Solution Providers Leverage VC Firms As New Financing Source

There's a new player in town for channel financing.

Actually, several new players, thanks to a variety of venture capital and private equity firms eyeing investments in fast-growing cloud and managed services businesses. As a result, some solution providers are turning to this new source of financing to help fuel their growth.

Compared with the past couple of years, VC and private equity firms are showing increased interest in the channel, said Edison Peres, senior vice president, worldwide channels at Cisco Systems, during a roundtable discussion of channel chiefs with CRN editors earlier this month.

[Related: Channel Financing Week ]

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"What's interesting is that a lot of the venture capital players are now investing in the channel who never had an investment in the channel before," Peres said. "So this new money is coming in through these new venture capital guys who now see an opportunity in our world that eight years ago they didn't see. They see market transitions as an opportunity to make a play, and there are a number of market transitions happening right now."

Why are VC and private equity firms so interested in solution providers? Arguably the biggest factor is the move to recurring revenue streams around managed and cloud services; by virtue of their financially stability and cloud allure, these companies have become much more attractive destinations for venture capitalists.

"They believe in the transformation in the cloud services space and they share the belief of growth potential," said Grant Kirkwood, CEO of Unitas Global, a private cloud and IT outsourcing solutions firm that recently scored a big round of VC funding.

But how does VC funding differ from other types of financing for solution providers? Generally, collateral is mandatory in order to receive loans from a bank. However, many solution providers that focus on IT services don't have the hard assets to provide a bank, said Ron Edinger, CEO of VC firm Liquid Capital.

"Post-2009, banks were very oriented toward loaning against hard-asset collateral, and our model is meant to overcome that part of a bank," said Edinger. "While an invoice is a form of collateral, it's a different kind that bothers banks. [When VARs] want a higher growth model or bigger contract, their bank won't automatically increase their credit lines with the amount of the contracts they have."

With firms such as Liquid Capital, solution providers are able to have their working capital extended. Unlike banks, VC firms look at the assets of an IT company such as people, said Edinger.

"We take a very different view and have ways of collateralizing an invoice or contract," said Edinger. "They have to manage the cash flow and that depends on their customers paying them on time, so what we provide is a way of making sure [companies] always have the money to meet payroll to maintain their biggest assets, and their people."

Cloud and managed services provider ADAR IT secured a $2.4 million funding deal with Chicago-based VC firm MK Capital in February 2014. The investment will go toward expanding ADAR IT's sales team, marketing and geographical expansion, said Vadim Vladimirskiy, CEO of ADAR IT.

"We were cash-flow-positive already; we didn't need to bridge the gap but wanted to make sure this investment was a very strategic one with a growth projection in place," said Vladimirskiy. "The reason to go with a VC firm was for the strategic alliance as they have experience in the channel and their track record is attractive."

According to Vladimirskiy, VC firms aren't looking at assets from VARs because they are essentially becoming an equity partner.

"They are taking the same risk the founders are," said Vladimirskiy. "They are not lending the money to the venture; what they are looking for is a business model that has a lot of off-site potential in scaling and being successful when they [become] large."

VC firms can forecast the potential success of a company by looking at different metrics besides balance sheets, said Vladimirskiy. Such metrics include customer retention.

"How [well] they can retain customers is an indication that they're doing something well and will be continuing that when they grow," said Vladimirskiy. "In our case, MK [Capital] saw that our retention was very good and it's the culture that we built from day one where we always focus on our services to help our clients get their work done."

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MK Capital has extensive experience with channel partners, especially managed services companies, said Bret Maxwell, managing partner at MK Capital.

"We understand how to build them and working the distribution channel is our core part," said Maxwell. "We spend a lot of time with them. It's like real estate -- location, location, location -- and so for us, it's people, people, people."

Investing in a company requires looking at a VAR's market segment, differentiation and growth opportunity. Finding the right company to invest in yields promising results, said Maxwell.

"We invest in them for four to seven years and they will grow 10 times the size than when we started -- a $3 million company turns into a $100 million company" said Maxwell. "We provide capital and then help them recruit, build out their teams and help them strategize, introduce them to banking relationships. We become their most trusted adviser, they respect our opinion and we add value."

Unitas Global, Los Angeles, recently closed a funding round with two VC firms, MK Capital and San Francisco-based Azure Capital, for a total of $5.7 million. Kirkwood said the funding will go toward expanding Unitas Global's sales and marketing operations, which he said were in dire need of capital.

"We formed a number of strategic partnerships from a sales-distribution standpoint and we found ourselves overwhelmed with the opportunity coming in," said Kirkwood. "We came to a situation where we didn't have the resources from a sales team perspective to address that and we needed to raise capital."

Unitas Global's decision to have MK capital and Azure Capital as its investors simply lies in their experience in the channel and confidence in the cloud, said Kirkwood. "MK Capital is relevant to our space because of their experience. They were one of the first investors for Exodus, a large data center [hosting] firm in the '90s, and Azure Capital were the first investors in VMware," he said.

The growth of cloud services has blurred the line between solution providers and vendors, and the rising tide of cloud interest appears to have also raised the channel. Derek Roos, CEO of Platform-as-a-Service provider Mendix, which recently closed $25 million in Series B funding for global expansion, sales and its product expansion, said the cloud is "hot and getting hotter."

Roose said he hasn't had any problem securing funding for his cloud business; in fact, financiers have been approaching him, asking if they can also become investors in his company, he said.

However, according to Roos, a company that is solely cloud-focused isn't guaranteed financing and success. "It puts you in the spotlight but it doesn't mean you're a good business to invest in," said Roos.

There's a lot of opportunity for the cloud ahead, Roos said. "My perspective is that we are still in the early days of cloud," Roos said. "I think the best is still ahead of us."

Channel financing through VC firms will continue, as long as there is opportunity to grow within a company, said Frank Vitagliano, vice president of North American channel sales at Dell, during the CRN roundtable discussion with channel chiefs.

"The fact that the VCs are playing now [in the channel] and they really have never played there before is really a testament to the fact that this thing is a big opportunity," he said. "They've started to realize that there's money to be made here."