Valuing companies based on revenues is a bit of a stretch in my mind. Actual income/earnings/cashflow makes a lot more sense.

If you don't take into account expenses then you get some really wacky valuations: ie a company is in the business of selling houses (or other large cost item) for a small percentage higher than they bought them. If you don't take into account the cost of buying the house and running the business, and just look at the revenue from each house sale you will drastically over value the business. If they sell 50 $100,000 houses that they bought for $99k each and it cost them $500 in fees per house sale they would have $25k in actual earnings but $5 million in revenue. Valuing on a common "5x the yearly revenue" you would be willing to pay $25 million for a business that produces $25k per year (if you are willing to do so and have a lot of money I'll sell you a lot of businesses like that!).

Software is a higher margin business of course, but at the end of the day as an investor I care about how much cash is going to go into my pocket due to an investment rather than how much total cash passes through the companies books.

Even the 2x to 3x of earnings that sole proprietor/small software shops are getting now sounds outrageous to me. You're betting on growth (and paying like it's there) and hoping that clients don't leave for 2 to 3 years. Higher multiples can make sense if there are expenses you can cut to get earnings (or a very clear, easy to see growth opportunity [if that is there then why are they selling of course?]), otherwise you're just tossing away money.

That's fair, but you can only reason that way with an owner who is mentally "done" with his business, or his business is flat/ declining. For entrepreneurs that feel they haven't yet attained anything close to the full profit potential of their business, you just have to make them an offer they can't refuse, which leads to absurd valuations. Sometimes works great, sometimes it doesn't, hopefully it evens out positively in the end. That's the game you play when you invest.

There is a word for that: EBITDA

And interestingly, VC's themselves use it. See Fred Wilson's blog, avc.com, for example.

It's a different story if staff doesn't come with, which many times for businesses this small, is just the founder.