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New Web service: Hot investment or hype?

Investors say the "vertical service provider" niche could spark a revival of the broader technology sector, but critics say it's the newest fad.

When Jim Thomas wanted a new way to monitor his chain of sandwich shops, he had no idea he was participating in one of Wall Street's hottest investment trends.

Hoping to reduce theft at his Subway stores, the owner of San Francisco-based Cable Car Subway purchased a video surveillance system from San Francisco's VitalLink. One of about 200 start-ups in the so-called vertical service provider (VSP) niche, VitalLink installs hardware and gives restaurateurs and barkeepers daily reports from data stored in cash registers, video monitors and automated purchasing logs.

VitalLink's automated system increased Thomas' profit by roughly 2 percent and more than paid for its $150-per-month per-store cost. More importantly, the Web-based monitoring and accounting service gave Thomas a way to make sure his 30 employees weren't "standing around giving free soda and sandwiches to their friends."

"In terms of peace of mind, what I paid for it has been worth it," Thomas said.

People who invest in VitalLink and other VSPs say such companies routinely make corporate clients' profits increase--in some cases, as much as 100 percent. They are bullish on the young sector, touting it as a relatively undiscovered and potentially lucrative business with such promise that it could spark a revival of the broader technology market.

At a conference in San Francisco on Thursday sponsored by Crosspoint Venture Partners, enthusiasm around VSPs harked back to the good old days of 1998 and 1999, when investors preached that business-to-consumer and business-to-business e-commerce would foment a revolution in corporate America. Participating venture capitalists and analysts said VSPs in industries ranging from restaurants to airlines could someday record profits larger than those of technology bellwethers IBM, Cisco Systems and Dell Computer.

"What we're watching is dramatic and useful and potentially revolutionary," Crosspoint partner Rich Shapero said of the emergence of VSPs. "We bet a lot of money on these businesses, so we hope they'll be successful."

But some say the chest thumping is little more than hype. Critics insist that the segment--though certainly useful to industries that haven't fully adapted to the Internet age--cannot possibly sway broad economic cycles or by itself propel the tech sector out of the doldrums.

They point to the harsh reality that virtually none of the 200 or so companies in the young sector is profitable. Crosspoint has invested $350 million in 16 VSPs, including Buzzsaw, Believe, Dorado and NexPrise. None is profitable. VitalLink, one of the closest to profitability, is not expected to be in the black until the second quarter of 2002.

"They're on the right track, but I'm not sure if they know how expensive it is to make money," said Thomas "Tim" E. Bailey Jr., president of Alliance-Strategies in Portola Valley, Calif. Bailey, who specializes business development for technology start-ups, did not attend the conference but has heard more than enough about the promise of VSPs--and he's still skeptical.

"The profitability issue is the key," Bailey said. "Nobody's figured out what the right business model is."

VSPs defined
The precise definition of VSP is something that nobody seems to have figured out, in part because many companies are trying to glom onto the trend.

As buzz surrounding the segment gets louder, many application service providers (ASPs) have tried to recast themselves as VSPs because VSPs are more fashionable among venture capitalists and on Wall Street. ASPs, which essentially rent out their software and hardware on a subscription basis for companies that don't specialize in technology, have struggled lately with the general technology downturn.

But Crosspoint, which takes credit for the VSP moniker, says that VSPs should not be confused with ASPs. While a single ASP rents out services to any potential client, from e-tailers to automobile companies, a VSP specializes in a certain industry, such as semiconductors, financial services, chemicals or food. Software and hardware that a restaurant-oriented VSP would develop, for example, would be focused on the particular challenges of food-preparation and wait-staff costs, and the products wouldn't be applicable to the advertising industry.

VSPs typically provide the Internet connection to the corporate customer, either directly or through a broadband partner. They provide software that puts paper-intensive business tasks such as accounting or purchasing on the Web, yet they also have "domain expertise" that allows them to come up with special software for a specific industry, according to Crosspoint.

Perhaps the best example of a VSP is Sabre, the airline industry's first travel computer-reservations system and partner to nearly every major airline.

see special report: E-travel's unfriendly skies Established companies are developing VSP divisions that could someday rival the smaller start-ups. Fannie Mae has developed an automated underwriting system--Desktop Underwriter--that has become the mortgage finance industry's leading automated system. Microsoft and Oracle, although they don't call their products VSPs, are also developing their own Web services divisions.

DemandTec, another Crosspoint-funded VSP, promises that it will double clients' profits. The San Francisco-based company provides pricing and product information for the low-margin retail industry. For example, DemandTec will crunch data for a grocery store to determine exactly which products are the most profitable and which it could safely cut without losing customers. It can do the same thing for companies ranging from drug stores to catalog clothiers.

"We're pushing volume around," said DemandTec co-founder and Chairman Mike Neal. "You'd be amazed to know how many store managers don't know which products are the highest margin and which are money losers."

The 40-employee company has collected $18.4 million in funding and has 10 patents pending. It has 11 customers using pilot products in hundreds of stores representing $80 billion in sales.

But time may be running out for 2-year-old DemandTec. Crosspoint partner Jim Dorrian said the sour economy means that the venture capital firm, like its rivals, is investing only in companies that can promise and deliver profits quickly. He said the company is considering investments only in companies that can reach profitability in two or three years.

Still, Dorrian is bullish on the VSP model.

"In general, we've looked for a predictable horizon where profits come in a reasonable time frame with a reasonable investment," Dorrian said at the conference. With VSPs, "we can put our ear to the track and hear the profit train coming."