Momentum matters

In the 1990s it was easy to start a software company. Raise between $5 million and $40 million, hire a hotshot team of executives, and get a high-profile market research firm to anoint the chosen space with a three-letter acronym—or TLA. Once you were on track to reach an annual revenue rate of $40 million, it was off to the initial public offering (IPO) races.

But today, the name of the game is very different. Venture capitalists are dispensing funds with an eyedropper rather than a bucket. Hotshots are firing blanks, and the TLAs are all taken. Meanwhile, the cost of Sarbanes-Oxley compliance is pushing IPO revenue minimums to more than $100 million annually.

At the same time, software solution buyers who lavished dollars on emerging software vendors during the 1990s—when the market was growing at a rate of 12 percent to 15 percent—have become outright miserly. Growth has cooled down to around that of the gross domestic product. These users focus an increasing amount of their spending on maintenance and enhancement of the installed base, constituting a kind of "entitlement" program for software solutions (see chart).

Given this dynamic, where is the market going for hot, young vendors and how can buyers best tap the best of the new breed? For buyers, the traditional issues remain, with a just a few new tweaks added (see Sweat the details, grab the benefits). For sellers, however, it's a brand new game out there.

"Starting a company today is much different than it was five years ago," says M.R. Rangaswami, cofounder of Sandhill Group, a Silicon Valley investment group. "Today you can use open-source infrastructure, offshore labor for R&D, and have an on-demand model for product deployment. As a result, you need a lot less capital."

In fact, Rangaswami says a start-up today needs only $1 million to $2 million to get a company off the ground.

Perhaps an extreme example of this can be found in the recent acquisition of Kieden by Salesforce.com. Kieden, consisting of four founders, built a Google ad-word integration tool on top of Salesforce.com's AppExchange. Before it was acquired, it had 45 customers for an application that did not exist last Christmas. Kieden was started in January 2006.

While this type of start-to-finish trajectory is unusual, many newer vendors are adopting what amounts to guerilla tactics to penetrate traditional companies. One of the most popular strategies today is moving to a software-as-a-service (SaaS) model, which has one immediate advantage over traditional models: Because it is expensed and does not require direct interaction with IT groups, it can be quietly and quickly acquired by business units.

Another way smaller companies are getting around traditional buying centers and concerns is by "giving away" their software. For example, JasperSoft, a company that sells an open source-based reporting tool, has seen more than one million downloads of its software, with more than 10,000 corporations using its software. JasperSoft does not use a direct-sales model for its products, but rather lets customers come to it via free downloads of certain types of software at its site. Other companies following this approach include Alfresco, an open-source content-management solution; Compiere, an open-source ERP vendor; and SugarCRM, an open-source customer relationship management vendor.

But while it is easy to start something new, it is harder than ever for enterprise software or services companies to make the big hit in the public markets. NetSuite, which sells a variety of on-demand solutions, is rumored to be filing for an IPO. But in general, the new exit strategy for most vendors is acquisition by a larger company, or a venture group such as Golden Gate or Symphony Technology.

Perhaps indicative of things to come from other vendors is the $125 million NetWeaver fund that was set up by enterprise vendor SAP earlier this year to fund new and innovative companies. One suspects that a tight tie into SAP products—most likely to the exclusion of other platforms—will be one of the requirements of getting such funds.