Tags: competitive advantage, enterprise software, moat, SaaS, subscriptions, transaction revenue
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Yes, “software is eating the world” as Marc Andreessen puts it. But the software game is changing at a fundamental level. The opportunities are massive, but it is harder than it used to be to create sustainable value.
The big change is the revenue model for software; that is as fundamental as you can get. The revenue model used to be perpetual licensing. Then it moved to subscriptions aka SaaS. The next iteration is to transactions. The software enables a transaction to happen and the software owner takes a cut of the transaction as revenue. This fully aligns the interest of the software owner and the software user (as opposed to the licensing model where all the risk/reward passes to the user/licensee). This transaction revenue is variable but predictable; the metrics are similar to consumer web ventures.
Software licensing was a wonderfully simple game. Once you had built the software and sold it, all you needed to do was send a disk to the customer. The first time I saw this for real – I had sold the deal, signed the contract and asked “what do we have to do now?” and was told “just send them the disk”. This was a contract worth high six figures and the cost of the disk was a couple of bucks. During contract negotiations my boss told me that “the only thing we can warrant is that the software will have bugs”. My eyes were opened to the wonders of 100% gross margins. Customers eventually woke up and revolted against having all the risk passed to them; into this gap charged the SaaS pioneers.
During the SaaS wave of innovation, which started with Salesforce.com over a decade ago, the game got a bit more complicated. But only a bit. You now had to manage a data center or an outsourced infrastructure provider. Lots of vendors rushed in to make that pretty simple. Gross Margins went from 100% to around 85% to pay for the hosting infrastructure – still incredibly high compared to most businesses.
But SaaS is still a licensing game and that still passes most of the risk and all the upside to the customer. The SaaS vendor takes away the hardware capex cost and the technical implementation risk. But these are not costs and risks that keep the CXO folks awake at night.
To really build value in the enterprise software you need to build a moat to keep out the “ankle biters”. Then you need to put alligators in the moat. That may sound a tad cryptic, so let me explain.
“Ankle biters” is a term coined by Fred Wilson in this engaging talk to describe the startups that will invade any good niche with dramatically lower prices. The upstarts use open source and cloud infrastructure to copy the functionality of market leaders for a fraction of the cost and then use that lower cost to offer an alternative to the market leader at a dramatically lower price. A classic upstart game is to offer free license and charge only for maintenance. Say the market leader is charging $500k for a Perpetual License with 20% Annual Maintenance (ie $100k per year). The upstart simply charges $100k per year; whether they call this an Annual Subscription or Maintenance with a Free License is mostly optics.
It is very hard for the market leader to defend against this. Their cost structure and sales team incentives make it impossible to compete on price. The usual response is to greet the upstart with FUD and scorn, pointing out the functional gaps. This does not stop the upstarts; their customers happily trade a 10% loss of functionality for a 90% drop in price.
The only sustainable defense is to build a moat. Historically this has been through Patents but this is increasingly a weak defense (the reasons are too complex to cover in this post). The best moat is network effects, where each new user brings in more users or brings in data (or both). For example, you can easily recreate the functionality of Facebook, Twitter or LinkedIn but that does not give you a shot at beating those network effects champions.
Network effects is the best moat. In Consumer markets that is all you need. There is now plenty of advice, most of it free in blogs, telling you how to generate network effects. Despite all that advice, this is a totally Darwinian game, thousands of ventures attempt this and only a handful succeed.
Nobody has yet mastered the game of network effects in B2B. This game is just starting. Fortunes await those who succeed, as B2B has a direct revenue model; combining that direct revenue model with network effects is the magic quadrant of ventures.
What about the “alligators in the moat”? This is using service as a game changer. This matters in B2B where there is lots of functional complexity. To get people to commit to transactions you need to offer really high quality 24/7/365 support. That is of course not easy or cheap but once you build it you have a real competitive barrier.
Where Do Niche Enterprise Software Companies Go To Retire? October 10, 2012Posted by bernardlunn in capital markets, Enterprise Sales, Enterprise Web 2.0, SAAS.
Tags: george koukis, holding company, misys, private equity, rollup, temenos
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Many years ago I worked for Misys, after they acquired a company that I worked for. The founder, Kevin Lomax had simply taken the Hanson Trust model (for industrial companies) and applied it to software. Misys was a good exit option for the founding management team and Misys had a simple model that worked very well for a long time. The basic model worked as follows:
1. Buy a mature enterprise software company in a niche market. Mature meant lots of Maintenance Fees, which has good revenue visibility, almost SaaS like. I worked at Kapiti when Misys acquired the company. This was Misys’s first foray into banking software, their initial market was Insurance.
2. Buy other companies in the same niche, become the dominant vendor and get economies of scale. Fairly soon after buying Kapiti, Misys acquired ACT (a public company that had a couple of bad quarters and was available at a good price). ACT owned Kapiti’s two major competitors – Midas and Kindle. Overnight the instructions changed from “beat the crap out of those guys” to “compete, sort of, but do it nicely and for goodness sake don’t get into a price war”.
3. Then buy lots of young and more technically leading edge companies and sell that into the market that you already dominate.
So, what is wrong with this picture? Today, Misys is a shadow of its former glory. It was nearly bought by Temenos and now is a bit vulnerable after they walked away from the deal. In 1996, when Misys owned Midas, Kapiti, and Kindle (representing the number 1, 2 and 3 by market share), a tiny upstart run by a great entrepreneur called George Koukis decided that Misys was vulnerable and could be taken on! That was some crazy strategy, but he was right. His company was Temenos. The fire had gone from the belly of the Misys folks, but it burned fiercely at Temenos. (Watch George Koukis, a Greek, talk straight about the Greek Crisis, a refreshing entrepreneurial take on a tired old story).
