Small is beautiful for Web 2.0 start-ups

Rather than try to crack into the business market with a complicated, pricey product, Fried and his colleagues chose to stake out a fairly narrow sliver of the software world: hosted personal organizers and project management applications.

To Fried, the old way of doing things--where a start-up's success hinges on a few well-heeled customers willing to shell out big dollars--is history.

"I think the idea of enterprise software is dead. Enterprise software is kind of a dirty word--big bulky things that never work, were never delivered on time, and are too expensive," Fried said.

The enterprise software market is a multi-billion dollar industry that's still growing--albeit more slowly than in years past. But changing industry dynamics are making it a less attractive market to try to break into, say some investors and entrepreneurs.

"Investors are less excited about the tough sledding of that (enterprise software) business model," said Mark Hildenbrand, general partner for enterprise applications and infrastructure software at Onset Ventures. "There's no question that it's a challenged area."

Instead, the past two years has seen a proliferation of smaller companies building Web-based applications, sometimes referred to as Web 2.0, as well as open-source companies. Many of these firms can get off the ground with relatively small up-front investments, not the tens of millions of dollars that venture capitalists pumped into new software ventures in years past.

The business plan at 37signals, for example, is to build simple hosted applications and charge a monthly subscription fee to small businesses and individuals.

In the two years since launching its first service, the self-funded company has signed on hundreds of thousands of customers and it has no debt, said Fried. It has also founded a successful open-source Web development project, Ruby on Rails.

"You can build a great business on a niche product because with the Internet, you can reach a million or a half-million people," said Fried.

Sharp focus, wide angle
A number of technology changes are making very focused product offerings more viable, according to entrepreneurs and investors. Most significant is the growing popularity of hosted applications, or software delivered as a service.

The founders of Upstartle, which makes an online word processor, Writely, first considered building collaboration and document management software for corporate intranets. But they eventually scrapped that idea and decided to focus on word processing over the Internet.

"In the past, you had to do a huge, overwhelming thing--a suite of stuff. Now it seems like you can do a lightweight part, which would've seemed like a feature before, that can be stitched together with something else," said Writely co-founder Claudia Carpenter.

Because the "Internet has become an application platform," Writely can connect its word processor service to other Web services, such as blogs or photo-sharing sites, Carpenter said. Web sites are increasingly publishing APIs, or application programming interfaces, which let users and developers share information between different hosted services.

Another important technical advance is the emergence of AJAX a development technique for creating interactive GUIs and Web pages that can refresh Web server data automatically. With AJAX, programmers can build hosted versions of desktop applications, such as document and photo publishing, which offer a user experience similar to PC-bound applications.

In addition to pursuing a narrow product focus, new companies can get off the ground with significantly less money than a few years ago, according to entrepreneurs and investors.

Freely available open-source software is becoming increasingly robust and powerful hardware servers are relatively cheap. Five years ago, start-ups would have had to spend tens or hundreds of thousands of dollars for equivalent products.

Operating costs can be lower as well. 37signals, for example, has not spent money on marketing, relying instead on viral marketing techniques, like blogs and word-of-mouth advertising from its customers, said Fried. The company of seven employees has no sales people.

"What we're seeing with Web 2.0 is that the game of what a software company is and how it gets started has very much changed," said David Rose, board member of New York Angels, which is an angel investment organization that recently launched a practice for Web 2.0 companies.

Rose said Web entrepreneurs nowadays can go from idea to functional product in under a year with under a half-million dollars in investment. "It used to take multiple years, millions of bucks and years of top-down planning to get the first product out," he said.

The Web-based software model applies to both the consumer and the business market, said Richard Forman, managing director of RDF Ventures and a member of New York Angels.

"The fascinating thing about Web 2.0 is that it's a double-barreled track. On the one hand, you have user-submitted content which is a sea change for the Web and then you have Web services for collaborative interaction and ASPs (application service providers), which will have a real impact on the enterprise world," he said.

Companies such as Salesforce.com, NetSuite and now SAP have demonstrated that corporate customers are willing to forgo large-scale internal software projects in favor of hosted services, at least for some select applications, analysts noted. Even Microsoft, king of the shrink-wrapped software market, has taken notice.

Calling on the Fortune 5 million

A lower barrier to entry makes it easy for new ideas to turn into fledgling businesses. Maybe too easy, some analysts said.

Many Web 2.0 online applications can be put together with just a few people and relatively little upfront money and time. But by the same token, those services can be easily replicated, according to investors.

Also, some business models for Web 2.0 companies are not fully tested. Writely, for example, is still in beta and evaluating several different revenue models, including subscriptions for certain customer segments and, potentially, advertising.

Mark Hildenbrand

"We're seeing a proliferation of start-ups, many of which may be nice little businesses that will be beneficial to the founders, but few that have the fundamental ingredients for creating lasting, meaningful businesses," said Onset Ventures' Hildenbrand.

Although building enterprise software companies may be tougher, money continues to flow into the field. But companies may pursue newer strategies, such as open-source or hosted applications.

Onset's Hildenbrand, for example is focusing on companies that have deep expertise in a particular technical area, such as mobile devices or RFID. He's seeking technology that does more than automate a set of business processes at global 2000 corporations.

"That's now pretty darn easy to do and hence the value proposition of doing it is not nearly as strong," Hildenbrand said.

But for entrepreneurs like 37signals' Fried, that's a row not worth hoeing any more. And, he contends, keeping his business operation small and his product simple doesn't mean making sacrifices.

"I think we can be one of the most meaningful companies in the next 20 years," he said. "We don't care about the Fortune 500--it's the 'Fortune 5 million'--the small businesses that are doing interesting things."