Venture capitalists looking ahead to 2007 are optimistic about the financial potential of software as a service (SaaS), even though industry data shows that total investments in software companies are declining.

SaaS, which allows companies to access applications hosted remotely via the internet, typically while paying monthly fees, offers a more predictable revenue stream and lower research and development expenses to software vendors than packaged software products, says Jeff Horing, co-founder and managing director of New York-based Insight Venture Partners.

"Overall, if you can build a successful company it's a much better business model than licence sales," Horing said.

Total venture capital dollars invested in software declined 19% between the second and third quarters of 2006, and the number of software deals reached its lowest point in a decade, according to the Q3 2006 MoneyTree Report, compiled by PricewaterhouseCoopers and the National Venture Capital Association.

Horing said he and other investors at his firm are sceptical about growth for companies looking to make their mark by selling enterprise software applications, as opposed to those that market the SaaS model.

"From our view, convincing lots of Fortune 500 companies to buy a complex piece of application software is very difficult," he said.

Horing would rather invest in established companies that are looking to enhance profitability through buyouts, rather than growth, he said. To that end, Insight Venture financed a recent deal that allowed Primavera Systems to bolster its line up of project management software by purchasing two smaller companies.

Warren Weiss, general partner at Foundation Capital in California is also sceptical about investing in companies that sell packaged software applications. Weiss prefers investing in SaaS models that cater to customers that don't want to deal with a large systems integration project.

"Software as a service is clearly a very interesting area because of the ease of selling into these types of environments where users can use it without a big IT implementation," Weiss said.

He said he looks for products with the user-friendly features of Foundation Capital has invested in Rearden Commerce, which provides travel services for businesses, and BoardVantage, a company that provides hosted applications to boards of directors.

"We have about 11 of these types of (SaaS) investments and they're doing very well," Weiss says. "We're looking for new investments in that area."

SaaS is catching on partly because it allows small companies to gain the functionalities of large enterprises, he said. "It gives them a chance to level the playing field against their bigger competitors."

Foundation Capital does plan more investments in traditional software in the Internet infrastructure realm. Security and storage software, middleware integration, and networking software are among the potential investments, Weiss said.

Horing said he is bullish about growth in infrastructure software because of the success of selling products on the web.

"The internet has really transformed the sales model," said Horing. "The cost of selling your great idea is significantly lower."

Venture capitalists on the whole are predicting a "strong and stable investment climate" in 2007, but not necessarily in the software industry, according to the MoneyTree Report.

Only 23% of venture capitalists surveyed predicted growth in software investing.