The big question for all the holding companies that emulated Misys and all the Private Equity buyouts and roll-ups is how do you keep that fire in the belly? How do you go for growth when you already dominate your niche? The basic strategy is to move into adjacent niches. This requires a start-up/entrepreneurial mind-set, the kind of skills that the company had in its founding days and then lost.
Misys would have been fine had they not had a really driven entrepreneur like George Koukis coming after them. There was no disruptive technology or new market to worry about. Temenos had no tail winds to help them. The same is not true today. The legacy companies are being attacked by lots of Koukis like entrepreneurs and these entrepreneurs have the huge tail wind of working with native cloud technology. The old-software company’s retirement home is not as serene as it used to be.
Tags: enterprise software, ipo, salesforce.com, workday
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Where is the big enterprise software winner of the last decade? Where is the Oracle or SAP of the last decade? Or less ambitiously, where is the TIBCO, Cognos or Hyperion of the last decade? So far the only one to make it into the big leagues is Salesforce.com and it is unclear if they will actually make the breakout from their CRM niche to something bigger.
Workday has the ambition, funding, founder experience, breadth of offering to be this winner. This one will be interesting to watch, the SaaS Index is getting a new bellwether stock to join $CRM very soon.
Enterprise Software Sales – The Art and Science Of Accurate Forecasting September 30, 2012Posted by bernardlunn in Deal-making, Enterprise Sales, SAAS.
Tags: enterprise software, forecasting, new clients, revenue, sales management
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Forecasting new business sales revenue is hard. As any sales manager will tell you, that is the ultimate “no, duh” statement. Yes forecasting is very hard.
The reason is obvious – the future is uncertain.
Sales revenue forecasting is also enormously important. Ask any CEO who got hammered by their Board for missing their numbers. Forecasting drives so many critical decisions. Without good forecasts you cannot have a good relationship with investors and you cannot plan your business.
If the company is big and old you have lots of data to guide your forecasts and errors become rounding errors. However if you run a company that gets revenue from say 5 sales executives, you cannot rely on the usual statistical models. In startups the forecasting is also a lot tougher because there is a step ladder of forecasting difficulty:
- Very Easy: add-on sales to existing accounts. As a start-up you don’t have that much of this.
- Fairly Easy: new accounts within a geography and a niche where you have been selling for years. It is unlikely you will have many of these.
- Hard: sales of a well established product into a new geography or a new horizontal or vertical market.
- Really Hard: sales of a new product into a market that is not even well-defined yet. These are the blue ocean markets that allow startups to get traction and scale, but this is a very tough forecasting challenge.
Forecasting recurring revenue contracts such as maintenance can be automated quite easily. You can apply standard assumptions about decay (how many will cancel) and the growth will be based on new contracts.
The problems all come from forecasting new contracts. These are outside your direct control. You are extremely dependent on the judgment of your sales team. SaaS subscription models make new contracts less critical, but investors are still mostly looking for the new contracts (and churn) as the signals of success or failure. Whichever way you cut it, your VP Sales (Sales Director, Chief Revenue Officer, Chief Hustling Officer, whatever you want to call her) has a tough job where everything is on the line every day.
You obviously want more sales. Perhaps even more, you want to know what is likely to happen. You want accuracy.
Attempts to automate new contract revenue forecasting usually do more harm than good. The standard approach is to apply closure rates to the sales funnel. The idea is to make assumptions about how many calls it takes to get meetings and how many meetings it takes to prepare a proposal and how many proposals it takes to get a contract. Then you can say we have 10 deals at 40% probability, 5 deals at 60%, 3 deals at 80% and one deal at 90% based on where your deals are in the funnel.
This approach appeals to engineers and accountants. It appears to be scientific. The problem is that it generates a false sense of confidence and is very susceptible to gaming as in “lets bump up the number of meetings until we get the desired result”. It is a classic “garbage in, garbage out” problem.
It is better to build a system around what good sales managers do in the real world. What they want to know from a sales guy is “will this deal close this quarter?” In the real world it is always binary – it either closes or does not close. 90% closure does not hit the revenue numbers.
Sure this leads to “sandbagging”. The sales guy may have 2 deals that can close in the quarter. He will tell his manager that one will definitely close and keep the other one in reserve. If his “committed close” blows out he hustles to close his back-up deal. If his main deal closes, he can either get his back-up deal in this quarter and be the star of the quarter and pick up some nice accelerator commissions, or push it into the next quarter and get ahead of the game.
Everybody sandbags right up the CEO providing “earnings guidance” to investors. Is this a problem? As one Board Director put it, “I love getting sandbagged, it means surprises are much more likely to be positive rather than negative”.
Whatever system you put in place it will be gamed. The trick is not to try and avoid gaming as that runs against human nature. The trick is to get game theory working on your side.
Key recommendations for a sales revenue forecasting include:
- Align the input from sales guys with what the CEO has to report to investors. This sounds obvious, but there is a major disconnect in many companies.
- Measure input accuracy. The old saw, you cannot manage what you don’t measure, applies here. How accurate was salesman x in the past? Note that this is not the same as “did salesman X make target? The question is “at end Q2, salesman X forecast $1m for Q3 and $1.2m for Q4. Now at end Q3 what was the actual result?
- Reward accuracy. Revenue is always rewarded, but with accuracy being so critical to the company why don’t we explicitly reward accuracy? One reason is that we are too focused on budgets and targets. These are only plans. What we really want to know is what will happen this quarter? Accountants and spreadsheets can measure the difference between actual, forecast, budget and target and the gaps can be used to kick ass. But don’t confuse that with the main objective of getting accuracy.
