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September 19, 2007

The Rebirth of Enterprise IT

My partner, Chip Hazard, has been an enterprise IT VC since he joined Greylock in 1994.  He and I have watched with some amusement as everyone and their brother in the VC community has been writing off enterprise IT as a boring industry and reinventing themselves as consumer VCs.  With some coaxing, he agreed to do an update on a guest blog he did a few years ago on the topic.  Here it is:

When Nicholas Carr wrote his now-famous Harvard Business Review article over four years ago, “IT Doesn’t Matter”, the most damning claim to our industry was that IT had become a commodity input – irrelevant as a source for strategic advantage. Many pundits, from Larry Ellison on down, began pontificating on the maturation, consolidation and eventual death of the enterprise software business – at least for companies whose names are not IBM, Microsoft, Oracle, SAP or Symantec.

The general thesis goes something like the following: 1) corporate IT departments are looking to reduce, not increase their number of vendors and are therefore not inclined to work with start-ups; 2) customers no longer are pursuing best of breed strategies, but instead want integrated suites to simplify deployment and operations; 3) the sales and marketing costs of large enterprise software solutions are extremely high and drive a need for significant investments that are beyond the capabilities of many early stage companies; 4) the overall rate of growth of the software industry as a whole has slowed and there are few areas for innovation. Common analogies used by these pundits include the maturation and consolidation of the automobile and railroad industries in the early to mid 1900s. Pretty depressing stuff.

In the last six years, many venture capitalists are submitting their own vote on this debate with their feet, as the percent of funding dollars to software companies has declined from 25% of all venture disbursements in 2001 to 19% in the first half of 2007. Anecdotally, when you walk the halls of VCs around Sand Hill Road and Route 128, you hear a similar refrain: “We’re diversifying away from software... we are experimenting with consumer-driven business models... we like Web 2.0/new media plays”.

So where does that leave a talented entrepreneur (or VC, for that matter) with deep experience in this now passé field? While challenges remain, we submit that there remain numerous glimmers of hope in the enterprise software market – and certainly the recent reopening of the IPO market and the more robust M&A environment has brought some of these to light. If you look at some of these recent successes, themes and strategies emerge that entrepreneurs can adopt to drive the creation of successful companies:

