THINK IT Services

The most recent issue of Forbes magazine has a scathing article questioning the financial returns being generated by venture capital (VCs) firms.

This article will encourage many institutional investors who serve as the VCs’ limited partners (LPs) to look elsewhere for places to invest their monies.

A broad-based abandonment of the VC community by these LPs will make it doubly difficult for entrepreneurs to find funding in 2009.

Many VCs will be forced to put a moratorium on new investments, others will refrain from making additional investments in current portfolio companies, and some will shut their doors entirely.

Combine the poor track record of many VCs with the downright mismanagement of individual and institutional investments by hedge funds and private equity firms who funneled monies into Madoff’s ponzi scheme, as well as the virtual shutdown of the IPO market, and the prospects don’t look good for funding opportunities in 2009 for privately held companies.

This could significantly slow the growth of the Software-as-a-Service (SaaS), cloud computing and broader on-demand services market.

SaaS, cloud computing and on-demand services companies with strong prospects will still find funding. For instance, Aria Systems (a THINKstrategies client) recently won a new round of funding from Venrock.

However, weaker companies will have a hard time surviving in this more challenging economic climate.

My friend Phil Wainwright’s latest blog post re: LucidEra’s new pre-sales program, Pipeline Healthcheck, confirms many of my initial observations when the company first introduced the program in October. Phil’s post includes a number of interesting stats which LucidEra’s founder, Ken Rudin, also shared with me at Salesforce.com’s Dreamforce event.

LucidEra’s decision to move away from the typical free-trial approach to selling SaaS is significant because it exemplifies a subtle trend which is brewing in the on-demand services market.

Although many SaaS solutions can be sold using a ‘try and buy’ technique, a growing number of SaaS vendors are discovering that they must employ other sales tactics to sell their solutions. In some cases, like the LucidEra example, it is because they are trying to demonstrate the power of their functionality to a target buyer who is unfamilar with the basic idea. In other cases, the SaaS vendor is offering a more complex solution which is going to have a significant impact on the customer’s operations and requires greater sales skills and resources.

An example of this second scenario is Salesforce.com’s growing focus on large-scale enterprise sales. Selling its customer relationship management (CRM) solution to Global 2000 companies requires more than a 30-day trial to be successful. That is why the company has been aggressively recruiting traditional software salespeople from companies like Oracle and SAP to attack major accounts. I had an opportunity to speak to over 700 of these ‘big-game hunters’ at Salesforce.com’s North America sales kickoff meeting last February.

This shift in sales strategies and tactics has raised concerns among the VC and broader investment community about the long-term viability of the SaaS industry. These investors are worried that adding more high-powered salespeople and creating more complicated sales processes will increase the cost of sales and reduce the operating margins of SaaS companies. They are concerned that this will undercut the price advantage of SaaS over traditional, on-premise software vendors.

An example of this thinking is a recent post by Evangelos Simoudis of Trident Capital. While there is a legitimate concern that many SaaS vendors, like companies in general, have a tendency to be inefficient in the way they allocate their sales and marketing budgets, I believe some of the investment community’s angst is based on an industry benchmark which is no longer relevant.

That benchmark is the exorbinant operating margins which incumbent software vendors (iSVs) have enjoyed over the years. Investors are concerned because they haven’t seen profit margins of over 60% from SaaS companies like those they’ve been accustomed to seeing in the packaged software industry.

However, if you look closely iSVs are finding it equally difficult to sustain their profit margins as customers become disenchanted with high upfront perpetual license fees and escalating maintenance costs. So, comparing emerging SaaS vendor profitability with historic iSV profitability is no longer valid.

I debated Bruce Richardson of AMR Research on this point earlier this year. Bruce was questioning whether the SaaS industry could sustain itself given the high cost of sales and marketing reported by the publicly traded SaaS vendors. My view then and now is that the long-term profitability of SaaS is not reflected in today’s financial reports for two reasons,

1. The SaaS industry is still in its infancy and SaaS vendors must spend a disproportionate amount of their revenues, and/or VC funds, on sales and marketing to educate customers about the intrinsic value of their on-demand solutions. This includes the ‘try and buy’ and other sales and marketing techniques aimed at encouraging rapid adoption.
2. Companies like Omniture, Salesforce.com and SuccessFactors are intentionally overspending on sales and marketing to aggressively win market share. As Josh James of Omniture has stated in his blog and at industry conferences, SaaS companies which know their ‘magic number’–the incremental revenues generated by every additional sales and marketing dollar spent–are obliged to put the ‘foot to the metal’ now so they can win as much market share as possible before the industry consolidates.

So, my concern isn’t whether SaaS is a profitable business model. Instead, my concern is whether the VCs, private equity firms and other traditional funding sources are going to retreat from the SaaS market because they have unrealistic expectations for this sector.

While it is reasonable for them to be more conservative in their funding strategies and investments given today’s economic crisis, it would be disappointing to see them abandon the SaaS market because they’ve lost faith in the business model.

I’ve just returned from my last business trip of the year. This time I was in Washington, DC, hosting the Software-as-a-Service (SaaS), cloud computing and managed services track of NetworkWorld’s IT Roadmap event.

