The search for next-generation cloud startups

Seattle’s roots in cloud computing run deep.

Much of this stems from two local tenants, Amazon Web Services and Microsoft Azure, and then, too, the engineering talent that has spilled over to wannabes (Google, Facebook and Salesforce have facilities there) and to the scores of startups growing up in the sun-deprived Northwestern United States.

To investors, such as Matt McIlwain of Madrona Venture Group, the region is a fecund environment for this increasingly potent trend in information technology.

“We do think of it as Cloud City,” said McIlwain, a managing director at the firm. “Most of our companies are based in the Pacific Northwest, and 100 percent of our companies are using one or more types of cloud services, and actually 100 percent of them are using at least one Amazon Web Services cloud service.”

McIlwain says he is excited by intelligent cloud application companies and micro services. He also argues an increase in M&A is possible this year.

VCJ recently had to opportunity to speak with McIlwain about cloud investing. An edited transcript of the conversation follows.

Q: What areas of cloud expertise stand out in the Seattle region?

A: The first piece is the infrastructure part of the cloud. How do I build the basic building blocks of an infrastructure offered as a service and how do I make that available to any customer?

There is an element of understanding how infrastructure, or distributed systems, works and there’s an element of delivering it and operating it as a service. Then there is an element of making it easy for somebody to consume.

Q: Which sectors are seeing the most company formation in the area?

A: We see a lot of companies that are related to virtual reality and augmented reality. That’s a big trend right now.

We also see a lot of companies in the intelligent applications area. We are actually seeing quite a big trend in terms of companies using natural forms of human interaction with technology. Some people call that natural language processing, or natural language understanding.

Q: Are you seeing much of an increase in activity at the intersection of machine learning and cloud?

A: It’s no accident that Amazon has its Amazon Machine Learning service and Microsoft has its machine learning. But also you have companies like Dato in our portfolio that provide machine learning as a service so you can turn any application into an intelligent application.

Cloud has actually gone from being this infrastructure as a service to a place that I can store and use data in new ways and now with the machine learning capabilities I push all the way up into my applications and make my applications far more intelligent.

Q: What do you see on the next-generation applications front?

A: What we’re discovering now is that beyond the infrastructure services, there are all kinds of data services that are enabled on top of cloud infrastructure. We’re seeing new kinds of data stores in the cloud, new kinds of data warehousing in the cloud, new kinds of data flows in the cloud.

In other words, I stream data into my system and then I use different techniques to have that data trigger actions or events.

Q: What areas of cloud most interest you as an investor right now?

A: The one thing I mentioned before is the idea of building intelligent cloud-base applications that can help do some kind of business better. Amperity is an example. It is a company that is helping retailers with customer satisfaction.

I think there will be a lot more applications built from scratch that will leverage the agility of cloud infrastructure and leverage the power of data and machine learning to be just a better application for a business problem. That problem might be preventing fraud, or that problem might be travel and expenses, or that problem might be customer support. There is going to be a lot of opportunities in next-generation intelligent applications.

Q: Anything else?

A: The other thing going on that we think is a big deal, and this is pretty early, is the way of building applications using lots of little services. People call them micro services. Being able to take a lot of little services that independent development teams can work on and put those together in a macro service and deploy it in a very modern, architected way.

This whole area of micro services, which is leveraged off another buzzy term called containers, is only possible because we have cloud infrastructure. That is super early but a very exciting area.

Q: Are public market multiples on cloud companies at an appropriate level now?

A: The category of cloud SaaS was pretty fully priced last year vis-a-vis long term historic multiples of revenue for SaaS companies. And so the fact that there has been some modest correction this year is not surprising and probably healthy. I think you’ve got to drill down on a company-by-company basis.

If you look at a company like Atlassian, for example, which has hundreds of millions in revenue and is growing quite nicely and is significantly profitable, it’s hard to make the case that it is over valued. In fact, you could make the case it is under valued.

Q: You keep close tabs on the strategic landscape in the cloud. What do you see taking place in enterprise cloud?

A: A lot of the big traditional enterprise technology companies have discovered how hard it is to deliver cloud services, especially cloud infrastructure as a service. They have become more active at making acquisitions or thinking about acquisitions as a result of that.

We saw EMC buy Virtustream last year. We saw Accenture buy Cloud Sherpas last year. We recently saw Oracle buy a company called Ravello Systems.

Q: Do you see the possibility of more M&A this year?

A; Since we have seen a little bit of softening in the late-stage market’s valuations, I think there is more of a closing of the gap between what a buyer might be willing to pay and what a seller is expecting to get in terms of M&A transactions.

Assuming the capital markets remain relatively moderated, as they seem to have at the end of the first quarter, we could see, for some of those technological reasons but also for some of the capital market reasons, an increase in M&A throughout the rest of 2016.

Photo of clouds by Alastair Goldfisher