It has never been easy for business software companies to break into the exclusive billion-dollar club—hitting $1 billion or more in annual revenues. Only 14 pure software companies (not including giants such as IBM that also sell hardware) have managed to reach the magic number. And it is getting tougher, not easier. Just two companies founded since 1990—Siebel Systems and VeriSign—have managed the feat.
“The opportunities to build a software company today are as good as ever,” says Eric Schmidt, CEO of Google, “but it will be harder and harder to build companies of the scale of old.” Schmidt should know. Before joining Google, he was the CEO of Novell, a member of the billion-dollar club, and he is now on the board of directors of Siebel Systems.
In short, the software industry is consolidating as it matures. Some have argued that such consolidation is a sign of trouble for customers and entrepreneurs alike because it will lead to less choice, less innovation and higher prices, and make it harder for smaller companies to compete. But there are good reasons to believe that is not the case, and that the software industry is as healthy as ever. Innovation, one of the key metrics for measuring the health of the software industry, has been strong throughout the past decade. The commercialization of the Internet led to a wave of new technologies that changed the way software was used. And as might be expected, many of the new ideas came from software company startups, among them the Web browser, application server, digital certificate, firewall, application service providers, procurement automation and the search engine, to name just a few.
Some of these products, like the Web browser and application server, were what used to be called “killer apps,” or what business guru Clay Christensen today might call “disruptive technologies.” A few of these products might have even launched the next billion-dollar software firm. A lot of investors certainly thought so—mistakenly as it turns out. Just look at the multibillion-dollar valuations that were assigned to Inktomi, BroadVision, Vignette, Ariba, Commerce One, E.piphany and Red Hat.
“It was absurd,” says Raymond Lane, former president and COO of Oracle, another billion-dollar player, and now a partner at the venture capital firm Kleiner Perkins Caufield & Byers. “Investors wanted to get in on the gold rush.” Most of those companies stood little chance of breaking the billion-dollar mark, and none of them will ever live up to those lofty valuations. Yet by and large, their failure to reach $1 billion was no fault of their own. Each had innovative products, experienced executive teams, plenty of money and willing customers.
Underestimating the Competitors
Underestimating the Competitors
What kept these startups from joining the club? They met entrenched competitors that proved to be much more nimble than the typical big company ever used to be. Digital Equipments fatal lack of response to the disruptions created by the PC is a case in point. But this time around, the big established firms have responded much more quickly with products of their own. And that makes it a lot tougher for the little guys to get big.
These days, when an entrepreneur develops a winning technology, it is a sure way of attracting the attention of people like Bill Gates and Larry Ellison, who have almost certainly read Christensens The Innovators Dilemma. In fact, they could have written the book, because thats exactly how Microsoft and Oracle came to power. Each of these companies developed new products, MS-DOS and the relational database, that changed the competitive landscape to their advantage.
Because large software companies are responding faster to new technologies, entrepreneurs are finding the going a lot tougher. Innovation may still originate with the startup, but it is the large company that is often the one to capitalize on it, either by buying up a small firm or developing its own product. And thats a good thing for the CIO, because it provides more choice. The CIO can go with a startup if it is important to deploy the product first, or wait a bit longer and buy a comparable product from one of the established companies, with all of the benefits that provides.
To see this at work, it is worthwhile to take a close look at what may have been the most successful startup to emerge from the Internet era, BEA Systems. BEA pioneered the commercialization of the application server, software that helps customers link different applications, databases and other software across the Internet. Banks, for example, use application server software to link their new online banking systems with their ATM networks. As more and more businesses moved such services to the Net, the demand for application servers exploded, and BEA grew right along with it, hitting $976 million in revenues last year. According to Gartner Dataquest, sales of application server software from all vendors in 2001 totaled $3.1 billion.
But as the market matures, BEA is having a more difficult time. The company is no longer competing against other startups. Instead, its up against the likes of IBM, Oracle and Sun Microsystems. These companies are taking advantage of their size and breadth by bundling their own application server software with their hardware, services, applications and related software. Today, close to two thirds of the application servers are sold bundled with other products.
For BEA, that spells trouble: The company simply doesnt have the breadth of products to bundle with its application server software or to replace the revenue it takes in from its primary product. So BEA is losing ground. The company has hung on as the number-one seller of stand-alone application server software, with 34 percent of the market, just ahead of IBM, which has 31 percent. But IBMs sales of its WebSphere application server software grew 71 percent last year, while BEAs sales grew only 23 percent. And the market for stand-alone application servers is just 38 percent of the total market.
In the larger market for bundled application servers, BEA ranks second, with a 24 percent share, while IBM is on top, with 33 percent. Oracle was third, with 12 percent, followed by Sun, with 8 percent. BEA will probably squeak into the billion-dollar club this year, but it is unlikely to emerge as the dominant software firm in its market, as have companies like Microsoft, Oracle, SAP and even Siebel.
But the markets increased depth certainly makes life easier for CIOs, who have more competing products to choose from in this maturing field, and who can negotiate better deals by buying a collection of products from one vendor. And CIOs can further benefit when these products are integrated in hopes of making them work together more easily.
Meanwhile, it may be more difficult for entrepreneurs to build large software companies, but that isnt dissuading entrepreneurs and venture capitalists from trying. The resulting firms may just be a bit more modest. “What is the category that could be the basis for a billion-dollar software company?” asks Googles Schmidt. Just about every function in a large company, such as finance, sales and manufacturing, has already been automated. For those core functions, along with products like databases and application servers, companies are standardizing on a handful of big suppliers.
“This becomes the basic platform, the transaction engine, for most companies,” says Lane. On top of that platform, there will be many opportunities for small software companies to develop tools, niche applications and services that help CIOs develop semi-custom systems for their companies. These may not be billion-dollar opportunities, but they are big enough to build sustainable businesses. “There will be a few big players, with a lot of little players by their side,” predicts Schmidt. As New Age proponents used to say in the 1960s: “Small is beautiful.”
Eric Nee, a longtime observer of Silicon Valley, has served in a variety of editorial positions at Forbes, Fortune and Upside magazines. His next column will appear in September.