  • Innovate to drive efficiency. For many times over the last decade, enterprise software companies positioned themselves as automating certain functional departments of corporations. First it was manufacturing, then financials, supply chain, sales, marketing etc. If this is your view of the enterprise software environment, then by and large Larry Ellison is right – there is little room for new categories and innovation. That said, if you spend time with the average CIO, you will hear a different story. In today’s “post-bubble” environment, CIOs have seen their staff and capital budgets cut back, but the demands on their organizations from business executives have continued to increase as companies seek to have a more flexible and cost-effective IT organization to support their business plans. CIOs have gotten their much sought-after “seat at the table”, but with that seat comes the pressure of accountability to deliver bottom-line results. Compounding this challenge of doing more with less is the sheer magnitude of the accumulated applications and technologies that have been deployed by enterprises over the last 20 years. The number of lines of code, disparate pieces of software, and points of integration has exploded exponentially. As a result, there remains a robust opportunity for focused vendors to drive innovative technology into enterprises to drive efficiency in IT operations. The bar, however, is quite high. If you can’t drive a 5 to 10 times reduction in key metrics, the status quo will prevail. A recent success story is Bladelogic, which went public in July of 2007 and trades at 13 times trailing twelve moths revenue, primarily due to the company’s success in automating data center operations, a key means to drive efficiency in IT operations. Opsware, which HP just agreed to acquire for $1.65 billion, is another example and also demonstrates there is a relatively healthy M&A market, as these innovative companies fill key product gaps for large acquirers, such as IBM, Microsoft, Oracle, HP and EMC, as well as mid-sized public companies such as BMC, CA and Symantec.
  • Wrap your software in commodity hardware. One of the complaints you will often hear from IT departments about working with a new vendor is the challenge of integrating their solution into their already complex environments. The mundane, manual tasks of requisitioning and provisioning the necessary hardware to run, or even pilot, the shiny new piece of software slows the path to adoption. As a result, a number of innovative software companies don’t appear at first blush to be software companies at all. Instead they sell pre-provisioned, plug and run, hardware appliances. Companies that adopt this model are not only able to leverage Moore’s law to drive performance, but also can ship their customers a unit that can be slotted into a rack and up and running in hours, not days. This allows customers to trial the solution and see the benefits immediately, mitigating the long sales cycles that plague many traditional enterprise solutions. Further, the appliance approach tends to lead to easier adoption by channels that are better suited to selling hardware than complex software. This appliance strategy was seen initially in the security software industry, but has since spread to other areas such as storage back up solutions from companies such as Data Domain, which recently went public and currently commands a $1.4 billion market capitalization on trailing twelve months revenue of $76 million.
  • Dominate a niche. Start-ups are often caught in a quandary. To raise money and hire the best people, they need to convince VCs, employees and other supporters of the company of a big vision and the opportunity to capture a billion dollar market. To do so, however, they run the risk of going too broad, too quickly and losing the laser focused approach that allows young start-ups to win against large, incumbent vendors. A better strategy is to instead think about climbing a staircase. You know you want to reach the next floor, but you don’t do that by trying to jump up 13 stairs all at once. Ask yourself, “What can I uniquely do today for a customer that solves a real problem and also provides a link to doing more things for those customers in the future?” In today’s age of rapid development, componentized software and offshore resources, software code is relatively easy and cheap to write, and is no longer the “barrier to entry” and source of competitive advantage it was ten or twenty years ago. Instead, what matters to customers (and potential acquirers) is the deep, domain-specific knowledge instantiated in that software. For an early stage company to build this knowledge, they need to be incredibly focused in a given domain and make sure they have people on their team who understand a customer’s business better than the customer does themselves. Unica, a recently public $80 million in revenue marketing automation company in Boston is a good example of this. When they first got going, they had the best data mining tools for marketing analysts on the planet. Not a huge market, but one that valued innovation and provided a logical steppingstone to campaign management, lead generation, planning and the other marketing tools that the company sells today.
  • Explore SaaS (software-as-a-service). If the key barrier to success for early stage enterprise software companies is excessive sales and marketing costs, adopting a software-as-a-service model may be the right approach. This is more than just selling your software on a subscription versus perpetual license basis. Instead, SaaS is all about making it easy for customers to understand, try and, ultimately, gain value from your software. In 5 minutes and for no up front cost, I can become a user of Salesforce.com. Within the 30 day trial period, I can self-qualify and decide if it is the right solution for me and worth the on-going subscription cost. Most importantly, I can potentially do this without consuming a single dollar of their sales and marketing spend. None of the airplane trips, four-legged sales calls, custom demos, proofs of concept or lengthy contract negotiations that lead to the 6 to 12 month sales cycle that costs a traditional software firm 75% of their new license revenue in a given quarter.
  • Consider Open Source. Open-Source is not about free software, but rather products that have seen, or have the potential to see, widespread grassroots customer adoption. A passionate end-user community has the benefit of driving a development cycle that quickly surfaces key product requirements and needed bug fixes. Further, the grassroots adoption of the product provides a ready installed base of early adopters who will promote the product across their enterprise, purchase professional services and acquire more feature rich versions of the product. Like SaaS, this is a way to mitigate high sales and marketing costs. When My SQL looks for customers for the enterprise version of their open-source database, they have to look no further than the estimated 11 million active installations of their software or the 750,000 plus people that subscribe to their email newsletter. RedHat’s version of Linux, Jboss’s version of the application server and Sugar CRM are three other well-known open source success stories, but other opportunities abound.

Enterprise software entrepreneurship and investing is certainly not for the faint of heart, but when pursued with some combination of the strategies above, we believe interesting opportunities remain for innovative companies to make their mark in the world and have a positive impact. Contrary to the claims of many, it is still possible to build these companies in a relatively capital efficient manner. Sticking to some of the examples cited above, it is illuminating to note that Bladelogic raised $29 million of venture capital before its IPO, Data Domain $41 million, Unica $11 million, Red Hat $16 million and Jboss (pre-acquisition) $10 million. Only Salesforce.com raised a lot of capital - $64 million – although almost 75% of that came in their last round when one would assume there was evidence the model was beginning to work.

In the end, we believe the analogy to the automotive industry is flawed. The manufacture and distribution of cars is fundamentally different from the software industry. In auto industry, there are tremendous benefits of scale, the underlying platform (tires, chassis, internal combustion engine, frame and skin) has remained the same for decades, and there is little room for small players to access end-users. Software, on the other hand, is a digital good and an information business. Innovation is limited only by the creativity of the author. Small teams can be extraordinarily productive - often times more so than larger teams and organizations. The underlying platform and architecture has changed several times in the last 30 years, and there is no physical product to distribute, thus end-users can be accessed much more directly. Is there a benefit to the incumbency and distribution might of IBM, Oracle or EMC? Absolutely. Does that mean there is no place for creativity, innovation and entrepreneurship in this industry? Absolutely not.

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What a great post. People are all caught up in this Web 2.0 madness which really stands for 2 founders, no revenue and advertising based. There are still lots of problems to be solved out there. You just have to be prepared to sift for gold in a stream less visited.

What a refreshing view. Xtra Effort's clients have included medium sized players like Unica. Our former clients such MySQL, Data Domain and MRO (and MANY others) have been acquired.

Every day I read about investments in life sciences and clean tech, and think about the investment (time, discipline, marketing) Xtra Effort would have to make to retool and become effective in these new markets. Our preference is remain as best of breed for enterprise solutions, but question our strategy.

Your Blog posting gives us- and our clients - rationalized hope.

Thanks!

Mark

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