This post is essentially a repeat of the article I posted at Sandhill.com but with recent comments from John Wookey, WSJ articles and “Cloud Computing” announcements from HP/Microsoft, I thought it would be interesting to post it directly to the SAP community to stimulate some conversation and ideas.
While I have been involved in bringing to market many successful software products over the years as an independent software vendor, I’m interested in hearing how you think large brands (e.g. SAP) might work better with the venture capital community to bring innovation that businesses can use.
After reading the article, perhaps you will disagree with my premise. Perhaps you will disagree on how to go about sparking the innovation pipeline. I don’t claim to have a lock on all the ideas which is why I’m interested in hearing yours.
The startup has been the traditional innovation pipeline that has fueled growth and returns for enterprise IT and enterprise software providers. Yet despite the need for innovative enterprise software solutions, there has been a dearth of venture funding for new enterprise-oriented software companies during this past decade. Consequently, it is my assertion that the traditional enterprise software innovation pipeline is drying up.
Given the current challenges associated with the traditional venture capital business model, the reluctance by VCs to invest in enterprise software startups, and the pressures faced by the large software brands such as SAP, I believe there is a unique opportunity for the venture community and major vendors to come together using a modified version of the classic “spin-in” model. The result could be a new era of innovation for enterprise software.
The Challenges Facing Enterprise Startups
According to VentureSource, from a high of 506 enterprise-oriented software startups securing a Seed or Series A round in 2000, only 201 new enterprise-oriented software startups were funded in 2008 and the vast majority of those used a SaaS, PaaS, or IaaS business model. Very few traditional model enterprise-oriented software companies were funded at all, the notable exception being in enterprise search and analytics.
Why? Enterprise IT – the target market for these solutions – and the incumbent enterprise IT software providers (e.g. Oracle, SAP, MS, IBM, etc.) have conspired to build a virtually impenetrable gauntlet for startup software companies to overcome. A start-up whose products are not part of a “blessed” corporate architectural standard will find selling its innovative enterprise software solution a very tough slog. It will bear the burden of extended sales cycles, high sales costs and increasingly smaller budgets already spoken for by the big brands.
Those few companies that do manage to make it with breakthrough technology are quickly threatened by the incumbents. They are either compelled to sell the company at a time when the multiple for the management team and venture firm is potentially uninteresting or face increasingly greater sales risks as the big brands use their internal relationships to raise “fear, uncertainty and doubt” (FUD) about the long term prospects of your company and products. This, in turn, causes them to have to make bigger discounts with correspondingly lower margins, endure longer sales cycles, etc. until they finally give up and either sell out or call it quits. This phenomenon isn’t restricted to just small startups. Even larger enterprise software companies have had a difficult time surviving; look at what happened with PeopleSoft, Siebel Systems and Hyperion – all of them multi-billion dollar, global enterprise vendors.
Innovation Stagnation Sets In
Ironically, one of the problems that plague large software companies is that their ability to innovate and bring new products to market tends to be inversely related to their success and growth. That is, the bigger they get the less innovative they become. I believe there are two primary reasons for this perplexing phenomenon.
The first is that existing customers place increasingly significant demands upon the company’s product resources to provide bug fixes and deliver enhancements to current product lines. Over time, maintenance and product revenues from existing customers dwarf new customer revenue so companies must invest the majority of their resources to secure these revenue sources, leaving few resources for new product initiatives.
Second, the public markets expect companies to generate increasingly better operating results – improved revenues and margins each and every quarter. Investing in new product initiatives results in little short term revenue increases. The problem is compounded by the fact these new product investments immediately impact the expense side of a public company’s balance sheet. This can lead to poor margins and a depressed stock price which in turn can jeopardize a senior management team’s employment tenure with the company.
An advantage a successful public software company would seemingly have is access to cash to fund new product initiatives. However, while many of these companies do throw off a substantial amount of cash each quarter the quandary they face is that they are unable to use that cash to finance new development initiatives without negatively affecting their quarterly income statement. Interestingly, if they allow their cash balances to grow large enough, shareholders begin to demand the company increase its overall returns through quarterly dividends. Therefore, other than providing a safety blanket buffer for liquidity, cash offers virtually no medium-long term competitive advantage for a public software company.
Some public software companies have adopted the strategy of using their cash and/or stock to innovate and grow through acquisition; the in-quarter investment expense correspondingly offset by an equal increase in total assets. The downside is that this can take a substantial amount of cash and/or requires very liquid stock. Therefore, this approach is generally limited to a very few large companies such as IBM, Microsoft, Oracle and SAP. Additionally, these companies are reliant upon finding companies that are willing to sell, they must pay a premium to the market value for the company, the technology they acquire must be architecturally consistent with their current products to gain immediate benefit, and more importantly they must entice existing key personnel to stay – which is very hard to do.
