The Motley Fool investing team is always trying to learn, grow, and adapt. One of the many ways we do this is by speaking with other investors who we admire. On Jan. 8, Mary D'Onofrio of Bessemer Venture Partners (BVP) graciously agreed to speak to our team about her framework for investing in cloud companies.

Mary D'Onofrio

Image Source: BVP

Bessemer Venture Partners is one of the oldest venture capital firms in the United States. It has invested in over 120 companies that eventually had an initial public offering (IPO), and it currently has over 200 portfolio companies, including one of the largest cloud portfolios of any venture firm (according to BVP), with more than 50 current cloud portfolio companies.

D'Onofrio joined Bessemer Venture Partners in 2018 to launch the firm's growth practice. D'Onofrio also developed Bessemer's Cash Conversion Score, is an author of Bessemer's 10 Laws of Cloud Computing, and is one of the key architects behind the BVP Nasdaq Emerging Cloud Index, which serves as the definitive benchmark for public cloud companies.

Some of D'Onofrio's recent investments include LaunchDarkly, HashiCorp, and BigID. Other Bessemer investments have included LinkedIn (acquired by Microsoft), Twitch (acquired by Amazon.com), Shopify, Twilio, PagerDuty, Pinterest, Wix.com, DocuSign, Box, Periscope, Qualys, Canva, and hundreds more.

D'Onofrio is a cloud expert and engaging public speaker. In her presentation, she went into depth on the 10 Laws of Cloud and the Cash Conversion Score.

The 10 Laws of Cloud is a roadmap for cloud CEOs to scale their businesses. Some of the key points are...

  • In the cloud economy, scale wins: Cloud market leaders often capture more than 50% of the market value, benefiting from a virtuous cycle in which a first mover, product, execution, or leadership advantage generally creates a flywheel of successful financing, hiring, product refinement, and customer retention in which the winner takes most. The market leadership and presence also allows companies to think about "second acts" (new products, adjacent markets, etc.) to expand their total addressable markets (TAM) earlier in their lifecycles, expanding their moats further while enjoying the benefits of scale.
  • Growth at optimal cost: This law examines the trade-off between revenue growth and profitability and tries to ensure that the cash burn is rational and sustainable.
  • Invest behind the cloud sales and marketing learning curve: Sales and marketing (S&M) is generally the largest operating expense of a cloud company, so ensuring that a go-to-market strategy is optimized (CLTV/CAC is positive, reps are attaining quota, etc.) before investing behind that strategy is imperative. In other words, experiment with S&M before scaling.
  • Product as a competitive advantage: Although finding the optimal go-to-market strategy is paramount, it is the company's product that ultimately determines market leadership in the long term. This is why BVP is looking to partner with founders that are product-obsessed, product evangelists that understand customer pain points and are laser-focused on investing in research and development (R&D) and solving customer problems. Increasingly, enterprise products that capture market share are able to deliver consumer-like experiences with an easy-to-use, sleek user interface and great customer service.

The Cash Conversion Score (which D'Onofrio created) is a proxy for return on invested capital (ROIC) on dollars invested into a cloud company. Across the Bessemer portfolio, Cash Conversion Score is directly correlated with the internal rate of return (IRR) generated by an investment. In other words, after back testing, D'Onofrio found that it is highly predictive of future returns! The metric is simple to calculate (and D'Onofrio provides a Good, Better, and Best Framework for different scores), but it is a highly robust summary metric because it is impossible for a cloud company to have a good Cash Conversion Score without having strong underlying software-as-a-service (SaaS) fundamentals including strong product-market fit and a scalable S&M engine. For cloud company CEOs, the lesson of the Cash Conversion Score is that capital should only be raised and deployed when that capital can be successfully used to generate revenue.

I look forward to incorporating D'Onofrio's framework into my research of publicly traded cloud companies. Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.