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:

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:

• Erik Keller’s “The Death of Packaged Apps?”
• Ray Lane’s “7 Laws for the New Software Landscape” ).