Author: Bernard Lunn

Small cap hell is where you end up in about six months after your IPO, when all the high fives and champagne have receded into a distant memory. Unless your company is big enough. How big is big enough? According to Investopedia, small cap refers to companies with “a market capitalization of between $300 million and $2 billion.”

That’s right, to escape small cap hell you need to have a market cap over $2 billion.

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To put that in perspective, that describes one out of 14 publicly traded SaaS companies (Salesforce.com). So 13 out of 14 are in small cap hell. Actually, two out of the 14 are micro cap, i.e. below $300 million in market cap. This matters to all of us. A healthy public market for Web tech ventures ripples all the way down to seed level investing and drives the innovation economy.

What Does It Feel Like To Be In Small Cap Hell?

Lonely. Nobody cares about your little venture. To the team that endured blood, sweat, toil and tears to get to $50 million in revenues, and then go through all the SEC gyrations to become a public company, that is tough to accept. Here is what you can do.

1. Hire a strong investors relations team and send out lots of press releases, be accessible to the press, go on road shows and speak at conferences for investors. Your IR team can take care of the mechanics, but this is also a big time-suck for the CEO and CFO. (And you cannot say, “Sorry we missed our numbers we were too busy schmoozing folks like you.”) The result is a lot of work and you have to do it – but the payoff is small. Every other small cap is doing the same thing.
2. Buy back your own shares. That tells even the most dimwitted investor that you think the stock is undervalued, and as you run the company you probably know. This is fine if you personally are vastly wealthy or you have massive amounts of cash laying idle on the company balance sheet. In other words it is not an option for most companies

Social Media IR Rides To The Rescue?

Agoracom is a modern IR firm. They use online methods to tell your story. That may not sound like a big deal, but IR is a pretty conservative business, so just using a few tools like Twitter intelligently is a big step forward.

Agoracom’s pitch is that they can “tell your story”. For a while there will be an opportunity to use modern methods while your competitors are stuck with their buggy whips. But that advantage will erode really fast. So this is where the new Finance 2.0 sites like Seeking Alpha, Stocktwits, Kaching and Covestor may have the key.

I decided to test this on the 14 publicly traded SaaS companies.

Finance 2.0 For Small Cap: It is Too Early To Tell

Select a classic small cap stock in the SaaS Index. For example: RightNow Technologies (RNOW). At time of writing, they have a market cap of $525 million. It is a cool company that is growing fast and delivering good results for customers. So how much coverage do they get on these new sites? In my test I looked at RNOW for the period Jan. 1 to March 1.

StockTwits: There were nine tweets about RNOW, and many of them mentioned RNOW among a list of other stocks. Some are not very helpful, such as: “Does anyone know the future of $rnow ?”

SeekingAlpha: This has two posts that were specific to RNOW and they seemed high quality. That is better than nine tweets that don’t say much.

Covestor: This is interesting to play around in. You can see the last 10 trades done by Covestor members in RNOW. But you cannot drill from that to any rationale into RNOW. The system is set up to do that, but there is just nothing there yet.

Kaching: This gave good news aggregation on RNOW. It looked better than YahooFinance (still the starting point for lots of investors) but seemed to lack depth. Nor did it have any fundamental new information.

So, from the limited perspective of one small cap, these sites are at this time not the answer.

What about “ye olde stock forum” on Yahoo Finance? Their message board for RNOW for the same period of time has 28 posts, not including the threaded replies. That puts them way ahead of the newcomers.What about quality you ask? What is the use of a lot of noise from anonymous posters pushing the stocks they own (or panning the ones they short)? That seems to be the problem with all these sources.

Wanted: Patient, Long-Term Investors

Found: Momentum-chasing day traders.

You want investors who will buy into the quality of your technology, understand your value proposition, like the market you are in and think you are doing a reasonable job managing the business. In other words, you want Warren Buffett.

That is not what these new sites are delivering. They do not seem to be the key to escape from small cap hell.

Let Your Story Surface

The evolution seems to be:

1.0 Tell Your Story. This is standard investor relations. The updated version of IR is to be present where investors hang out, which today means online. But it is still the old broadcast model.

2.0 Let The Crowd Tell Your Story. This is classic social media – and it suffers from classic social media problems. You might trust a user-generated review on Yelp before going to a diner, but you are likely to be a bit more nervous before investing your kid’s college fund in a company.

What we need is something that reverses the flow, that lets investors discover you, that lets your story surface. This is where XBRL may help. (For a basic intro to XBRL read our earlier coverage.)

The Current XBRL Disconnect For Small Cap Is Temporary

XBRL was not any help when I was compiling the data for the 14 companies in the SaaS Index for the Saas Insights Report (a paid report for investors available from CapitalMarkets.com. Disclosure: The guest author wrote this report). The reason is simple. Only one out of 14 reported to the SEC in XBRL format. That company is Salesforce.com (CRM). The reason for that is also simple: The SEC currently mandates that companies with a market cap higher than $ billion report using XBRL. That is what creates the disconnect:

1. XBRL will enable the good investments from small cap companies to surface, but,

2. Only big cap companies report using XBRL (and they have no trouble reaching investors).

The good news is that disconnect is temporary. The second wave of new XBRL filers in 2010 is estimated to include 1,500 – 2,000 reporting companies, and the final wave in 2011 is for about 10,000 additional companies.