For example, take a look at how many senior executives and managers remain at SAP or Oracle 1-2 years after an acquisition; by that time, the top talent from those companies usually leave to ‘pursue other interests’. Unfortunately, these are the very people who invented the new technology and created a successful business. They may have a maintenance stream but they are left with little innovation talent.
Look at Workday; this is Dave Duffield’s SaaS-based reincarnation of PeopleSoft. Many of the better personnel from PeopleSoft – who were part of the Oracle acquisition – are now at Workday, readying that company to take on Oracle and its PeopleSoft installed base.
None of these issues are necessarily showstoppers but each of them introduces complexity and expense and requires a significant investment of executive and employees’ time.
These problems, and others, can result in product innovation stagnation over time and lead to competitive vulnerability for established public software companies that must serve customers and investors simultaneously. At some point, the lack of a steady pipeline of innovative, private enterprise-oriented software companies to fuel their need for growth could lead to their ultimate decline.
Reinventing the “Spin In”
I believe the challenges facing venture capitalists and major software vendors have combined to present a new opportunity to work together using a modified version of the classic “spin-in” model.
For this discussion, I am defining a “spin in” as a company formed with the explicit endorsement and investment – including personnel, cash and IP – by a large software company and venture investors. The express purpose of the spin-in is to build strategic products and/or go after new markets with the ultimate objective that the large software company will acquire the spin in at some point in the future.
The concept is relatively straightforward and has been tried, tested and proven most successfully in high tech by Cisco but it has also been used by companies in other industries as well as the federal government. However, this approach has not typically been employed by software companies.
Why? Well, primarily because there hasn’t been any need. Large software companies have had the benefit for years of relying upon the venture community to finance a plethora of competitive software startups that identify new markets, create innovative technology, and secure customers. Once some/most of the technical and business risk s are removed and the 2-3 leaders emerge, the large software companies have been able to approach these “winners” and acquire one of them either willingly or unwillingly. This process has been used successfully by many of the larger brands including, but not limited to: Computer Associates, IBM, McAfee, Microsoft, Oracle, SAP, and Symantec.
Another reason spin-ins have not been utilized much by the software industry is due to the widespread “Not Invented Here” (NIH) syndrome that most successful software companies express. The attitude is typically “We can do this better, faster, and cheaper ourselves.”
However, the facts tend to conflict with the attitude. As companies grow, few really innovative products are started, completed, and successfully brought to market. Each year when the products organization and executive team sit down to consider all the proposed projects for the following year, there is a finite budget to distribute. A line is drawn and all the projects that fall below the line go unfunded. The projects that are usually funded are those that are the current mainstay of the company; the ones that are most likely to generate short-term product and maintenance revenue.
The dilemma is that those projects that fall below the funding line could very well be the innovation the company needs to thwart competition and secure and grow substantial future revenue streams. In addition, many of those proposed, unfunded projects may come from some of the most talented personnel in the company. When those projects don’t make the cut, the people associated with those projects can become extremely frustrated and threaten to, and often do, leave the company to “pursue other interests.” This can put a significant brain drain on the company.
A New Framework for Spin-Ins
The framework of the spin-in structure I am proposing is different from the more traditional approach and it is my attempt to address the issues of each of the constituents involved: the large software company, the venture investor and the “spin-in” management/employees. While there are some financial/structural problems associated with the spin-in derivation I am proposing (there are no panaceas), I believe the benefits could far outweigh them.
The key to selecting a specific project/product as a candidate for a spin in is to ensure the product is strategic to the success of the large software company and that the market opportunity is large enough to support an independent entity. A product idea that is just a feature of a larger product suite is not a suitable spin-in candidate. Think of it this way, if it won’t pass a venture capital firm’s due diligence as a sizeable, standalone firm it isn’t a viable candidate as a spin in.
There are several important elements required to make a spin in a viable financial structure for the large software company, the investors, and the employees. Below is my proposed framework for such a structure.
The first objective is to ensure the spin-in’s financials are kept off the large software company’s books and preventing it from diluting the large software company’s earnings while the spin in grows to profitability. To achieve this, the large software company must pass an outside auditor’s scrutiny demonstrating it doesn’t possess a majority and/or controlling interest. Practically, this means the company must own less than 20 percent of the spin in and cannot have a formal seat on the Board of Directors.
This is why the large software company needs the venture community as a strategic partner. The large software company can own at most up to 20 percent so it cannot execute this on its own. The venture community is the ideal partner because it brings money and expertise in building start ups.
