Do SaaS ventures need VCs?

Does the rise of SaaS mean an end to venture capital investment in software startups? That's the impression I'm getting after hearing from several SaaS entrepreneurs. Their business models are becoming so predictable they simply don't need the risk capital.

I had some interesting responses to my posting last week about Financing SaaS ventures. One of the most interesting got me thinking whether the best SaaS ventures actually need venture capital. Obviously someone needs to put up enough money to cover the founders' living costs while they develop the application, although entrepreneurs often do that simply by leading a hand-to-mouth existence for a couple of years, so that's not a huge sum to raise. Of course there are certain costs involved in putting an application up on the Web — but most of those can be negotiated on a pay-as-you-go basis these days. The main cost is sales and marketing, but if you have a really good application that markets itself virally, those costs can be kept pretty low too.

So it really might be true that the best SaaS ventures — the ones with the most compelling applications — will never need venture finance, so long as they have enough capital to get going in the first place. Here's what Isaac Garcia, founder and CEO of Central Desktop, told me in an email exchange:

"We are running a very cash positive business built on subscription revenue and we've 'taken out' most of the risk over the past two years. With recurring revenues, steady monthly, predictable growth and low overhead we are able to demand higher valuations than typical startups.

"And, as your article noted, the type of financing we are seeking is very different from financing deals we've done with prior companies. We are looking at much lower numbers, leveraging lines of credit and other debt financing — because the risk is so low!

"In many ways, SaaS companies are not VC plays — at least, not in the traditional sense. Once established with a product to market, a properly run SaaS company can accurately predict its revenues and growth — which means that it can also predict, with relative accuracy, exactly how much cash it needs for expansion and when and how much of an ROI the lender/investor will receive. This time frame is usually much shorter than traditional VC horizons and less risky. This also means that the terms are different than most deals."

In other words, a properly run SaaS company is not a risky enough proposition for venture funding. VCs want to invest in companies that have a higher risk factor than most good SaaS players, which allows them to extract a greater share of the equity in return for providing funds. Their reward for taking on this risk is the 'hockey stick' growth of a handful of good bets, which provides enough return to make up for the failures.

There may still be some companies that want to go for a more aggressive growth path and who therefore need bigger injections of cash. And as TalkBack commenter Assymetric1 points out, there are alternatives to monthly subscription model that entail more risk for vendors:

"Some on-demand providers also have a pay-for-performance model. In this case there is more vulnerability for the SaaS provider and investor/lendor, if there is a precipitous decline in performance (sometimes for reasons outside the vendor), or the customer temporarily turns off the app. Additionally, as the ad model emerges for apps, other considerations will emerge."

But Garcia's comments — together with other feedback that I've received privately from elsewhere — suggests that the large sums of money VCs typically prefer to invest simply aren't appropriate for most SaaS ventures. Their founders prefer instead to borrow smaller amounts against the stable margins and predictable revenue growth of their businesses, leaving VCs out in the cold.