xactly. Cindy has deployed over $100 million in venture funding to help dozens of startups reach successful outcomes including prior portfolio companies Red Aril (acq. Hearst Corporation) and WildPockets (acq. Autodesk). Named to the lists of the Most Influential Women in Technology (Fast Company), the Most Influential Women in Business in the Bay Area (SF Business Times) and Power Player Investor in the Cloud (AlwaysOn), Cindy’s prior high-tech career includes successful stints as a management consultant, VP of Marketing (Scopus, IPO) and founder/CEO (Vivant, acq. EVLV/ORCL). Follow @IlluminateVC.

Comments

By Steve Davis

Cindy, interesting article. I am pleased to see the gap filled between the Angels and Series A VC. I think this gap has held back a number of companies who have either not sourced funding when needed or have taken Series A rounds setting them onto a path to large exits or perceived failure. I agree the alignment of interests is key. Entrepreneurs put their money, heart, soul and talent into their ventures. Investors bring capital, know how, contacts and balance. Having each party clear on the outcome means they can work together more effectively, focus on building great businesses and celebrate together when they win!

By Cindy Padnos

Thanks for the feedback Steve. I am all for an alignment of interests. Having been a founder/CEO myself I know how important it is to have investors and a board that is supportive of your business strategy. I am definitely looking forward to some of those joint celebrations you mention in our portfolio!

By Sharon

Hello Cindy,
Thank you for this article and please excuse my English.
It feels like you described my own situation as a SaaS entrepreneur.
After 20 years in the software business, about 10 month ago I have started developing quality control and knowledge management SaaS, but did not think about raising money until recently.
Two weeks ago, after a tiny action of marketing I met my SaaS actual market.
The experience of meeting my SaaS customers outside the theoretical assumptions of the business plan made me realized that raising capital at this point will be profitable for both me and the investor.
Surprisingly I got a message from an investor couple of days ago, (I believe he read my tiny post of advertisement) and now I have to decide if it is about time to look for an investor or keep on going by myself slowly but surly. As you said “SaaS require less capital than ever before” and it is really easy to deliver the initial product” which I already did.
You are so right when saying that ” Once an initial product is launched, cloud-based startups typically need an infusion of outside capital to build a successful business” and it means that I should focus on finding right partners.
Thanks again for your article

By Cindy Padnos

Sharon – congrats on the progress that you’ve already made. Keep in mind that the value of gaining outside capital can be much more than just the money itself. I hope that you’ll seek and find investors that can add value in other ways as well – via introductions to customers, partners, candidates to join you in building your business, advice on your go-to-market strategy, etc. Good luck with the next steps!

By Sebastian

Hello Cindy,
i like your article! I ask myself if there is specific research concerning the optimal time investing in a startup as strategic investor. Of course the cloud shortens the startups’ lifecycle. but in general software firms have drastically increased growth life cycles. Maybe you could give me some hints, where I could get such information/research. Thanks for your article. I would be happy about an answer. Sebastian

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