Cloud computing companies that have developed business models based on recurring revenue streams continue to attract attention in the press and the investment community. It's no wonder: the Software-as-a-Service (SaaS) market will grow at a 19.5% CAGR through 2016 and global SaaS spending industry is projected to expand from $13.5B in 2011 to $32.8B in 2016. Related cloud segments in Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) are expected to grow at rates of 41.3% and 27.7% through 2016 respectively.1 The rapid development of these markets creates a compelling opportunity for such companies to grow and create long-term shareholder value.
Drivers of Enterprise Value in the Cloud
Recurring revenue business models carry a distinct set of measurements of success that are not readily revealed in GAAP financial statements. In particular, committed monthly recurring revenue (CMRR), customer lifetime value (CLTV), customer acquisition cost (CAC), and customer churn are key attributes that help determine enterprise value and the likelihood for sustained growth in value over time.
While there are several valuation techniques in use, one of the most common today is to value a cloud-based company using a multiple of forward-looking CMRR or its annualized equivalent, ARR. Currently, multiples for recurring models receive a premium in the market due to the perception of the committed revenue as being more "sticky" relative to non-recurring revenue found in other kinds of businesses. However, execution on the appealing valuations of cloud-based companies comes with a catch: financing.
Financing cloud-based businesses can be difficult through traditional means because recurring models make a trade-off at inception: a lower-priced perpetual revenue stream with a higher long-term value is chosen over a traditional revenue stream with higher initial price and lower long-term value. While the recurring revenue model is worth more over time, initially such models can require more cash upfront without traditional assets such as accounts receivable that can be used for debt financing.
Institutional equity financing often plays a critical role in financing the development and growth of cloud-based businesses. The competitive environment combined with the pace of innovation and market growth can create a funding requirement that is simply too great to fund with organic cash flow. In these instances, an entrepreneur is faced with little choice but to raise equity from a venture capital or private equity firm. A few companies in the market — whether through first-mover advantage, proprietary technology, or support from other non-recurring revenue business segments — are able to capture sufficient cash flow to grow organically without institutional capital while maintaining a competitive position in the market. Companies with that luxury find themselves in the enviable position of being able to raise capital at the timing and valuation of their choice.
In either circumstance, debt capital can play a key role in supporting the growth of a cloud-based business. A limited number of banks, including Silicon Valley Bank, have developed expertise in lending to companies with recurring revenue models. In rapidly expanding cloud-based companies, debt is especially appropriate to help finance customer acquisition costs where the return on investment from such spending is predictable and the company is in a growth mode.
Expertise in lending to cloud-based companies goes beyond more traditional lending products such as growth capital, A/R lines of credit, and cash flow-based lending and into specific financing of customer acquisition costs via a recurring revenue line of credit. Recurring revenue lines of credit are custom-tailored to each situation, and generally provide borrowing availability using a multiple of a company's CMRR.
Companies interested in financing their cloud-based business via external financing can prepare by putting in place the tracking and reporting tools necessary to understand the real performance metrics that drive value in their businesses. An early and periodic conversation with potential financiers will ensure external financing comes on board at the ideal time to support the growth necessary to remain competitive in the market.
1 Gartner Research. Forecast Overview: Public Cloud Services, Worldwide, 2011-2016, 4Q12,: February 8 2013