For some large companies, the lack of majority control makes a spin-in a non-starter because they don’t have formal control. However, ultimate control comes from the fact the spin-in is going to be highly dependent upon working with the large company to gain access to its marketing and distribution channels. For the spin-in to do anything to jeopardize that access is not in the financial interest of its management team and venture investors.
To attract a world-class management team and employees, the spin in will need to allocate a minimum of 20-25 percent.
Therefore, simple math suggests venture investors will own up to 60 percent of the spin in at its onset and may need to provide up to 100 percent of the forecasted cash requirements. The large software company can contribute any one or all of the following: IP, key employees, marketing programs, a ready-made distribution channel, and even cash to account for its percentage ownership position.
The primary difference between the spin-in structure I am proposing and a traditional spin in is the use of a financial “collar”. It is this collar that can ensure the large software company, the venture investors and the management team are incented to make the spin in become a successful business.
The terms of the collar I am suggesting gives the large software company a call option. This option includes a “first right of refusal” to purchase the company at a pre-determined multiple of revenue for a pre-determined period of time, thereby protecting the large software company from having to compete to buy the spin in on the open market. This is only fair since the spin in will require the large software company to provide a significant amount of marketing and distribution support.
To ensure the large software company remains interested in the success of the new entity over the long term, irrespective of potential market and regime changes, the venture investors hold a put option to sell the spin in back to the large software company at a certain point in time at a certain multiple of paid in capital.
The collar can be structured such that the management team and employees are incented to drive a range of increased valuation outcomes tied directly to revenue and expense objectives. For example, the call and put options can be set such that they don’t begin to run until Year 5. This gives the management team the ability to drive the company’s revenues as high as they can to drive a higher multiple if the call option is executed. If the put option is executed, the management team and employees only receive 50 percent of their equity ownership which incents them to make the business as successful as they can. Both options can expire at the beginning of Year 8 so that if the large software company or the venture investors don’t execute their option, the management team is free to operate thereafter.
Although it is beyond the scope of this article, I have put together a set of terms and models with a variety of outcomes that show how this modified spin-in approach is financially attractive to the large software company, the venture investors and the management team.
Benefits of a “Spin-In” Approach
Software innovation is still needed by the large software companies and enterprises. For all the reasons discussed, large software companies are not able to do much real innovation internally. For at least the past five years, the venture community with few exceptions hasn’t been willing to fund new start ups focused on traditional enterprise software. And, due to current macro-economic conditions, the venture community is struggling with its business model. As a result, I believe the enterprise software innovation engine could slowly grind to a halt if the status quo remains. I believe there is a unique opportunity for both of these communities to partner using a modified spin-in approach. While clearly requiring compromise by all parties involved the spin could solve a number of key issues that could enable the enterprise software innovation cycle to thrive.
The potential benefits of a spin-in approach for large software companies are:
- Strategic projects that might not be funded because they are below the line are able to get funded.
- The cost of development is carried off the parent company’s balance sheet until such point the product is in the market and generating revenue so it is potentially non-dilutive to corporate earnings.
- The parent company is able to effectively retain key personnel by enabling them to exercise their entrepreneurial spirit.
- The spin in retains some of the parent company ‘DNA’ so cultural issues that affect most acquisitions are minimized.
- The products that are developed can be managed such that they are architecturally consistent with the parent company’s products so there is little overhead integrating the “spin-in” products.
The benefits to the venture investors are:
- They can be certain the technology and business being created are interesting to the large software company from the onset, so they can invest with some confidence that the startup will ultimately have value v the typical 9 out of 10 failure rate they normally experience.
- While the upside will be capped, it his highly likely there will be a reasonably positive return within 5-8 years and therefore the investment will be accretive to the fund’s multiple and IRR.
The benefits to the entrepreneurs are:
- You will be funded!
- Lack of sales and marketing, not technology, is what typically kills most enterprise software companies. With a strategic investor/partner that is motivated to give you access to its customer base with a relevant offering this issue is mitigated.
I have shared this concept with a few large software companies and I think I’ve heard all the reasons why my spin-in concept won’t work. The primary issue generally tends to be the Put on the collar. However, all of this is negotiable and workable. As a former senior executive of a large software company, I haven’t yet heard anything to date that, with some work and compromise, makes the concept a non-starter.
I believe that SAP might benefit by experimenting with this modified spin-in approach. Certainly, its efforts with a SaaS-based model have been met with fits and starts. The modified spin-in model I’m suggesting might be better for SAP to leverage the SaaS business model which is clearly hostile to its existing business.