Santa Clara University

2008 Venture Capital Outlook - Software

It’s not a particular business model or technology that’ll get your company funded in 2008. The key is to solve a valuable business problem.

Bryan Stolle, Mohr Davidow Ventures and CIE Advisor

Over the last few years, no entrepreneur pitching a VC for funding would use the words “enterprise software” in their company description. Last year, no entrepreneur refrained from using the word “SaaS” to describe their business model.

Investment trends come and go but software has been the leading category of venture funding for many years. Nearly $5.3 billion was invested in 905 companies during 2007.

Right now, software VC activity is hot again. But what’s different these days is how VC firms are thinking about “software” investments and what entrepreneurs should focus on during their fundraising.

What’s Hot? Solving Business Problems
The way that VC firms think about delivering value to business problems in a company has fundamentally changed. What was traditionally categorized as a software company isn’t necessarily how we think about it anymore.

The most important factor in determining whether we will back a company is whether it solves a critical business problem. The problem must be serious, urgent and there must be significant value to the customers in solving it. The solution must be affordable, rational, and really solve the problem. Finally, solving that problem cost-effectively must allow the creation of a large market, or allow the company to take significant share in a large market.

To most VC firms today, there is no preference for how the problem is solved, as long as it makes sense for the market. It could be delivered as a software-as-a-service (SaaS) solution, an appliance, an open source download with premium add-on services, an ad-supported application (“freemium”) or as an outsourced business process. There is software-enablement somewhere in the process but it doesn’t matter whether the customer is exposed to it or not.

During the last several years, startups regularly pitched their companies saying, “It’s going to work because it is based on the SaaS model.” Thankfully, we’ve moved past that in the last year or so as the success of other models has becomes apparent, and entrepreneurs realize it takes more than the latest fad in business models to build a great company.

The majority of entrepreneurs seeking funding today are very conscious about their business model, and why it makes sense for their target market. They are very knowledgeable about their space and their customers, and have been thoughtful about what will work best─whether it’s most important to reduce friction in the sales process, accelerate adoption, facilitate growth and expansion (“land and expand,” as we say,) or some other benefit.

Software VC Climate is Favorable
Looking forward to 2008, venture investment in the software space will continue to be active. In addition to a steady stream of seed and first-round funding events, we’re going to see lots of follow-on rounds for the many new software companies that have been funded in the last few years and are starting to really gain traction in the marketplace. In fact, 44 percent of 2007 software VC investments went to later-stage companies compared to just 36 percent in 2005.

It’s pretty amazing how many new software-related ideas are coming to the table these days. I think the main reason for the uptick is that for the previous seven-plus years, few software sectors were “hot” in terms of market activity (with the notable exceptions of compliance and security.) Most enterprises were still focused on getting their Oracle or SAP installations working or obtaining value from the massive investments they’d already made in their current systems. A few enterprises were working on new initiatives “around the edges” with function-specific solutions, like PBWiki for corporate wikis or Genius.com or Landslide for improving sales/customer interaction, or HelpStream for community-based and self-help customer support, but they were the exceptions for the most part.

However, the business world today is very different. If you mentally transport yourself back to the late 1990s, you can start to better appreciate the sea change that has roiled business IT. Back then, outsourcing was happening but not everywhere. We might have worked with a few firms to design, build and deliver our products, but not many and not always. We talked about being global, but most businesses really weren’t, especially below the Global 1000. Today, businesses in virtually every industry collaborate heavily (or entirely) with other firms to help deliver products to customers, and most of the partners are spread around the globe.

Not ten years ago, I remember having debates about whether it made sense to hire a VP of sales─or any other senior manager, for that matter - that wouldn’t be stationed at headquarters. Now, almost all the companies we see have a distributed workforce that includes members of the senior executive team who work remotely. A global, distributed team is involved in bringing most products to market today.

At the same time, enterprise IT is rapidly becoming “consumerized.” Rather than being controlled and led by the IT department and the CIO, users across a company can easily go online or to a store and get a product that they need to do their job better. Today’s worker doesn’t think twice about running out to Fry’s, buying a wireless router, and configuring it on their own, saying, “If IT can’t do it, I’ll just do it myself.”

These trends are critical to the future evolution of the software industry. Why? Think about how and when the major enterprise software vendors developed their products. They were all started many years ago and were designed to run companies with centralized operations. The business world is a very different place today and there is a huge opportunity for new software solutions to take the place of these older enterprise applications which have a very tough time delivering value to a distributed, user-driven organization.

