It's Cloudy, But When Will It Rain?

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.