Software start-ups feel the pinch

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."

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,"

By giving customers the source code to its products, Intalio provides customers a sort of insurance policy that they could keep operating even if Intalio company goes away, Ghalimi said. In addition, having a widely used open-source business process management product makes the company attractive as a potential acquisition down the road, he said.

Several other companies are seeking to commercialize open-source products, such as databases and development tools, by selling support services. Another common model is to provide a free open-source version and charge for an enhanced edition.

Embracing open source also means completely revamping a company's operations. For example, the low acquisition-price of open-source products means that software companies cannot support high-cost sales and marketing employees. Instead of hiring a large cadre of salespeople, some software companies say they rely on developer interest and telesales.

Although open-source may be a popular business model for new companies, larger incumbent providers are dipping their toes into open source as well--without totally undercutting their profitable product lines.

Microsoft shares code with developers. IBM last year bought Gluecode, an open-source application server company, and offered its Geronimo products to small business customers as an alternative to WebSphere Application Server.

Like open source, a software-as-service company needs a different operation than traditional software companies as well, said Alms at Agistics.

Having a single version of an application makes ongoing support simpler but the company needs to coordinate with several different service providers. Also, far more attention needs to be paid to software design to ensure it can stand up over time, he said.

The amount of money required to start a hosted-software venture may be higher than a traditional software company. Salesforce.com, for example, required about $65 million in venture funding before it went public, according to Trinity Ventures. Rangaswami noted that payments to hosted-software companies tend to be spread out over time, rather than pay out upfront.

Matrix Partners' Skok said companies that sell on-premise software--rather than hosted software--need about $30 million to $35 million, in general, to get started, which is consistent with years past.

However, firms have to find a way to break into corporate accounts without an expensive sales process, he said. For example, storage management company AppIQ, recently acquired by Hewlett-Packard, signed reseller partnerships with more established providers, such as Hitachi.

Open-source companies can be started and operated for lower costs than the traditional enterprise software model, said some software entrepreneurs and investors.

In a recent blog entry, Marc Fleury, CEO of open-source company JBoss, argued that a shift to open-source products and yearly subscription contracts will disrupt business models run by incumbent software companies. "We can survive, nay, thrive on lower revenues, and that is a crazy new world for our competition," Fleury wrote.

Running the numbers

Corporate buyers--who often seek to work with fewer, trusted vendors--still spend money on software, particularly to make IT infrastructures more cost-effective and flexible.

In a report from November last year, Gartner forecasted spending on applications and software infrastructure to grow 7.7 percent through 2009, fueled by spending on products to revamp corporate computing systems around more flexible service-oriented architectures.

Gartner predicts consolidation in the software will continue through 2007 as large vendors fill out their sell a "stack," or broad suite of integrated components.

If start-ups are not acquired by a larger player, they can't cash in through the public stock market as easily as in the past. More rigorous regulations make filing for an IPO--a route to riches for many software companies in the past--more difficult.

"In general, the cost of IPOs has gone up a lot, probably in the three-and-a-half to five million dollar range," said Ben Horowitz, CEO of data center automation software provider Opsware. "If you look at how big you have to be to afford that off your bottom line, that's pretty substantial."

Still, optimism and entrepreneurial spirit live on in software. Ultimately, the new tacks taken by software start-ups are a sign of changing market conditions, rather than a sign of flagging innovation, said Ram Gupta, CEO of startup Cast Iron Systems and a former Peoplesoft executive.

Cast Iron has taken a novel approach to tackling application integration, a costly job that can cost large-business customers millions of dollars a year. The company's appliance approach changes the picture dramatically, Gupta claims. In one case, Cast Iron closed a deal in thirty days--a process that takes several months for incumbent integration-software providers.

"It does become harder in the enterprise space, of course, because of consolidation," Gupta said. "That being said, any time in history of innovation, if you have good innovation, a good, differentiated offering and execute flawlessly, you will succeed, times being whatever they are."