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Nick StoffregenPrincipal

Why We Look for Software Investments Beyond the Cloud

Last year, annual global spending on public cloud services surpassed $125B—growing by 30% since 2019 and finally dwarfing enterprise spending on data centers. The sudden reality of remote work increased demand for software-as-a-service (SaaS) products as companies moved operations into the cloud, and investors took note. While overall venture capital exits decreased for the first time in five years in 2020, exits for SaaS startups grew 10% year over year on average. Specific verticals within SaaS performed even better: Horizontal deals nearly doubled from $12.7M in 2019 to $20.2M in 2020, while vertical deal sizes nearly tripled from $12.7M to $37M.

It’s no surprise investors supported SaaS at a time of uncertainty, and not just because of how the pandemic shifted business. Investors have been enamored with SaaS cloud software for the past decade because it has become short-hand for recurring revenue, growth potential, and scalability.

But here’s the problem: While cloud infrastructure makes it easier for early-stage startups to grow quickly, the costs can outweigh the benefits for more stable or mature companies.

While many investors exclusively focus on cloud, Elsewhere Partners believes in a more balanced approach: If a company’s on-premise or hybrid offerings demonstrate potential for profitability and growth, we’ll lean in to learn more. In this article, we’ll walk through why we believe there’s promise in underappreciated delivery models beyond pure cloud, and how you should think about vetting investors if you’re not an exclusively cloud software startup.

What’s behind the cloud paradox?

A16Z recently did a great job of analyzing the paradox of the cloud: It can be the best option in the early stages of a company, but eventually puts pressure on margins as the company scales and growth slows. I found myself nodding in agreement as I read the article, but for a slightly different reason. This perspective echoes many of Elsewhere’s reasons for investing in startups with other software delivery models. However, the tradeoff is not only relevant to a company that throttled growth for years and then stabilized. Founders who drive for pragmatic growth, instead of the “billion or bust” approach, must consider the high costs of public cloud architecture even in the early days.

Cloud technology undoubtedly has its benefits, especially for early-stage high-growth companies. It allows you to scale quickly without a large capital investment upfront. It also enables you to ship imperfect products, because you have the ability to release updates several times a day with new features or fixes. This aligns well with the fail fast and minimum viable product teachings of the startup world. In addition, cloud-based SaaS subscription models typically create a steady revenue stream with high retention. If customers stop paying, they lose access to the product entirely (versus license models, where the customer essentially owns a version of the software forever).

At the same time, as highlighted by a16z, the cloud comes with consequences: For example, public cloud prices can be up to 12x the cost of running your own data center at certain maturity stages. In addition, many experts point to how reliance on the cloud poses greater security risks than hybrid models. For our earlier-stage pragmatic growers, saving 10-15% of revenue on cloud costs could make room for more developer hires, a marketing budget, or avoiding a second mortgage/maxed out credit card.

Guided by the pursuit for scalable growth, we believe that many investors have conflated the benefits of software with the benefits of cloud. It’s not the only option to drive highly recurring revenue and scalable growth.

Why we see value in on-premise and hybrid models

While we have several cloud-based startups in our portfolio, we also invest in companies with more traditional on-premise software or hybrid models (a mix of cloud and on-premise). We support these businesses for three main reasons:

  1. Pragmatic growth strategy

We invest in businesses that take a pragmatic approach to growth, rather than operating with a billion-or-bust mentality. Since early-stage teams that are building on-premise or hybrid products need to be incredibly thoughtful about how they allocate resources and build out the product, they tend to conceptually align with our pragmatic growth mindset.

  1. Product management and hygiene

Second, we’ve found many stellar teams with on-prem and hybrid products who exhibit best practices with strong product portfolio management—they are shipping out well-built products and they don’t have numerous versions of the product sitting with different customers. These teams often take a product-led approach to growth and have a deep understanding of their target customer through strong feedback loops that serve as inputs to new features. This enhances customer value and naturally extends the product’s value proposition.

  1. Possibility of subscription models

Lastly, you can still structure payments for the use of on-premise or hybrid delivery products as recurring subscription revenue. Instead of the old-school revenue model for on-premise software—sell a perpetual license (so the software is the client’s forever) and charge ongoing costs for updates and support—startups can charge a subscription in-line with SaaS peers. All else equal subscription revenue is subscription revenue, whether it’s in the cloud or not. Teams employing this strategy have an extra source of funding (no hosting costs) to re-invest into their product and go-to-market teams.

How to find alignment with investors

If your product and customer base is best served by on-prem or hybrid infrastructure, make sure to find investors who are not only aligned with your vision but have the relevant experience to accelerate and maintain your momentum as you scale. This means not only looking for investors who take a pragmatic approach to profitability and growth, but also those who have experience helping these types of companies through to a successful growth story and exit.

For example, our portfolio company Itential launched with an on-premise product and reached significant scale with high capital efficiency. Now that they’ve reached a major growth milestone, we’re providing more operational expertise along with the right-size amount of capital to help the team launch a hybrid model with a new cloud offering for enterprise customers.

The perspective on cloud is shifting

Over the next few years, I think we’ll see the “cloud or nothing” frenzy fade and investors become more amenable to other delivery models again. As we learn more about the long-term impact of cloud on company growth and profit margins, the investor perspective will start to catch up.

Each flavor of cloud, on-premise, and hybrid software products come with various benefits and challenges. (Hint: We’ll be digging into more of the product side of this conversation in future posts.) The key thing is to find people who believe in your product and can help you work toward your ideal exit goals.

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About the Author

Nick Stoffregen

Nick is a Principal at Elsewhere Partners where he co-leads investment efforts in infrastructure software. Previously, Nick was a software investor at Serent Capital and consultant at Bain. Originally from Indiana, Nick is passionate about bringing capital and operational expertise to companies outside traditional venture hubs.