If you get good input, the rest of the job is fairly routine and can be automated relatively easily.
Four Gates That Multi-$billion Ventures Pass Through. September 28, 2012Posted by bernardlunn in capital markets, Enterprise Sales, IPO, SAAS, start-ups, Strategy Workshop.
Tags: software ventures
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I also think about these Four Gates in the form of a funnel, with lots at the top and very few at the bottom (just like a sales funnel):
Gate #1: Conceptual Clarity.
Gate #2: Prove the Concept.
Gate #3: Scale within Niche.
Gate #4: Expand and Dominate.
It takes totally different skills to go through each of these four gates. Few founders have all the four different skills needed, which is why so many ventures fail as they attempt to pass through these gates. Even harder is the fact that the skills, techniques and attitudes that make you successful going through one gate are exactly the opposite of the skills, techniques and attitudes that make you successful going through the next gate. Each gate requires a wrenching pivot.
Gate #1: Conceptual Clarity.
This is the “fit to the future” phase. This is where you have a vision of “a world where….”. From this you have a mission for the venture along the lines of “in this future world, we will…”. Finally, you have a strategy, as in “we will do this by….”
There has been a lot of fruitless debate about whether concept or execution is more important. This debate is silly, because you must have both. A bad concept that is brilliantly executed will be nothing more than a tough uphill slog with relatively little reward at the top if you get there. On the other hand, a brilliant concept with weak execution is nothing more than “woulda, coulda, shoulda”.
In consumer web ventures, the investment in this phase is coding an early version of the site; these ventures are usually founded by developers who can invest their moonlit coding time, knowing that the best way to articulate the concept is to show something. In enterprise software, the investment in this phase is talking to lots and lots of potential customers to really understand their pain points both now and the likely pain points in the future world that you envisage. The founder is often a sales executive in an established company who keeps hearing the same request from customers that his/her current employer has no interest in fulfilling. They start with a crystal clear understanding of the pain, but only when they team up with a great developer do they create a solution to that pain. The established vendors are not being totally blind, nor are they only inhibited by the innovator’s dilemma from cannibalising their core business. Usually a technological breakthrough is needed as well. Thanks to Moore’s Law the world is awash in technological breakthroughs but most of them are solutions looking for a problem. What differentiates the great ventures is a crystal clear understanding of the problem, because they have heard the pain described by so many customers and prospects.
I look for conceptual clarity in 4 dimensions:
- Large enough market. A niche might make for a great venture that can be bootstrapped or flipped, but these are criteria for ventures that can “go the distance” through the four gates into multi-$ billion in value.
- Massive disruption hitting that market. This is the kind of disruption that creates an existential threat to the major players in the market – think of Skype vs telephone companies or Google vs traditional advertising. If it is not disruption of that scale, the existing vendors will add the features they need to stay competitive (“adding that feature” may mean acquiring your venture, so this is fine for ventures that will be acquired before they go through all these gates).
- You have a 10x proposition. You have to be 10x better or faster or cheaper than the incumbents. That seems like a high bar, but it needs to be this big to overcome the start-up risk that you are asking customers to take. Tactically you may start by offering say 3X knowing that as the technology rolls onwards you have much more in reserve, but you must see where that 10x is coming from.
- You really, really want to do this more than anything else in the world and deep down you believe that you are the best person to pull this off. You are saying “damn the torpedoes, full steam ahead”. If you want people to take that risk with you, you had better believe it yourself deep down in your heart and gut. You also must be ready to commit to at least 10 years with 60 hour weeks, forget about a balanced life for a while.
Here are the two things you do NOT need to have at this stage:
- A strategy that seems viable to most people. Most great ventures look totally ridiculous to most sensible people in their founding days. You do need a couple of smart people to believe in the strategy, whether they be co-founders or investors. But get comfortable with the fact that most people think you are crazy (unless you actually are crazy, there will be times when you doubt yourself and when you think most people are right).
- Any proof that any of the four things on that checklist are true. Anybody who asks for proof at this stage does not know how this works and does not deserve to be your partner.
Many great entrepreneurs have conceptual clarity but are weak at articulating it, or too busy executing on the next phase. At this stage nobody cares about your concept. Only after you have passed the next gate does anybody care. Enterprise software ventures tend to be bootstrapped from customer revenues, not from VC, so the founders learn to focus their pitch on the immediate needs of customers who are ready to make a commitment now, leaving out all the futuristic, big picture stuff which would only scare potential customers. However, somewhere in the back of their mind, the great entrepreneurs carry a conceptual vision that is a lot bigger than the immediate solution that they offer to get through Gate # 2.
Gate #2: Prove the Concept.
This is the “fit to today’s market” phase. This is also what VC call “traction”. Many entrepreneurs stumble at this point because they are not consciously making the transition from thinking about the future to executing on the present. The future that you envisage may or may not come to pass. If it does, you may strike gold. However that won’t help you get traction with customers today. All they are concerned about is problems they have today. Your customers maybe happy to “shoot the breeze” about the future, but they will only spend their money on problems that they have right now.
That almost certainly means you get traction in a niche that is tiny compared to the big vision in your concept. This process of digging deep into a niche and focussing 100% on the present day needs is a vital step in turning dreams into reality. It is also 100% opposite to what you do to get through Gate #1.
In enterprise software, getting through Gate #2 means getting the first three paying reference customers. This is a tough job because most customers prefer to wait until you have these three references before committing; one way to drive enterprise software founders crazy is to ask them about this chicken and egg problem. These need to be real enterprise-wide deployments with customers paying 6 figures. A few logos of customers deploying the software in one small area and paying a few thousand dollars won’t make the grade. Lots of enterprise software ventures reach this stage and become cash flow positive without raising any VC, but then stumble at the next Gate.
