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Is Enterprise Software Dead?

Quite a few VCs told me that they are "not excited" about enterprise software

The shifting enterprise software market (business model, M&A landscape, investment, sales and marketing strategies, etc) is a subject that I studied quite a lot over the last few years. One of the angles that I use is to study the behavior of the venture capital community.

Quite a few VCs told me that they are “not excited” about enterprise software. Some of them stay away from this sector completely. Some of them will only invest in Software-As-A-Service opportunities. Some of them are desperately looking for web 2.0 consumer startups now (do you know any?:-)). At a recent social event, I chatted with a partner at an east coast VC firm whom I have known for many years in the “enterprise software” space. I was surprised to hear that his most recent enterprise software investment was done in 1999.

Despite the common wisdom that VCs are stupid (yes, some of them are. I maintain a personal list of VCs who I would advise companies to stay away from), I actually think quite a few of them are really smart and I have always learned a lot from conversations with them.  What is their issue with enterprise software? Is there money to be made with enterprise software? What is going on?

I think you can definitely make money with enterprise software. In fact, I believe enterprise software is still and will remain to be one of the most profitable industries. The fundamentals of software industry have not really changed from the days that VCs loved the software business:

  • Relatively low cost for production and distribution
  • High profit margin: IBM's software group had a gross profit margin of 84% in Q2 2006, compared with 26% in services and 34% in hardware. Oracle’s gross margin is over 90% for fiscal year 2006.
  • Relatively small investment required from start to exit. A software company typically requires $20M to $30M investment vs. a hardware or healthcare company that would typically require $50M+.
  • Relatively short investment cycle - exit in 1 to 5 years from initial investment:

However, there are significant changes in the software business: customers favor big vendors now and big vendors have unfair advantages. Over the last few years, a lot of customers have been trying to reduce the number of vendors and buy from only a small list of big vendors. This behavior is driven by the following reasons:

  • Customers have been burned by many ill-conceived startups that went out of business during the “dot com” crash. The burn made them less risk adverse and prefer to go with bigger and more stable vendors, even if the big vendor has an inferior solution;
  • The economic downturn over the last five years made most buyers much more conservative. Buyers tend to focus more on bottom line, stuff that are absolutely necessary to maintain the business , rather than top line and leading edge solutions that may bring significant advantages if successful.  
  • The ever increasing complex technology landscape caused buyers to reduce the number of vendors and technologies as a way to reduce complexity. Buyers prefer fully integrated stack from one vendor, instead of picking best of breed from multiple vendors and assembling different pieces together.
As a result, achieving significant size and scale as a vendor can actually mean increased access to customers and reduced cost in marketing and selling. On the other side, it is getting harder for smaller players to even get considered in some customer purchase cycles, which essentially translate into significantly increased cost for marketing and selling. It is no wonder that the number of billon dollar market capitalization software companies reduced from over 450 to about 160 over the last five years. It is no wonder that Oracle actually increased its profit margin after it purchased PeopleSoft and Siebel. It is no wonder that IBM did over 40 acquisitions over the last three years (majority are software acquisitions).

Further, this market condition means that it is harder to grow a company from a startup to a billion dollar outcome. Startups are more likely to be acquired before it is even close to reach a critical mass – because the barrier to reach a critical mass for small players is so much higher than before. Without reaching a critical mass, the acquisition price is most likely to be under $100M, if there is a “successful exit” at all.  Now you can see a VC’s perspective – it is not exciting to invest $30M into a company for an outcome of $60M.

(If the above is all what I learned about enterprise software business, call me an idiot in writing this to educate more VCs to stay away from enterprise software).

However, I don’t think the software space is dead at all. I am actually excited about the opportunities within the software space – it is exciting not only because there is a lot of money to be made for investors, but also because most people don’t see these opportunities and are shying away from the software business.

More to be followed in future posts.

Quite a few people have written some insightful articles on enterprise software, for example:

More Stories By Coach Wei

Coach Wei is founder and CEO of Yottaa, a web performance optimization company. He is also founder and Chairman of Nexaweb, an enterprise application modernization software company. Coding, running, magic, robot, big data, speed...are among his favorite list of things (not necessarily in that order. His coding capability is really at PowerPoint level right now). Caffeine, doing something entrepreneurial and getting out of sleeping are three reasons that he gets up in the morning and gets really excited.

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Most Recent Comments
Sanmao 08/07/06 05:24:12 PM EDT

It make sense for the oberservation that the standing points you have. I'd like to see if the history can repeat itself like this.

Francois Dubuc 08/07/06 05:04:57 PM EDT

Hi Coach, you ask if we know some SaaS companies ? Yes I know one that started in 2001 to develop a native SaaS. Today, their SaaS have over 100,000 users and is a complete ERP, CRM, CMS, SFA and PMS, purely online. The ERP actually competes SAP, Navision and others in their own domain. That's probably the actual most advanced SaaS available today. So take a look at www.activemedia.qc.ca for the corporate website or www.activeintranet.net for the software as a service entry door. So you asked if we know SaaS company, I answer I know one of the best one !

AJAXWorld News Desk 08/04/06 05:28:55 PM EDT

Despite the common wisdom that VCs are stupid (yes, some of them are. I maintain a personal list of VCs who I would advise companies to stay away from), I actually think quite a few of them are really smart and I have always learned a lot from conversations with them. What is their issue with enterprise software? Is there money to be made with enterprise software? What is going on?