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Summary:

The innovation coming out of the cloud computing market has, in many ways, made infrastructure startups interesting to venture capitalists again. Despite our excitement over the potential of cloud computing to transform IT, however, weighing on the minds of many in the VC community is what sort […]

iStock_000005910800SmallThe innovation coming out of the cloud computing market has, in many ways, made infrastructure startups interesting to venture capitalists again. Despite our excitement over the potential of cloud computing to transform IT, however, weighing on the minds of many in the VC community is what sort of time frame we should expect for exits. To put it more bluntly, we want to know when it’s going to rain — when VC investments in cloud computing will result in acquisitions or even an IPO.

The hype surrounding cloud computing is creating upward pressure for the industry to produce rainmakers.  And there are a lot of cloud startups forming — at Panorama, I see a venture funding pitch from at least 10 new startups every week, at least half of which are cloud startups working in the Infrastructure as a Service (IaaS) and Platform as a Service (PaaS) spaces.

In order for a cloud computing company to make it rain, there needs to be evidence that it has the potential to take a market by storm.  After talking to a number of large incumbents that could be acquirers of cloud startups, the key items that would drive them to an acquisition are:

  1. Rapid customer growth — Solid evidence of non-linear customer growth. Not every cloud needs to grow like Facebook or Salesforce, but it needs to be growing — quickly.
  2. Sustained revenue growth — Monetization of the customer growth.  Even Twitter has a monetization strategy now and acquirers are looking for clouds that are accretive to revenues.
  3. Low churn — Keeping existing customers lowers the cost of acquiring news ones — and proves that people will continue to pay for the company’s cloud services.
  4. Widespread use — Adoption in multiple geographies shows that the cloud is not a one-market player but can scale to a global level.

Consider Slicehost. It was acquired by Rackspace after just two years of operations, during which its user base grew to over 15,000 from nothing. Such rapid customer growth, combined with strong business metrics and hosting services that were complimentary to those of Rackspace made clear the value proposition of buying Slicehost. And Rackspace got a great deal — the combined purchase price of Slicehost and another acquisition announced at the same time, Jungle Disk, was around $11.5 million.

While the purchase price may have missed the venture capital returns mark, buying Slicehost appears to have reaped major benefits for the company: Rackspace currently has a $2.3 billion market capitalization and a 4X multiple on enterprise value to trailing 12 months revenues. Granted, cloud computing is only part of the Rackspace services offering that also includes dedicated hosting, but the market is clearly valuing the company’s cloud business at a higher multiple than a normal managed hosting provider. For example, Savvis, a competitor in the managed hosting space that recently enhanced its own cloud computing offering, has a market cap of $895 million and a 1.5X multiple on enterprise value to trailing 12 months revenues. The market appears somewhat kinder to Terremark, another managed hosting competitor that offers cloud services; it currently sports a 2.8X multiple.

Once a cloud startup has appealing business metrics, there are a number of potential acquirers that can help make it produce rain. There are the large cloud incumbents like Amazon, Google, Microsoft and of course, Rackspace. Likewise, there are large companies trying to move into the cloud marketplace from adjacent markets, such as Akamai, AT&T, Cisco, EMC, HP and IBM. There are also the managed hosting providers like Savvis and Terremark that will likely be looking to continue bolstering their cloud offerings.

With Rackspace setting the mark, the current market enterprise values and revenue multiples for cloud startups is compelling. If they can follow the path of Slicehost, then it appears that those of us in the venture capitalist community focused on the cloud will indeed be breaking out our umbrellas some two years after first funding such startups.  And, according to my calendar, the rainy season will start by late 2010.

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  1. Chris Albinson Sunday, November 1, 2009

    Allan interesting post – it may start raining in 2010, but the monsoons are not likely to come until 2011 or later.

    I think we are very early in this shift and there is a tremendous amount of “enterprise class” issues that need to be resolved from APIs, data access, partitioning, security, reliability, scalability, reporting, provisioning systems, etc. This is not to say that we won’t have some great progress in these companies and some interesting early exits. It just means the $1B exits are a ways off.

    We need to hit a tipping point when the majority of enterprise applications are cloud based. This will happen – not because the economics of cloud are better (they are), but because cloud based apps create business value through the “federation/mash up” of data and the democratize distribution of this data to point of impact.

    Think about having 10-100X the information organized by context of the decision/action (history of client, geo, time, customer data, competitive data, dynamic pricing, etc) for every front line worker (doctor, engineer, lawyer, sales rep, food service, hospitality, etc). All delivered real time on any device type.

    We are not that far away from this.

    The realization of this productivity impact will have a measurable impact on US GDP and is the point when $B plus company exits will happen.

    1. Chris,

      In reply to

      “Think about having 10-100X the information organized by context of the decision/action (history of client, geo, time, customer data, competitive data, dynamic pricing, etc) for every front line worker (doctor, engineer, lawyer, sales rep, food service, hospitality, etc). All delivered real time on any device type.”

      I’m sure you are a very smart guy but that is a bit of gobley gook IMHO.

      No hardcore cloud computing person I know see’s cloud computing as a data integration revolution. I think you’ve wandered into the wrote revolution with that comment.

      Best-

      James

      1. James — perhaps it isn’t “hardcore cloud computing,” and agree that data integration and data quality are thorny problems, but I have to agree with Chris that creating a shared, multi-tenant common repository of information–whether federated or integrated–is a major use case for cloud services: in the physical world, the Library of Congress or the new Magritte Museum in Brussels are examples. Whether books, patents, weather data, or anything else, aggregation follows winner-take-all dynamics, and real-time broadband wireline and mobile access to that information, appropriately filtered and contextualized will create competitive advantage via accelerated business processes and decision-making.

        Joe

  2. I think Chris is right. The torrential rains [which will also have some parties selling in Billions of dollars]will come by 2012.

    I expect the great convergence not start only by then and something that will reach full motion by 2015. By then norms would have been set in order to allow for a seamless social/collaborative (which will help firms grow customer base exponentially) and business convergence. So if you are working on a smart idea then do the following as well.

    – Learn from other mistakes (yes, you could have sold your company for $100M slicehost had you waited a bit)
    – Wait for the technological and sociological development/maturity in enterprise to take place in order to build more mature solutions
    – Look for gaps which are being left wide-open such as Security, Regulation, Pricing which can be easily integrated in the common marketplace
    – There is a whole lot of little LOBs that can be build on the PaaS stack so you can also do several companies on that stack as well
    – IaaS stack needs more mature and robust answers to problems such as bandwidth (intra- as well inter-Cloud)*, they need to be solved. You can be the hero start-up there
    – Expensive, toxic software**: You can think on several clever tactics to build an arm within your start-up OR set a start-up that can tell you that you can save 10 times the money on that expensive software stack as well!

    So yes wait patiently and torrential rains will come :)

    *,** Disclosure: I have both these start-ups in my portfolio (and also several others)

    Tarry Singh

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