In consumer ventures, getting through Gate #2 means proving fit to market in a niche. So the service has to work and deliver what those consumers want. In the lean startup model, this is when all that pivoting takes place. However great entrepreneurs don’t pivot at a conceptual/strategic level, they got through Gate #1 with conceptual clarity, but it may take multiple tactical pivots to get traction in a specific niche.
Gate #3: Scale within niche.
This is the “make it work as a business” phase. This is when you throw out the lean startup guide book and start working like a real business with serious amount of capital and real management bench strength. Blowing it at this stage for lack of resources – human or financial – is dumb.
During the last decade, most enterprise software vendors that made it past Gate # 2 got acquired. VCs mostly shunned enterprise software during this time and it takes huge amount of self-sacrifice by the whole team to make it past Gate # 3 without VC. At this stage – you have the 3 reference customers, you have proved the concept – the acquirer will not consider your revenues to be meaningful, so you will be acquired for your R&D value with a bit of credit for the quality of your customer relationships. If you are lucky, you hit a market just at the point where two behemoth vendors who compete like crazy absolutely must, must, must have this technology….. If you raised VC, the acquisition value at this stage will usually be a disappointment to investors. As VCs usually get liquidation preference, this will be an even bigger disappointment to founders and management. If you bootstrapped past Gate # 2, the value you will get from the trade sale will still be life-changing as you don’t have to share the spoils with VC. However the big money, the fame and fortune, is reserved for those who make it to Gate # 3. One way to look at this is, don’t raise VC unless you are determined to make it past Gate # 3.
Entrepreneurs who want to build enterprise software ventures that make it through this gate need to make the tough transition from founder-led sales to a scalable, professional sales team. This is harder than it sounds for reasons that I describe in this post.
For consumer web ventures, the big obstacle at this Gate is proving a scalable and profitable revenue model. There are now trade offs and conflicts to be managed between the needs of free users and the different needs of paying customers (i.e advertisers) and that is often hard for the entrepreneur who won in the last Gate through their self-proclaimed single focus on user experience. This is when we see the free users (“if the service is free, you are the product”) start to get annoyed as the company starts to monetize them more aggressively (think of Facebook or any other social media venture), but a great entrepreneur and management team can navigate their way through this challenge.
Businesses that make it through this phase are “in the catbird seat”. You have a profitable, scalable model that you can grow with internal resources as long as you like. You will be fending off acquisition offers all the time, both from financial buyers (private equity funds) as well as strategic buyers. You get to choose when and who you sell to. Or you may choose to go all the way to Gate # 4.
Gate #4: Expand and Dominate.
This is the post IPO sustainable public company phase. This is where ventures grow into their original conceptual potential, moving beyond the niche orientation that you need in order to get through Gates 2 and 3.
For consumer technology ventures, consider the difference between Apple and Google and all the batch of 2011 IPOs. Apple and Google look good on all financial metrics, they built a superb monetization engine, not just superb products.
In the enterprise software space, only one company has broken through into the big league during the last decade and that is SalesForce.com. There have been plenty of SaaS IPOs, but only a few of them have escaped the “small cap hell” by getting a valuation over $2 billion. It remains to be seen if this decade will produce more big winners, but that is the subject of another post.
The “expand and dominate” Gate #4 is about getting back to that original founding conceptual clarity, of realising the big picture potential. All the long years of the earlier Gates are simply laying the groundwork to make this possible. This is another wrenching pivot. The skills, techniques and attitudes that got you up to Gate # 4 are all about focussing on a niche, constraining ambitions for the future while concentrating on the immediate opportunities. If you have done a good job in the transition through Gate # 3, you will be able to leave the quarter by quarter growth to a highly competent team. That frees the founder CEO to focus on expanding into adjacent markets and dominating their market. Dominate may sound harsh to some ears but it is what public market investors expect, that is what the high valuations given to fast growth tech companies are based on.
Entrepreneurs that make it through Gate # 2 get the opportunity to exit and that can be a good result if they have bootstrapped to that point. Entrepreneurs that make it through Gate # 3 get the opportunity to exit and that is a good result for founders, management (this is when those stock options become life-changing) as well as any investors who are fortunate enough to be along for the ride. The Silicon Valley VC orthodoxy for a long time was that no founder has the right profile to make it through all the 4 Gates. Therefore VCs have usually tried to either sell the business at each of these Gates or find professional management to replace the founder CEO. (I refer to the Founder CEO as the key, even though there are often co-founders it is one of them who emerges as the leader). That conventional wisdom is being seriously questioned today as we witness the failure of “professional managers” from big companies to drive the growth of start-ups. When you look at the really great success stories, you tend to see one highly charged entrepreneur who takes it all the way through these 4 Gates – think of Gates, Ellison, Page, Zuckerberg, Bezos, Jobs, Benioff. Their ability to pivot and personally change at each of these Gates is the story of their success. It would be crazy to see these entrepreneurs in their founding days and envisage them as the CEO of a multi-billion $ publicly traded company, yet some of them actually do that. The current VC fund structure, with its need for exits to return money to the Limited Partners, is not conducive to backing entrepreneurs all the way through these four Gates. So we are likely to see some innovation in this area as the rewards for backing entrepreneurs through all four gates is very big.
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About 10 years ago, I wrote a post called Enterprise Software R.I.P. The venue that I published in has long since disappeared into the digital dustbin, but my trusted laptop files retrieved it, so it is published below. I decided to revisit this post because I have come to the conclusion that enterprise software did not die, it just went into a coma and it is now coming out of that coma.