Imagine the Information Discovery Tools

When I go to my local wine store, the owner asks me what I want and we have fun with my standard reply that I want something “incredibly delicious and ridiculously cheap”. Investors want the same. Warren Buffett got to be one of the richest men in the world by finding a few of those.

When all companies file in XBRL (and some geeks have created some neat tools to help sip more effectively from that firehose), ordinary investors will be able to create really powerful filters to find those “incredibly valuable and ridiculously cheap” companies.

They won’t find them among the big cap companies. They will find them among the thousands of small cap, micro cap (and yes, even nano cap) companies. When the value surfaces, they can reach out to IR who can them tell their story.

Of course, when all this pans out, the opportunity to find the bargains will disappear. That is the price of an efficient market.

But the value to all the companies trapped in small cap hell will be immense. They can focus on building value knowing that the value they create will surface.

And that will have a great impact on the innovation economy.

Photo credit: Chris Whiteside

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It looks like the joke may have been on me. When Yammer debuted from TC50 in 2008 I posted a very negative story. That is unusual. I am an entrepreneur and know how hard it is to build a startup so I love celebrating the success stories. In Yammer’s case, it looks like I was wrong. (This is one case where I love being proved wrong!)

In the last few months I was hearing positive things from customers about Yammer. Then I saw Emergence Capital put in $10 million. There must be some serious traction for that to happen. So I spoke to David Sacks, CEO at Yammer, to find out the story behind this news. There are some interesting lessons in their success for other SaaS entrepreneurs.

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Yammer Traction

Raising $10 million from VC that really understand SaaS is not traction, but it is evidence that traction is probably already there. I was keen to find out some numbers.

Sacks told me that Yammer has over 60,000 networks (a.k.a companies using Yammer) and that the average network has more than 10 employees. So that means that they have over 600,000 “seats”.

But most of those are free. The Yammer story is about how well freemium can work if done right. Sacks told me that they have a conversion of about 10% to 15% from free to paid. So you can do the math. Actually you cannot really, this is normal in a private company that opens the kimono slightly but won’t do the full disclosure that you get and expect from a public company.

But you get the basic picture. They are getting lots of free users and converting a reasonable number to paid. And they don’t need Superbowl ads to do this. So the CAC/ACV ratio (customer acquisition cost divided by annual contract value) looks like it must be pretty good.

Simple Is Good

When Yammer won TC50 I saw many other ventures that had far more sophisticated technology and models. So it seemed like a joke that something as simple and derivative as Yammer should win.

But in the startup game, simple is good. There is a reason we often have to remind ourselves to KISS – keep it simple stupid. It is hard to get noticed and even harder if your proposition is not brain-dead simple.

One analyst who tracks Enterprise 2.0 told me that Yammer was like the “gateway drug for social media in the enterprise”. It is so simple to get started. Then when you get some benefit you look around for additional features. Sacks was keen to point out the sophisticated features that Yammer has now built for enterprise customers. You can see them on their site, and the big companies using Yammer and singing its praises (such as Sungard) would demand these features.

But adding on features when you get market traction is not that hard. That is not the story. Getting traction is the story.

The ‘Google Price’

Their base price is $3 per user, per month, and they have a Gold version at $5 per user, per month.

That is what some people call the “Google price” (how high they price their apps). Zoho is in the same range. In the non-digital world we call this the Walmart price, a.k.a the China price.

At scale, these prices lead to a great business. But you have to get to scale. Starting with these price points makes scale more achievable.

No SaaS startup can ignore this price point any more. A low entry price reduces friction. Remember the 10% to 15% conversion from free? Price is key to that.

Google Buzz Will Kill Them. So Will Twitter. Hmmm…

I spoke to Sacks on the day that Google Buzz was buzzing. Actually I had already switched off Buzz, deciding that it is a time suck, and no longer believe that Google wins at every game they enter just because they won the biggest game of all – search/PPC.

When Yammer first came out I thought that Twitter could replicate their “private mode” with a few lines of code. They could and it would have stopped Yammer dead in its tracks. But they did not. They still could, but now Yammer has some traction. If Twitter offers this capability now, Yammer can still make it. And Twitter has a priority list of mega-big opportunities as long as your arm – and this one is probably way down the list.

So Yammer may be able to carve a big enough role for itself between the gorillas.

The Great Unified Messaging In The Sky

Yammer is a replacement for email. That obviously does not mean people stop using email, they just stop using it for some messages. That is happening already. Messaging is getting fragmented and that creates its own problem. So lots of smart folk are going after unified messaging. Google is using millions of people as a consumer research panel by throwing Wave and Buzz out there and analyzing the reactions.

Somebody will get unified messaging right. But it will require some user interface magic. If Apple focused on this… ? In the meantime, we can expect fragmentation for a long time to come. Yammer’s approach to this was simple and elegant.
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The short answer is “as much as you need”. The more tactical answer is “as much as you can raise cheaply”. The latter is a pragmatic view. Raise more than you need when times are good. Just because you raise it does not mean you need to spend it – capital efficiency is always good!

