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VCs eye big cloud software returns despite dwindling valuations

By Sarah McBride

SAN FRANCISCO (Reuters) - A cloud software boom has nudged startups into unlikely realms such as dairy farms, yoga studios and back-of-the-building loading docks, leading venture capitalists to hope for stratospheric returns.

Venture capitalists poured more than $11 billion into software last year, more than into any other sector and about double the amount in 2010, according to the National Venture Capital Association. The number of deals in which venture firms have backed software startups has risen by about half in the same time, to 1,570 last year.

Not everyone shares their enthusiasm. Wall Street investors are voting with their wallets when it comes to the hottest sector, known as "software as a service" or SaaS. Internet-delivered, subscription-based software has slumped this year, with big companies like Workday Inc and Salesforce.com Inc each shedding around 9 percent of their market value.

Venture capitalists say that decline has dragged down the valuations of private companies. A few months ago, VCs counted on companies trading at 10 times forward revenue when they went public, instead of five times today.

While those numbers might have some observers muttering about bubbles, venture capitalists defend their bets, saying that software is just starting its advance into all kinds of unexpected and lucrative places.

"People are getting it more than they used to," said Jason Pressman of Shasta Ventures, which uses mobile devices to make formerly deskbound software reachable from anywhere, could supercharge the adoption of business software.

Such ventures increasingly must target a smaller slice of business given that the easy broad terrain of human-resources management, bookkeeping, and the like have already been taken.

"I see a lot of startups going after super niche categories," said Chuck Ganapathi, a former Salesforce executive and founder of Tactile, which synchronizes data from calendars, social media, and other programs.

Few SaaS start-ups will become the Microsofts and Oracles of tomorrow, but venture capitalists said that does not faze them. The also-rans will get bought up by big established software companies scrambling to adapt to a cloud-based market.

MISMATCHED

And a lucky few SaaS businesses will make it all the way to a public-market debut, as Workday did two years ago.

"The top 20 percent become real companies," Scott Weiss of venture firm Andreessen Horowitz said in an interview.

Others, he wrote in a blog post last year, will be sold, but the big businesses that buy them will not always know how to handle their start-up acquisitions.

"They will smother these (start-up) companies with too much negative attention, mismatched sales forces, and misunderstood business models," Weiss predicted.

From his perspective, that just creates a double investment opportunity, as the bigger companies' bungling paves the way for entrepreneurs to revive and try again the SaaS idea that withered once a bigger company bought it.

SaaS allows companies to easily try programs without technology infrastructure upheaval or tedious staff training. Dropping a SaaS program is no big deal if it does not work out. The flexibility accounts for why many industries are beginning to embrace the model and bring it mainstream.

At Irvine, California-based loading-dock servicing company McKinley Equipment, technicians ditched three-part carbon-paper work orders for iPads and ServiceMax software. ServiceMax, which earlier this year raised $71 million in new funding, directs the technicians to malfunctioning loading docks, helps locate the bug, and streamlines the ordering of replacement parts.

"In the old days, when a technician needed something, he would draw a picture, 'I need this part, it's the thingamajig that connects the blah,'" recalled McKinley Chief Financial Officer Kevin Rusin, pointing to delays or wrong parts being delivered. Now, ServiceMax and greater use of photos help identify the right gear for order that day, contributing to double digit revenue growth at McKinley.

Other niche players include Dairy.com, which allows farmers to track their milk; and MindBody.com, which allows yoga studios to manage class schedules and customers. Yesware's software analyzes interactions with emails, telling salespeople who has opened and forwarded around their messages so they know where to focus their follow-up efforts.

Even though SaaS seemingly encroaches everywhere, many venture capitalists remain reluctant to invest, perhaps because they think of software in the traditional non-mobile, non-accessible way, said Battery Ventures' Roger Lee.

"Most people's framework for investing is in the rear-view mirror," said Lee, who blogs frequently about software. "What you need to do is completely change your frame of reference."

(Reporting by Sarah McBride; Editing by Christian Plumb, Edwin Chan and Richard Chang)

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