To a casual observer, there is not a lot of difference between coma and death. First let me say what I mean by coma/death in this context. Of course there is still lots of enterprise software and a few huge vendors doing very well and lots of small niche vendors operating in the cracks between those behemoths. But where is the Oracle or SAP of the last decade? Or even the BEA or Cognos or TIBCO of the last decade? Where is the start-up that broke into the mainstream and became a multi-$billion success story? I am referring to the death of innovation in enterprise software. This decade has not been conducive to enterprise software ventures. It is no wonder that most VCs ignored enterprise software during this decade.
Ten years ago I sensed that this was happening. It was disturbing to me because enterprise software was the world that I understood so well. I felt like the Polish Cavalry in the Second World War. The Polish Cavalry was renowned as the best in the world. They could shoot with great accuracy at full gallop and turn on a dime, nobody could match them. None of that helped them when the Nazi dive bombers and tanks rolled into Poland in 1939. I had mastered a game, but the game had changed.
So I set out to understand the consumer web. A decade later I am not a master of that game, but I understand it “enough to be dangerous”. That helps now that I am coming back to enterprise software because the consumerization of software is a big part of the renaissance of enterprise software. However it is only one part of that renaissance. Enterprises are more than the sum of their parts, they cannot simply empower every employee with consumer web type tools and hope they all pull together to grow the profits. That is why I remain sceptical of the hype around Enterprise 2.0 tools, all those “Facebook tools within the enterprise” ventures. These are “shiny objects” that make Gen Y employees happy and can have an incremental impact on productivity, but they are hardly game-changing in the way that say relational databases and ERP were game-changing in their day. Sure it helps to have better user interfaces that encourage collaboration. But there is a lot more at stake for enterprises and therefore for the employees. Enterprises face a perfect storm of three tsunamis hitting at the same time – Digitization, Globalization and the Debt Crisis. This is an existential crisis for large companies, their very reason for existence is being called into question. Business-as-usual won’t help them navigate this perfect storm. Therefore software-as-usual won’t help them navigate this perfect storm. That is why there is a huge opportunity again in enterprise software.
But I am “getting too far over my skis”. I want to return to the R.I.P post from ten years ago. There was a lot that I got right. I could see the dismal grind of consolidation. However some of my gloom was due to the terrible, but transitory, backwash from the end of the technology nuclear winter. These were the days when nobody was buying any software, innovation was dead, the only answer was to get into real estate speculation. Thankfully I resisted that temptation, it ended in a bust worse than the Dot Com bust, one that we are still living through. In hindsight the biggest thing I got wrong was:
“The “IP everywhere” rollout is exactly that, an implementation of proven technology by big vendors”.
That was wrong because the “IP everywhere rollout” fundamentally changes the rules of the game. The IP everywhere rollout makes transaction costs cheaper externally than internally. This is the practical realization of Coase’s Theorem. Coase, an economist writing in the 1930s, posited that firms grew big based on the fact that transaction costs were lower internally than externally. The Internet makes external transactions dramatically cheaper; this is the “frictionless commerce” that is now becoming reality. This challenges the very basic idea that scale is always an advantage. All those roll-ups, acquisitions and mergers in the industrial age were based on the theory of economies of scale; in Coase terms they were based on the theory that transaction costs were usually cheaper internally than externally. This goes to the very heart of what makes an enterprise big, why it needs to be big to win. This is as far from business-as-usual as you can get.
I also lost the plot a bit here as well:
“The return of the single vendor stack. IBM, Sun and HP are putting together complete solution stacks that look suspiciously like the pre-Wintel proprietary solution stacks provided by hardware vendors such as IBM, DEC, Data General, Olivetti, Burroughs, Univac, Wang and other dinosaurs that once ruled the earth. “
I had that both right and wrong. Yes, the vendor stacks forced consolidation. I got that bit right. But of course this is no different from the pre-Wintel proprietary solution stacks and they all disappeared into the dustbin of history; only IBM survived and thrived, DEC, Data General, Olivetti, Burroughs, Univac and Wang are all history. I saw that but I did not see how it would end. The answer is that when IP everywhere rolled out enough, the proprietary solution stacks started to become threatened. That is happening now. Sun has already fallen, it’s great technology is now one part of the Oracle stack. HP is a seriously troubled company. Again, only IBM has emerged stronger from this wave of change.
Perhaps the most fundamental mistake I made was in my definition:
“First a definition; enterprise software is the core, mission critical stuff that manages transactions, accounting and management information.”
If you define enterprise software that way then certainly it is “game over”, but that is only a definition of the first wave of enterprise software. The next wave, enabled by IP Everywhere will tackle much more critical issues than basic administrative functions. These critical issues will be the subject of anther post but they will address the existential question for enterprises which is how to grow when economies of scale is no longer the driver of growth.
I also mistook the fact that real time enterprise was only in the “slough of despond” that always comes after a period of hype when I wrote that:
“real time enterprise” is a fancy name for what the industry is gradually evolving towards
Real time enterprise needed to wait until the IP Everywhere rollout was more complete. For example, now that about 50% of the 7 billion people on the planet have mobile phones, you have to operate real time to thrive. The IP Everywhere rollout also enables real time enterprise solutions to be implemented practically.
Enterprise Software R.I.P
(Note: this was written late in 2002 and is copied here unchanged).
This is a receding Tsunami. Thousands of companies rode this one to fortune, but it is now crashing on the beach and the backwash is pulling a lot of companies underwater.
We are still in the early stages of the enterprise software consolidation and the most sensible option is to sell out for the best price you can get. Then you can find another wave that is growing. Or you can get out of the industry as thousands of talented, experienced executives have done in the last few years. For those who love the industry but hate the idea of working for one of the gorillas, this article highlights how to find a reasonably protected niche market
First a definition; enterprise software is the core, mission critical stuff that manages transactions, accounting and management information. The industry has been doing this for decades and there really are only so many ways you can slice the cake.