In this post I look at what VC are saying SaaS ventures need to raise to get to scale and profitability. But I’ll also look at what VC are doing – what SaaS deals they are funding currently. I look at the capital efficiency drivers, what you can do to reduce your need for capital. And finally, I show you which VC are active in SaaS today.

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What Are VC Saying?

The answer according to Bruce Cleveland of Interwest is about $40m.

Take that seriously. Cleveland is a SaaS specialist with serious operational experience who has done his research on this subject. But as he points out, the details matter. There are two points of caution:

1. This is looking in the rear view mirror at ventures funded some time ago that did an IPO in 2007 or earlier. It is a different world today – less capital available and less need for capital.
2. VC are happy with models that require a lot of capital. Capital is what they have to offer and if you need a lot they are in the driving seat.

Lets look at the operational details, the capital efficiency drivers, in a minute. First, lets see what VC are actually funding today.

What Are VC Doing?

We looked at the Series A round for 17 SaaS ventures that closed after January 2007:

• Clarizen
• Maxplore
• Loopfuse
• Jive Software
• SlideRocket
• Elastra
• Syncplicity
• SocialCast
• AriaSystems
• Lavante
• Lithium Technologies
• Maxplore
• PivotLink
• SmartTurn
• Zuberance
• InsideView
• Bill.com

These 17 ventures raised $90.25 million total, an average of $5.3 million. That sounds like the “old normal” $5 million Series A. You can see how you would get to $40 million for a venture that is getting traction and can do a series of larger rounds at higher valuations. Lets say, a) $5 million; b) $10 million; c) $25 million; and total: $40m.

If the C round is pre IPO, everybody does well. But that is the old normal. The new normal is different. First, those 17 deals had two outliers: Jive raised $15 million and Bill.com raised $17 million.

Now let’s start with a later date. If we filter by Series A deals that were done after the market meltdown in Q4 2008, the average more than halves to $2.55 million. Those five deals are:

• Maxplore
• Loopfuse
• Syncplicity
• Zuberance
• SocialCast

Capital Efficiency Drivers

There are two numbers to obsess over.

1. How much does it cost to acquire customers? Cleveland defines this as CAC/ACV, or Customer Acquisition Cost divided by Annual Contract Value. If this is less than one you are in good shape. You can take this further. If you can get your customers to pre-pay for the year and your CAC/ACV is less than one, you can self-finance growth at least on the marketing side. Charging annually rather than monthly will slow down growth but that would be a small price to pay for controlling your own destiny. In some markets, customers will pre-pay in return for a discount and that is certainly the cheapest capital you will ever get.

2. How much do you need to spend per customer on infrastructure? The SaaS pioneers made a big play out of having their own data centers. When SaaS/Cloud was new, this was essential. Today you will be courted by lots of big, deep-pocketed, credible cloud vendors selling PaaS, IaaS and HaaS on a pay-as-you-go basis. The pay-as-you-go basis means you don’t spend precious capex on infrastrucure.

But more important is the total ICC or Infrastructure Cost per Customer. If this is low enough you can afford to be more creative with your freemium strategies – which will reduce your CAC/ACV if done right. In other words, your R&D guys had better pay attention to performance engineering from the get go. The days of throwing sloppy code out there and covering your mistakes with huge dollops of cash later are probably over.

Who You Gonna Call? SaaS Funders!

You need capital to build a SaaS venture. You can self-finance using the cash flow from another business. (Typically a professional services business as this requires no capital.) This is what both 37 Signals and Zoho/Advent did. But that is still capital, it is just your own capital!

If you have a small niche, you might need very little capital as it is easy to reach your market. Which is a good thing as no VC will fund a small niche. If you are have a venture that is in that rare magic quadrant that is both viral and monetizable… well you are one lucky dude!

For SaaS ventures that are going after a big market and have normal marketing characteristics, VC (probably preceded by Angel) is the conventional route. If you do decide to raise VC for your SaaS venture, it is better to go to a SaaS specialist.

We know this is not an exhaustive list. It is not meant to be. We have seen many VCs do one or two SaaS deals. We want to highlight the VCs that have done more than that, and that have an active focus on SaaS (a section on their site, a partner focused on SaaS, some interesting research, etc.). These are the ones that made that cut:

• Bay Partners
• Benchmark
• Bessemer
• Emergence
• HummerWinblad
• Interwest
• Northbridge
• TrueVentures
• Venrock

What you really need to know is, who is funding SaaS ventures right now. Here is the much shorter list of VC that have done two or more SaaS A Series deals since the start of 2007:

• Emergence
• TrueVentures
• HummerWinblad
• Venrock

OK, let’s make a really fine filter. Who has done SaaS A Series deals since the market meltdown in Q4 2008? That list is down to two firms:

• Emergence
• TrueVentures

In raising money, relationships matter – a lot. So if you know a VC that is not yet active in SaaS, call them. If your venture puts them on the SaaS map, they will love you. For most VC that like Internet or software like SaaS, the business model attractions are screamingly obvious.

Photo credit: Mokra
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