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.