The keynote speaker at the event was Bechtel Corporation’s CIO, Geir Ramleth, who gave a fascinating talk about how his IT team is transforming the way Bechtel leverages technology and business applications by modeling their operations on YouTube, Google, Amazon.com and Salesforce.com, rather than traditional enterprise organizations.

Ramleth has recognized that these on-demand service providers are delivering high-value solutions in an amazingly low cost fashion, making them the envy of CIOs at many of the greatest companies in the world.

Although Ramleth’s team has decided that today’s commercially available SaaS and cloud computing solutions don’t meet their corporate requirements, they still felt the operating model of today’s on-demand service providers is worth imitating.

Ramleth’s presentation echoed many of the ideas which THINKstrategies has been advocating for the past seven years. His team recognized the ease of use and operating efficiencies of consumer-oriented web-services and SaaS vendors, and decided to benchmark their internal operations based on these successful models. As a result, they have not only increased end-user productivity, but dramatically reduced their operating costs.

Click here to read more about Bechtel’s transformation process.

Given the proliferation of Software-as-a-Service (SaaS) and cloud computing players over the past year in response to the rapid rise of customer interest and demand, it was easy to predict that a shake out in the on-demand services market was inevitable. The question is whether today’s turbulent economic environment will accelerate this shake out process and kickstart a series of mergers and acquisitions heading into 2009.

One school of thought is that many of the weaker players in the on-demand services market are not mature enough to attract buyers and, therefore, the volume of acquisitions will not be any greater than normal.

Compounding this situation is the fact that many potential acquirers are facing their own financial challenges and lack the currency to take advantage of a “buyer’s market” and make acquisitions.

I’m not an expert in the art and science of M&As, that’s why I’ve established alliances with key players in this business. But, I am intimately involved with many on-demand service providers who recognize that they must strengthen their competitive positions in order to survive and succeed in an increasingly challenging economic climate and competitive landscape.

Therefore, a number of companies are looking at ways they can expand their market penetration via acquisition. For instance, I’ve have the privilege of serving as a senior advisor to Triple-Tree, LLC, which has seen a significant uptick in its pipeline of deals over the past few months. Triple-Tree has announced two deals in the past week alone,

• Paisley–a governance, risk and compliance SaaS vendor–has signed a definitive agreement with Thomson Reuters, a provider of intelligent information for businesses and professionals. Thomson Reuters is acquiring Paisley to provide customers a ‘one-stop’ compliance management and internal financial control solution.
• SearchAmerica–a provider of payment prediction data and analytics to the U.S. healthcare industry–has been acquired by Experian, a global provider of information, analytical, and marketing services to organizations and consumers to help manage the risk and reward of commercial and financial decisions. The acquisition will permit Experian to extend its Credit Services and Decision Analytics activities in North America to help healthcare providers manage their billings and cash flows.

These were not ‘asset’ sales. Instead, they are deals which enable the respective acquirers to expand their portfolios and market reach, and permit the acquired companies to achieve a solid exit. These transactions also typify the blurring of the lines between software, business and information services sectors.

You can expect to see a steady stream of these deals through 2009 as the on-demand services industry evolves and is reshaped by broader macro-market trends.

I’ve been suggesting for a few months that the Software-as-a-Service (SaaS) and ‘cloud computing’ market has been experiencing a ‘gold-rush’ era of accelerated growth. The rapid adoption of SaaS solutions was confirmed by THINKstrategies’ latest survey in conjunction with Cutter Consortium.

Just like in the original gold-rush of the 1800s, today’s ‘cloud-rush’ is not only attracting a proliferation of players, but also an assortment of unsavory characters.

The scandal surrounding IT Factory of Denmark is the most recent example. If you haven’t been keeping track of this one, it is worth reading about. The company’s CEO, Stein Bagger, disappeared before Thanksgiving after financial ‘irregularities’ were discovered at his company and a half billion kroner were found to be missing from the company’s bank accounts. Bagger is presumed to be hiding out in Dubai, and his company has fallen into bankruptcy.

The scandal doesn’t only affect the company’s employees, customers, partners and creditors. It also is a black-eye for the tech industry. As TechCrunch reports, just this September the Danish version of Computerworld named IT Factory “Denmark’s Best IT Company 2008″.

Another scandal involving a SaaS company unfolded in October. In this case, Entellium’s CEO and CFO were arrested for keeping two sets of books to disceive the company’s board of directors and investors. The company is facing bankruptcy and its assets are likely to be sold to another vendor.

Once again, the impact of this scandal extends beyond the company’s employees, customers, partners and investors. Entellium won numerous industry awards for the quality and innovative nature of its SaaS solutions from a variety of industry associations and publications before the company’s executives were discovered to be cooking the books.

While these might be isolated cases, they are a clear indication that the SaaS/cloud computing market has grown to the stage in which it is likely to be a target for more of this type of deceitful behavior.

For instance, I’ve even discovered a new online directory which is structured curiously like my SaaS Showplace and includes almost an identical list of companies which is attempting to exploit the SaaS/cloud computing market.

These ethical threats to the SaaS and cloud computing movements could undercut the success which the on-demand services marketplace experienced over the past year, and could combine with the uncertain economy to derail the momentum many SaaS/cloud computing companies were anticipating in 2009.

All of us who have worked hard for years building the SaaS/cloud computing market will have to work even harder now to combat these threats and safeguard the integrity of the on-demand services industry from these opportunistic, scurrilous characters.