Of course it is a huge industry and is not going away. The issue is whether this is an environment conducive to start-ups. Look at the things that customers are now focused on such as data center consolidation and integration. These require big companies. The “IP everywhere” rollout is exactly that, an implementation of proven technology by big vendors.
Attempts to hustle up big new growth waves within enterprise software have failed. Wireless is a simple another delivery option and “real time enterprise” is a fancy name for what the industry is gradually evolving towards. These are add-ons to existing products from big companies.
What is driving this consolidation?
The proximate cause is the after effects of the bubble bursting. Massive over-investment and the dramatic drop off in demand puts the buyer in control.
The buyer has always hated the traditional enterprise software model; too many small vendors blaming each other for projects that don’t deliver business results. In a buyer’s market, they get what they have wanted for a long time.
Investors demand the earnings visibility that comes from a recurring revenue model. When customers and investors both demand the same thing you can be pretty confident that it will happen.
The return of the single vendor stack. IBM, Sun and HP are putting together complete solution stacks that look suspiciously like the pre-Wintel proprietary solution stacks provided by hardware vendors such as IBM, DEC, Data General, Olivetti, Burroughs, Univac, Wang and other dinosaurs that once ruled the earth.
ASPs with solutions engineered from the ground up for the Net, such as SalesForce.Com and Intranets.com are getting real traction and proving that it is possible to deliver real solutions over the Net for a monthly fee.
So will all the customers simply plug into a few giant Con Edison style utilities? Is our only option to work for/invest in these utilities? Thankfully the answer is an emphatic no. The utility analogy can be stretched too far. IT has a far bigger impact on a company’s profitability than electricity and there are a lot more variables. So how can smaller independent companies prosper in this new world?
Leverage the stack for your own high growth niche. Offer the total solution on-line for a monthly fee. This reduces the buyer’s risk and thus enables start-ups to get that critical early traction. The good news is that it is now much easier and cheaper to put together a total solution from a mix of outsourced data centers, open source frameworks and offshore developers. All you have to do is find an emerging growth market.
Operate right at the top of the stack where you are dealing directly with end users (aka a vertical market solutions focus). Look for business sectors that are growing fast but that are small enough today to fall below the radar screen of the gorillas.
Web Services based “features”. Experienced venture builders look at most new ventures and say, “that is not a product, it is simply a feature”. The best that can happen to these “companies” is that they get sold for R&D value. It is possible – but not yet proven – that Web Services will enable small companies to thrive by offering these features on a pay as you need basis over the Web.
Mine the backwash. There is a lot of money in maintaining old systems, catering to the conservative customers and forgotten niche markets. These forgotten markets last much longer than you would think from listening to industry analysts. This is low on the glamour stakes but if you are in business to make money it is worth remembering the old saying “there’s brass in that old muck.”
Private label commodity providers. This is another low glamour business, suitable for low cost operators. You sell your product through other solutions providers without your brand being visible. Of course you may eventually pull off the “Intel inside” trick and move up the stack, but even pure commodity players can make good money if the market is big enough and you focus on efficiency and being the lowest cost provider. You will need to bundle excellent support and show that your TCO is lower even than open source.
This a good time to take stock and get ready for the recovery with a new positioning. Markets will recover and IT will remain central to business. But don’t expect it to be like it was before. Prepare for dramatic change and find where you can add the most value.
Attention Enterprise Cloud and SaaS Vendors: CAPEX is no longer the problem, OPEX is the problem. August 25, 2012Posted by bernardlunn in Enterprise Sales, Enterprise Web 2.0, SAAS.
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One of the big value propositions for SAAS has been:
- No CAPEX
Pay as you use licensing converts IT from CAPEX to OPEX. That has worked brilliantly, perhaps too brilliantly. While nobody was looking, the CFO’s attention shifted away from CAPEX. This is hard for cash-strapped start-ups to understand, but big companies have ridiculous amounts of cash on their “fortress balance sheets”. They have so much cash that they don’t know what to do with it. They can give it back to shareholders via Dividends and Share Buybacks; that gives a short term boost to the stock price, but it is not what they are paid to do.
They want propositions from vendors to spend that cash to:
- improve the profit margin by reducing OPEX. That is a much better way to boost shareholder value than buying back their shares.
- generate new revenues. This is why acquisitions are so popular, but shareholders prize organic growth more than acquisition led growth. If you have a credible way to grow revenue organically, you will seriously get the attention of the CXO folks in their corner offices.
Now look at the standard SAAS/Cloud pitch from this corner office:
“you won’t need to spend that plentiful cash but by letting us grow unchecked within our organization we are in danger of letting our OPEX get out of control”.
Your frictionless customer acquisition has become their out of control OPEX spending. The “no CAPEX” pitch was ideal market entry pitch for SaaS and Cloud vendors, but it is no longer the compelling proposition that it used to be.
No CAPEX still works well for two types of customer:
- Startups and smaller companies. They are always cash-starved. But as a vendor you have to bet that one or more of these startups will become big. It is incredibly hard to scale a business if all the customers are startups or small.
- Operating units within an enterprise. They tend to have minimal external IT budget as they are supposed to get big IT projects approved through the internal IT department via the CIO. That internal process can be expensive, lengthy and political.
Both of these can be excellent market segments for vendors, but this should not be mistaken for an enterprise value proposition.
