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Where have enterprise software start-ups gone? Why should we care? And, what can be done?

May 4, 2009 By 7 Comments

While innovative enterprise software solutions are still needed, there is a dearth of funding for new enterprise-targeted software companies within the venture community. Why? Because enterprise IT  – the target market for these solutions – and the incumbent enterprise IT software providers (e.g. Oracle, SAP, MS, IBM, etc.) have conspired to build a virtually impenetrable gauntlet for start-up software companies to overcome. If you – the start-up that is – are not part of a ‘blessed’ corporate architectural standard you will find selling your innovative enterprise software solution a very tough slog. You will bear the burden of extended sales cycles, high sales costs and increasingly smaller budgets already spoken for by the big brands. 

Those few companies that do manage to make it with breakthrough technology are quickly threatened by the incumbents. You are either compelled to sell the company at a time when the multiple for the management team and venture firm is potentially uninteresting or face increasingly greater sales risks as the big brands use their internal relationships to raise fear, uncertainty and doubt [FUD] about the long term prospects of your company and products. This, in turn, causes you to have to make bigger discounts with correspondingly lower margins, endure longer sales cycles, etc. until you give up and either sell out or call it quits. This phenomenon isn’t restricted to just small start-ups. Even larger enterprise software companies have had a difficult time surviving; look at what happened with PeopleSoft, Siebel and Hyperion.

Consequently, over the past 5 years there have been fewer and fewer venture-backed enterprise software companies initiated. The enterprise software start-up has been the ‘pipeline of innovation’ that enterprise IT and enterprise software providers have relied upon to bolster their returns. Yet, that pipeline is now drying up.

Ironically, one of the major problems that plagues large public software companies is that their ability to innovate and bring new products to market tends to be inversely related to their success and growth. That is, the bigger they get the less innovative they become. There are two primary reasons for this perplexing phenomenon.

The first is that existing customers place increasingly significant demands upon the company’s product resources to provide bug fixes and deliver enhancements to current product lines. Over time, maintenance and product revenues from existing customers dwarf new customer revenue so companies must invest the majority of their resources to secure these revenue sources, leaving few resources for new product initiatives. Second, the public markets expect companies to generate increasingly better operating results – improved revenues and margins each and every quarter.  Investing in new product initiatives results in little short term revenue increases. The problem is compounded by the fact these new product investments immediately impact the expense side of a public company’s balance sheet. This can lead to poor margins and a depressed stock price which in turn can jeopardize a senior management team’s employment tenure with the company.

An advantage a successful public software company would seemingly have is access to cash to fund new product initiatives. However, while many of these companies do throw off a substantial amount of cash each quarter the quandary they face is that they are unable to use that cash to finance new development initiatives without negatively affecting their quarterly income statement. Interestingly, if they allow their cash balances to grow large enough, shareholders begin to demand the company increase its overall returns through quarterly dividends. Therefore, other than providing a safety blanket buffer for liquidity, cash offers virtually no medium-long term competitive advantage for a public software company.

Some public software companies have adopted the strategy of using their cash and/or stock to innovate and grow through acquisition; the in-quarter investment expense correspondingly offset by an equal increase in total assets. The downside is that this can take a substantial amount of cash and/or requires very liquid stock. Therefore, this approach is generally limited to a very few large companies such as IBM, Microsoft, Oracle and SAP.  Additionally, these companies are reliant upon finding companies that are willing to sell, they must pay a premium to the market value for the company, the technology they acquire must be architecturally consistent with their current products to gain immediate benefit, and more importantly they must entice existing key personnel to stay — which is very hard to do.

For example, take a look at how many senior executives and managers remain at Oracle 1-2 years after an acquisition; by that time, the top talent from those companies usually leave to ‘pursue other interests’. Unfortunately, these are the very people who invented the new technology and created a successful business. Oracle may have a maintenance stream but they are left with little innovation talent.

Look at Workday; this is Dave Duffield’s SaaS-based reincarnation of PeopleSoft. Many of the best folks from PeopleSoft – who were part of the Oracle acquisition – are now at Workday, readying that company to take on Oracle and its PeopleSoft installed base.

None of these issues are necessarily showstoppers but each of them introduces complexity and expense and requires a significant investment of executive and employees’ time.

These problems, and others, can result in product innovation stagnation over time and lead to competitive vulnerability for established public software companies that must serve customers and investors simultaneously. At some point, the lack of a steady pipeline of innovative, private enterprise-oriented software companies to fuel their need for growth could lead to their ultimate decline and downfall.

Given the current issues associated with the traditional venture capital business model (e.g. lack of liquidity) and the fear to invest in enterprise software start ups, and the innovation/growth pressures that the large software brands are faced with I believe there is a unique opportunity for the venture community and the large software brands to come together.

My proposal to address this growing problem is to use a modified “spin in” corporate structure to bring these two communities together. Put to work successfully by Cisco, I believe a version of this structure could help to ameliorate the lack of liquidity and lack of innovation that the venture community and big brands are facing.

I will speak more about this concept in my next blog post.

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    • http://www.interwest.com Bruce Cleveland

      If corporate investors had the people to manage the start ups, it could work. The skills required to be successful in a large company, however, don’t necessarily translate well to the start up world. This is why I assert that a partnership between the corporate world and the vc community makes sense.

