Software start-ups feel the pinch

Small fish in the shrinking software sea are embracing open-source, software as a service to get an edge over their larger rivals.

Ismael Ghalimi started software-maker Intalio with a solid business plan and leading-edge technology. But like many software entrepreneurs, Ghalimi is finding that isn't enough.

After six years without showing a profit, company executives decided it was time for plan B: Rather than sell customers pricey, high-end software, Intalio decided to sell open-source software instead, cutting the price from about a half-million dollars to zero. The company would charge for support and a license fee when its software is deployed on closed-source databases and middleware.

Intalio's dramatic strategy shift reflects the difficulties of operating a software start-up in a rapidly consolidating market. The upheaval in business software is unraveling the traditional formula for start-up software companies, prompting smaller players to bet on novel business models and technologies.

"Enterprise software is a mature market and you can't compete head-to-head against IBM, Oracle or even SAP. You just can't--they have too many resources on the engineering side and they own the customer," said Ghalimi, Intalio's founder and CEO. "It's just brutal out there."


What's new:
With ongoing consolidation in the industry, operating a small business-software company is tougher, prompting start-ups to bet on new business models and technologies to compete with larger providers.

Bottom line:
The traditional formula for starting an enterprise software company is being strained by consolidation, but start-ups are embracing open-source software and new pricing strategies to get an edge.

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Entrepreneurs and investors say fundamental changes in the business software market are rewriting the rules of engagement for potential software upstarts. Corporate customers are buying from fewer, larger providers and choosing different purchasing models, notably annual subscriptions in place of upfront fees. With the traditional equation for starting a company being strained, smaller firms hoping to survive need to pursue new business tactics and technologies--such as open source and hosted services.

"A critical requirement for start-ups is that they've identified an area where pain is extreme, so extreme that a company is willing to deal with a start-up and willing to pay money for it," said David Skok, a partner at venture capital firm Matrix Partners. "No question, it's tough."

Hardly a week goes by without a reminder of the ongoing vendor consolidation. Larger software companies have emerged as a new tier of active consolidators, including IBM, Oracle, Microsoft, Computer Associates International and Sun Microsystems. As these larger companies bulk up--either by acquisition or internal development--smaller software companies are finding fewer niches to fill.

"Over time, (large vendors) have built out so many dimensions in the enterprise software arena, it's nearly impossible for a start-up to come in competing with the old software model," said Dean Alms, the CEO of Agistics, which recently landed $2 million in initial funding to create a hosted offering to provision employee services. "It's like going after an automobile company--there are so many moving parts now."

Alms, a former PeopleSoft executive, said Oracle's successful takeover of PeopleSoft sent shivers down the spines of many entrepreneurs at smaller companies, showing that even a large company like PeopleSoft couldn't defend itself. "If your exit strategy isn't to be acquired, you'd better have a rock-solid plan," he said.

Investor and consultant M.R. Rangaswami calls the changes in the software industry "seismic." "The ground is moving beneath the software industry," he wrote in a recent Sand Hill Group article. "More than simply market maturation, the enterprise software sector is shifting to an entirely new way of doing business."

What's the plan?

Traditionally, software start-ups could carve out a living by being a "best of breed" provider that offered a specialized product superior to larger vendors. In areas such as back-end software for building complex systems, small companies could charge large fees-hundreds of thousands of dollars--for licenses to fund further development.

Today, living among giants appears to be getting tougher. Many corporate customers are still feeling the sting of software purchases from small outfits that went out of business or couldn't keep up with feature requests, according to industry executives and analysts.

"There's this feeling that people are not going to be burned again,"

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