The great enterprise software startups of the past almost all bootstrapped without Venture Capital funding. They could do this because selling perpetual licenses is wonderful for generating cash. Sure, selling perpetual licenses will lead to problems in the long run – huge pressure to close big deals at the end of every quarter and lack of revenue visibility. For most entrepreneurs this is a bridge that they can cross at a later date. In the early years the three golden rules are 1. Cash Flow, 2. Cash Flow and 3. Cash Flow. The other part of the perpetual license model is the Annual Maintenance Fee. As this is cumulative, it creates revenue visibility as the venture matures. Look at the financials of a mature enterprise software company and you will see a big % of the revenues coming from Annual Maintenance Fees which have similar characteristics to SaaS subscription fees – good revenue visibility and low churn.
Tags: cloud, consumerization, enterprise software, SaaS, salesfo
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Today’s hype is all about the Cloud, which is a triumph of marketing. Marc Benioff, Founder/CEO of Salesforce.com, is the trailblazing pioneer who executed brilliantly on a marketing blitz with the No Software tag line and image. It was brilliant, but something grated on me. Salesforce.com was still all about software, just software delivered in a different way. “Software is eating the world” as Marc Andreesen puts it. This is the golden age of software. The tag line should be More Software.
What Benioff really meant was:
“you don’t need to install our software on your hardware”.
That does not exactly trip off the tongue. It sounds like branding conceived by an engineer – totally precise and accurate….and quite useless.
Or he could have said:
- No CAPEX.
That is the Pay As You Use Licensing model. Again, this is precise, but useless as marketing. Working out the trade off between monthly payments vs perpetual licensing is Finance 101. Plenty of traditional enterprise software companies offer a monthly payment option and this can help to get a deal “below the radar” of a corporate CAPEX authorisation process; but that is hardly a game-changing revolutionary approach. Many companies, savvy to this move by vendors, require authorization for the full length of the contract (e.g. they multiply the monthly fee by 24 if it is a 2 year term).
Or Benioff could have said:
- No Hardware
- No Data Center
That would have been more accurate. No Hardware is the simple core of the cloud computing value proposition. Salesforce has been adamant that they will never license their software for use within a customer’s data center. That gives them lifetime value and great revenue visibility. They can maintain that position with customers as they get their initial traction with end users who have zero interest in the hassle of installing software on hardware in data centers. By the time the Salesforce sales guys get to the CIO level, they are already entrenched at the end user level, so they have enough negotiating clout to hold this line. As Salesforce.com has the scale and technology to buy hardware at least as efficiently as their biggest clients this works. This is tougher for startups without any buying clout.
So now we have:
- No CAPEX
- No Hardware
Now, lets add Consumerization. Now we can say:
- No Committment
- No Documentation
This is more radical. Many enterprise software vendors fail at this step.
No Commitment means users pay monthly and quit any time they want without penalty. When I was editing the SAAS Insights Report, there was one quarter when Salesforce.com was panned by Wall Street analysts because the company had moved from a policy of insisting on at least 12 months commitment, to asking for no commitment. This meant that analyst’s models that forecast future revenues based on contractual committments saw a weaker forecast. If they had bothered to ask their colleagues analysing consumer centric subscription businesses, they would have looked at churn models and cost of customer acquisition and concluded that Salesforce was making the right move. This showed me that conventional Wall Street analysis is often deeply flawed; but that is another story.
No commitment naturally leads into Freemium. The conventional enterprise response to the need to try before you buy is the free trial. This is quite different from freemium, which is free forever with limited functionality. This is a game that large companies can play more easily. For example, I am confident that Google will survive and won’t feel under financial pressure to adversely change the terms of their free Gmail service. A free service still requires me to invest my time; if the vendor goes smash or changes the rules, I lose that investment.
The key to No Commitment is Low Churn. If you get high churn, if users pay for a couple of months and then terminate, your customer acquisition cost will be too high.
Low Churn means that users actually find it useful. Which leads onto to next one:
- No Documentation.
Would you use Gmail if you needed a Manual to get started? Consumerization means really, really user friendly software. You know what to do the moment you see the screen and you can get real value immediately. If you want to become a power user, you can do so gradually. If you want to use related modules, they are loosely coupled but integration is automatic.
Consumerization is the real revolution in enterprise software. Cloud Computing and Pay As You Use Licensing are usefull iterations of the current model. Consumerization is the seismic shift that will:
- Dramatically lower the cost of customer acquisition and on-boarding for vendors (and therefore enable lower prices for customers).
- Bring the customers and partners directly into the systems and processes on a peer level with internal employees.
The last point is critical. Enterprises have already cut a lot of costs. They won’t stop, cutting costs is like weeding the garden, a job you always have to do. But senior management priority has shifted decisivelty towards revenue generation. Enterprises today are very cash rich and profit margins are at an all time high, but management teams are all struggling to grow the top line.
Online networking is changing how business is done in fundamental ways. The consumerization of software is not only about letting Facebook addicted Gen Y and Z feel more at home at work. Nor is it just about incremental productivity improvements from easier to use software. Consumerized software is about enabling front line employees to connect in real time and in context with customers and partners. Business is evolving from managing hierarchies to managing ecosystems. That requires a radically different type of enterprise software. The revolution in enterprise software that commenced with cloud and SaaS is just getting started. It is this aspect of consumerized enterprise software to add the final one:
- No Walls (between employees and customers).
Today’s enterprise software is a 5 point mantra:
Vendors can choose which of these 5 mantras to focus on. There are trade-offs and some vendors will do well be focussing only on one or two of these mantras.
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Table of Contents
How To Use This Report
This Quarter – Regular Readers Start Here
Momentum: The Q-Q Revenue Growth Winners
But Value Does Still Matter
State Of The SaaS Market This Quarter
Buy, Sell & Short Recommendations
The SaaS Investment Thesis
This Report Is SaaS, Not Cloud: The Top Of The Stack
Why SaaS Is Better For Customers
Why SaaS Is Better For Vendors (ie Management Team)
Why SaaS Is Better For Investors
What Investors Need To Think About
Buy The SaaS Index Or Individual SaaS Stocks?