  • jay shah

    this is a great blog.. in fact as a recent MBA graduate and a 10 year veteran in enterprise software space, i have been looking into any interesting startups/midsize companies to apply my experience and interests.

    and the search has been quite disappointing.. SAP, ORCL and IBM it is.. seems as exciting to work there as the government of india railways..

    any pointers ?

    • http://www.interwest.com Bruce Cleveland

      I think there are many SaaS opportunities emerging to take on the incumbents — initially, they are targeting the SMB markets — as their products gain increased capabilities they are able to move up market. Although the business model may be different, the same fundamental principles apply; they must address and solve business problems critical to the success of these companies. Ecosystems have emerged around the Front Office/CRM (e.g. Incentive Comp, Forecasting, Analytics, etc) and the Back Office/ERP, SCM, HCMS. One of the most exciting is Workday — Dave Duffield’s new company. I would identify a key business problem area that excites you and then research that space for SaaS entrants. I would figure out who has the best management team/product strategy and investors and go after securing a position there. Also, some really interesting new enterprise technology is in analytics. Companies such as AsterData, ParAccel are experiencing good growth and are well financed. Try there. Good luck!

  • http://www.linkedin.com/in/bookershowers Booker Showers

    Since the beginning of the decade I have been touting the integration of products. However, software development companies focused on target markets and coveted niche applications that were built for a single purpose with no thought of integrating with the outside world. The driving force for these companies was the Venture Capital “exit strategy” mantra. “Exit Strategy” was always the motivating factor for innovation, which presents an innovation paradox.

    In addition, the “exit strategy” did not promote a long term technology vision.

    Starting in 2004, companies started taking integration more seriously by wrapping SOA around the notion. However, many enterprises were already established with a smorgasbord of software applications. One for payroll, accounting, hr, back office, etc.

    As an IT consultant, I see so many silo departments and applications. IT and Management struggle to glue all the information together into meaningful data to make meaningful decisions.

    Mergers, acquisitions and start-ups all put the actual technology on the back-burner. When companies merge or make an acquisition, how often does the diversity of the IT systems come up? Strong companies who focus on innovation like Apple are rare. I believe their core believe in creating something cool, is there reward and the money that comes as a result of the coolness factor is an added bonus.

    Creating something cool seem irrelevant to VCs. VCs want to know how they’re going to get their money back. Which is a valid concern, hence the paradox. The pressure to give the VC back their money in a projected time frame, versus the freedom to create something really unique and COOL.

    Earlier in June I read that Microsoft is now saying software is dead. Wow, really?

    Just a little rant . . .

  • John DesJardins

    You raise some compelling points. I’ve had the same concerns myself about the enterprise software space. It seems that IBM and Oracle in particular are entirely reliant on acquisition of smaller software companies to add innovation into their products.

    Perhaps enterprise software should follow a similar model to outsource the innovation aspect of their business as consumer businesses. For example, development of new foods, fragrances, toys, etc. are often outsourced by big businesses to specialized boutique firms.

    Why not create a startup that focuses on innovation outsourcing? My idea is to create a company that concentrates on creating new product innovations and then hands them over to larger firms to market, sell, and support them. This creates a clear separation where the innovators can be 100% on what they do well, and follow agile methodologies to deliver products quickly.

    It also avoids the struggle of VCs to have to evolve the team from startup into mature global business. The company would be able to grow while maintaining a focus on innovation. So, there is less need to scale, add global sales and follow the sun support, add consulting etc. Instead, scaling would be to add more specialist innovators focusing on other niches.

    Would love to hear your views on this concept.

    Best regards,
    John DesJardins

  • http://www.interwest.com Bruce Cleveland

    Here is the major problem with my proposal and it ties directly to your question around outsourcing innovation: it goes directly against the organizational behavior of successful high tech companies for them to admit they are not great innovators and need any help in this area.

    Here is how the logic works; they are large and successful because they beat everyone else to become the market leaders in their category. So, by definition, they must be smarter and better than everyone else.

    The fallacy of this thinking, however, is that the company they were when they were small is seldom the company they are when they are the market leader. Many of the people who helped them to innovate have left and the internal politics won’t easily allow new ideas and people to flourish at the expense of the status quo.

    And, as long as the large successful company continues to be large and successful, it isn’t going to do anything to dramatically different — it doesn’t want to negatively affect its current position. So, the company is driven internally and externally to keep doing what has made it successful.

    It’s only when a large successful company begins to falter that it is compelled to do something different. Change its management team. Change its products. Change its markets. Change its business model.

    So, until we see large companies such as Microsoft, Oracle, SAP, etc. really stumble, I don’t think we’re going to see a shift in their current methodologies. It’s too risky for them.

    So far I have found no large companies interested in even trying to execute a spin in in order to try to spark innovation. Until something goes horribly wrong with the top line of their companies, the current management teams will not be motivated to do anything but what they are currently doing.

    So…as I told my kids when they were growing up, get great grades in math and science because that will get you your first job. However, really pay attention in your Organizational Behavior class because if you learn to understand the psychology of people and groups, that will define your career.