OnStartups

Note:  This article was derived from a chapter of my MIT graduate thesis titled  “On Startups:  Patterns and Practices of Contemporary Software Entrepreneurs”.  This paper was submitted in partial fulfillment of my M.S. degree in June of 2006.  A full copy of the paper is available at the MIT archives and will be made available on this site to registered members within the next several weeks.

The Enterprise Software Market
 
In the early years of the software industry, the primary consumers of complex software systems were large enterprises which could leverage technology for strategic advantage.  This need within large enterprises gave rise to many of the well recognized categories for “enterprise software” such as customer relationship management (CRM), enterprise resource planning (ERP), business intelligence (BI) and content management systems (CMS).

Each of these categories created significant shareholder wealth for the companies that dominated them.  Examples include SAP, Oracle and Siebel (now owned by Oracle).

The reason so many software companies, particularly startups got into the enterprise software market in the 1980s and 1990s was very simple:  Despite the dominance of some large players, the market was relatively new and you could command a price premium.  Further, in many cases, the upfront license fees were enough to allow you to fund the company mostly (if not entirely) on customer revenue.  Those were good times.  Instead of focusing on how to raise capital from VCs, you could actually focus on finding a handful of customers that had the pain you were out to solve and get them to pay some license fees upfront.  

I experienced this phenomenon in my first startup, which was a classic enterprise software play.  We sold high-end software to high-end customers for relatively high-end prices.  The company was bootstrapped (started with < $10,000) and did not raise any venture capital.  (Though we did complete a late stage funding round in our 7^th year in business).  I ended up taking advantage of some of the industry consolidation and sold the company to another, much larger enterprise technology company in 2005.

As the industry evolved and matured, the market for enterprise software became increasingly challenging.  Enterprise customers became dissatisfied with the terms being offered by enterprise software vendors – especially those involving high upfront fees.  Because of the pressure to meet quarterly forecasts, high-pressure sales tactics came into play.^[1]  Ultimately, as both competition increased and the return on investment (ROI) of these large-scale enterprise software products came into question, power shifted to the customer.

At the recent “Software 2006” conference, Ray Lane (former executive of Oracle) outlined some of the challenges with enterprise software, many of which are particularly acute for software startups looking to address the enterprise market.  The following are some of the most critical challenges identified^[2]:

1.  Startups may find it difficult to access large, enterprise buyers
2.  Enterprise customers often have long evaluation cycles and committee-based purchasing.  These extended sales cycles are difficult for cash-strapped startups to manage.
3.  Enterprise customers often have large customization requirements before the software product can be useful to them.  Though these customizations can often be a source of revenue, startups often lack the resources to take on this effort.
I agree with Mr. Lane’s assessment of the situation, but would add a few additional challenges for startups focused on large enterprise customers:

1.      Many enterprise software categories have big competitors that are hard to unseat.  When up against these competitors, size and stability of the vendor is often a dominant variable in the selection criteria.  It is not sufficient to have a better product.  Fortune 500 firms often make the safer choice.  This is particularly true with the heightened focus on security and compliance.

2. Some enterprise software categories are seeing increased pressure from open source offerings.  This creates further pricing pressure and the need to differentiate.  Given the choice between paying a startup tens or hundreds of thousands of dollars for an advanced software package or trying out an open source package that does something similar, more and more enterprises will consider the open source option.  They have the resources to take on the open source implementation risk.  There is also the added advantage of control.

3.  A smaller volume of potential customers often creates high revenue concentration (whereby most of your revenues come from just a few customers).  This creates risk in that these customers will have a high degree of leverage (and are not afraid to use it).  This reduces what you can charge for maintenance, service and upgrades.  It also has the potential of distorting a startup’s product road map as these high revenue customers can coerce what they need out of a startup, even though it may not necessarily be in the best interests of the startup or its other customers and prospects.

Targeting The Fortune Five Million

The above reasons are why I think more and more startups should start looking at the lower end of the market.  Forget the Fortune 500 and start thinking about the Fortune 5,000,000.  These are the millions of small businesses that have historically gone underserved by the software industry.  For the record, there are actually over 10 million such businesses here in the U.S. – but I use the 5MM number because Fortune Five Million sounds better and uses alliteration – which I like.

Here is how the Fortune Five Million market differs from the large enterprise market – particularly from the perspective of a startup:

1. You don’t get the benefit of high upfront fees.  So, capitalization will be an issue.  It’s harder (but not impossible) to bootstrap and build a business based on customer revenues.

2. There’s usually little room for high customer acquisitions costs.  Gone are the days of making multiple trips to the customer site to close a deal.  This kind of sales process was acceptable when you’re making over $100,000 per deal, but not tenable when you’re making < $5,000.

3. Though open source is certainly a consideration, few small businesses have the resources to find, filter and implement the right solution.  In many cases, going through the process of selecting, implementing and managing an open source package is higher risk than picking a startup that offers the needed functionality on a hosted basis.

4. Given that price points for the small business market are lower, it is rare to get caught in the revenue concentration trap.  As such, individual customers usually have little power and leverage. 

5. Small businesses often manifest behavior patterns that are similar to the consumer market.  This means that though these clients are often hard to reach, it is possible to have a very short sales cycle and there are minimum customization requirements for individual customers.  This gives startups to pursue the highly lucrative path of selling a large volume of the same product to many customers at exceptionally high gross margins.  By contrast, many enterprise software sales require a high degree of supporting service – which drives margins down and creates resource demands on the startup.

6. Small businesses have historically been high underserved by the software industry.  The market is dominated by a few large players (like Microsoft and Intuit) and then littered with hundreds of very small “point product” providers that are often focused on niche vertical markets.  For a startup, this means that there is still significant opportunity to address a reasonably large target market, but still stay out of the cross-hairs of the big players.

It is the above set of differences – and the fact that enterprise software is just so hard to sell that I’ve decided to focus on the small business market myself, with my latest startup.  So far, my experience has been mostly positive and the above factors have proven themselves out.  But, there are definitely a new set of challenges (the most significant of which is distribution).  But, for those considering creating a new software startup, I strongly encourage looking at the small business market.  A unique set of circumstances are starting to come together that finally makes this large and exciting market viable for a startup to address.  I’ll look at some of these factors that makes the current timing ideal in a future article.

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