Investors Focus During The Tornado Phase Of SaaS
Why We Measure Q-Q Revenue Growth
The M&A Driver And The Value Trap
Small Cap Hell aka Size Does Matter
Valuing The Salesforce.com (CRM) Bellwether
The 3-Point Bear Case On CRM
The 3-Point Bull Case On CRM
Is CRM A Platform?
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Salesforce.com (CRM) is a bellwether in the SaaS market. There are 3 reasons to think CRM is over-valued. There are also 3 reasons to think CRM is under-valued!
The 3-Point Bear Case On CRM
First, what is the case for Salesforce.com (CRM) being over-valued?
- PSR compared to peers is high. PSR (Price Sales Ratio) for the SaaS Index average (as of Aug 20th) was 5.00 and Salesforce.com is 9.01, indicating an over-valuation of 85%. Last quarter this overvaluation was “only” 60%. Given their market leader status that is not surprising. But for the first time, this level of overvaluation is flashing a warning signal. Concern factor: medium.
- Marc Benioff is selling shares. This was announced in the quarterly report on November 25th 2009. The % of his shares that is selling is significant. He has announced that he may sell 2,750,00 shares out of a total of 13,371,006 shares he owns. That is 21%. Whether investors are concerned about this remains to be seen. Insider selling is often a trigger for smart outsiders to sell. And the short sellers have picked up on this and are using it to drive their case. But it also may not mean anything. Maybe he wants to give serious money to charity and who can fault him (or Bill Gates) for doing that? Investors do not seem to be concerned so far, evidenced by the stock performance since he started selling. Concern factor: low.
- Their SaaS platform play has strategic issues. This is a more complex issue. Long-term growth will require moving beyond the original core market of sales force automation systems. They understand this very well. That is why they built the Force platform. It is also probably why they raised $500m in convertible debt, so that they can acquire businesses in adjacent markets. But making the transition from one market to being a platform for multiple markets is difficult. Very, very few companies have ever made that transition. Those that have made the transition are valued very highly. Taking a long-term position in Salesforce.com is largely dependent on your view of how well they will manage this transition. We have dedicated a separate section to this issue. Concern factor: Low for short-term traders, high for long-term investors.
The 3-Point Bull Case On CRM
Second, what is the case for Salesforce.com (CRM) being under-valued?
- Internet market leaders are never cheap stocks. Waiting for these leaders to become bargains has seldom worked.
- They have executed excellently to date. They have challenges ahead of course but their track record indicates they will manage them well. Long term investing is about confidence in management and they have earned that confidence.
- SaaS/Cloud is going mainstream and they defined the market and still lead it. They serve as a proxy for many investors to invest in SaaS. They have a big enough market cap to play this “pseudo Index” role.
How Did The Market View CRM Last Quarter?
In short, CRM outperformed the market significantly. In our view, the market was giving due credit to great Q-Q revenue growth in the last quarter. Analysts were negative on the last quarter and the stock went up. Most of them missed the great Q-Q momentum. Not wanting to repeat that mistake, analysts are positive on the latest quarter. But we think they are wrong. We finally think that CRM is due for a significant correction.
Why? The same reason we were bullish last quarter – the Q-Q revenue momentum. This quarter was not as good. It is not bad, but at CRM’s lofty valuation “not bad” is not nearly good enough.
What Does The Latest CRM Qtr Report Tell Us?
What we are looking for in this report is primarily Q-Q revenue growth.
If they grew by more than last quarter, that means they have accelerating growth. That would be amazing given a) their size and b) their high growth last quarter.
First, here is what we wrote last quarter:
“To recap, last quarter they reported Q-Q growth of 7.11% by adding $23.5 million of new revenue. To match that 7.11% this quarter they would have to add about $25 million this quarter.
Anything better than that means a fantastic result.
We will be looking for any “red flags” ie concerns. But barring that we are focused on Q-Q revenue growth.
What did they report? $377 million revenue. That is $23m in new revenue, which is almost the same as the prior quarter. As a % Q-Q growth that is 6.5% versus 7.11% growth in the prior quarter.
Our analysis? Very, very good. Not quite “knock it out the park” but close.”
What about this quarter? They got $17m in new revenue, less than the prior quarter. On a % basis, they grew 4.51% Q-Q, which is great for a company over $1 billion in annual revenue. But it is still less than the 6.5% last quarter and the 7.11% in the quarter before that.
This is not just the law of large numbers. The CRM growth momentum may be slowing a bit. At this level of valuation, CRM cannot even afford for that to be a question mark. The shorts may have a good quarter.
[i] Extract from 10Q: Marc Benioff, adopted a fifth Rule 10b5-1 trading plan (the “Fifth Plan”) on September 1, 2009.Under the Fifth Plan, up to 2,750,000 Shares may be sold in open market transactions at then current market prices on Mr. Benioff’s behalf at a rate of 10,000 Shares per trading day. Sales pursuant to the Fifth Plan are expected to commence on November 30, 2009 and continue for approximately one year. Sales under the Fifth Plan are subject to certain restrictions, and may be terminated at any time. The Fifth Plan also provides for gifts of up to 275,000 Shares to funds or organizations qualifying as public charities pursuant to Internal Revenue Code Section 501(c)(3). As of November 25, 2009, Mr. Benioff had beneficial ownership of 13,371,006 Shares. Actual sales transactions will be reported through filings made with the Securities and Exchange Commission as required.