Trends for Software VC in 2008
Against this backdrop of continued activity and evolution, I predict that software VC in 2008 will be shaped by a few key trends:

• Not Just SaaS Anymore
  The idea that all software investments must go into companies with a SaaS model has definitely passed away. The success of models such as open source, “premium” services, ad-supported and others has translated into a broad array of successful options for startups today. SaaS remains a very viable option and a model that will continue to grow, but investors and customers know that no one model will assure success, or best meet their needs.
• SaaS as an Appliance
  One area within SaaS that is growing quickly is the opportunity to deliver a SaaS product as an appliance. Marc Benioff proved to the world that you can put your data into the cloud and still sleep at night. The industry has definitely “crossed the chasm” in that respect. But what has also become apparent is that for some industries, for a host of reasons, the pure SaaS model is not an option. To address the needs of these customers, some SaaS vendors are taking their stack, putting it into a sealed box and placing it inside the facility. These SaaS appliances will open up a new portion of the enterprise market to SaaS while enabling the vendors and customers to reap most of the traditional benefits of the SaaS model such as minimal in-house maintenance/support, rapid deployment and upward compatibility of features, and a lower cost of development.
• The Straight Services Solution
  Another evolution of the SaaS model is simply offering a software-powered service that is delivered as an outsourced business process. The best example of this is ADP: rather than sell you software to do your payroll, we’ll just do it for you. One of our portfolio companies, Sabrix, is doing just that with their transaction tax offerings. The company leapt over SaaS when it realized that customers were happy to buy the entire outsourced business process.
• Tools for the Cloud
  As many operations move to the “cloud” in the next generation of the computing, it is necessary for enterprises to rethink the way they are doing things. Two areas which will be impacted are development tools/environments and analytics. In the tools area, new development environments will enable developers to take advantage of the cloud. And analytics in the cloud are also taking off. By using cloud-based analytics, executives can run the processes across a much broader range of data, without waiting weeks for IT to get around to setting up the data marts and analytics.
• The Flip to Outward-Focused Products
  The ironic thing about Salesforce.com is that although they are a leading poster child for how to build and operate a Sales/Marketing 2.0 model, they sell a “Sales 1.0” product. Enterprise 1.0 products manage how information is captured and delivered back into the company. The next wave of products are flipping that around: putting tools in the employee’s hands to be more effectively outward-focused and work better with their customers, partners or other groups outside the organization. This “2.0” application mentality is starting to become very popular with software entrepreneurs.
• More Premium Models
  The success of many open source, ad-supported and SaaS software vendors has arisen from selling some kind of “freemium” services. In order to receive additional features, avoid ads or gain customized features, customers pay a premium on top of the subscription price or the free download. This model will continue to gain acceptance in the software arena.
• Exits Will Slow
  Short of something miraculous happening to the U.S. economy, liquidity events among software startups will be negatively impacted by the recession that we are likely already knee-deep in. IPO activity will most certainly slow. Although recent levels of software M&A and technology LBOs have been healthy, 2008 activity will likely decline. The troubles in the credit markets will hurt access to cash for the private equity and LBO buyers, and instability in the stock market may keep major software M&A contenders on the sidelines for a while to survey the situation. That adds up to fewer buyers and more cautious buyers. It may take some time for things to pick up again.

Advice for Entrepreneurs
Software venture investment continues to evolve. Entrepreneurs with software companies that have the following characteristics will have the upper hand:

• A focus on a business problem that matters and delivers real economic benefit if solved
• An appropriate business model and delivery approach for the market being served
• A solid understanding of the target market
• A great team and set of advisors
• The ability to help VCs or other potential investors to understand the market opportunity and how it will support the development of a big, meaningful company

Although the current investment climate remains strong (at least at the moment) for software startups, economic conditions mean entrepreneurs should consider the following tips regarding venture funding in 2008.

• Be Capital Efficient
  Given the hazy visibility of the economic conditions of the latter part of the year, I’d advise startup CEOs to have a forecast for how a downturn could negatively impact their business and a strategy for operating during tougher times.
• Just Build a Great Company
  I’ve been surprised by the number of entrepreneurs who have told me that some VC is or has advised them to ignore sound business fundamentals or to invest in company building, because their “exit” will be via an M&A deal. The entrepreneur says something like, “We have this great idea for strengthening our company culture, or we want to invest in long-term customer success.” The VC responds, “Why bother? You’re just going to get bought in three years anyway. It’s a waste of time and money to build your company to last.”

But if you look at the market activity over the last two-and-a-half years, you’ll see we’ve witnessed close to 100 software-related IPOs. That’s not “bubble” levels but it is a pretty active, vibrant IPO market for a single sector. Obviously, it depends on the company, but I think that leading venture capitalists are certainly not ruling out the potential for an IPO, and looking exclusively toward M&A exits for all their software deals.

The bottom line? Software entrepreneurs must aim to build the best possible company they can. Building for expediency and a quick acquisition will rarely deliver returns to anyone. We expect most exits will take place five to seven years after the initial investment─no one knows what the IPO market will look like at that time. The only way to ensure success is to build a great company─and build it to last. Whatever the exit opportunity, a successful software company built to last will always command a higher price.

Bryan Stolle is a general partner with Mohr Davidow Ventures (www.mdv.com). Article republished courtesy of Stolle and SandHill.com