June 2003

Market of Niches

Weren't the late 1990s great? Remember...

• New multi-billion dollar businesses like the Internet, enterprise software, and optical networking.
• Start-up companies with management teams overstocked with great young talent and engineering ranks loaded with well-paid developers.
• Investors putting $100 million into new businesses to build new technology platforms, create new markets, bury potential competition, and worry about profits only after going public at multi-billion dollar valuations, just 2 to 3 years after formation.

A dreamy memory for some; a nightmare for most. While many are still trying to achieve the same goals of the late 90's, only with less capital, the business approaches used by the more promising emerging businesses today are totally different than those of just a few years ago. And its not just "back to the future," applying today what used to work just fine in the early 1990s.

Emerging businesses' approaches to growth must be fundamentally different than ever before

Instead, to create value in current information technology and communications markets, many of the basic tenets of the emerging businesses' approach to growth – be it technology development, go-to-market strategy, sources of capital, or business model – must be fundamentally different than ever before.

Rather than build and run businesses to pursue the next multibillion dollar market, successful growing companies, both private and public, are chasing a "market of niches." They are looking for niche opportunities to add needed functionality, cut IT costs, fill platform gaps, provide decision enabling analysis, and address vertical needs. Doing this well requires a different approach to the business. It also can produce a more valuable company.

Lets look at a prime example of where this new approach is on display - the enterprise software and services industry. The mid and late 1990s brought us new companies building big platforms and comprehensive applications to deliver e-business , ERP (enterprise resource planning), SCM (supply chain management), and CRM (customer relationship management). We also saw the beginnings of BI (business intelligence) and EAI (enterprise application integration) software to tie platforms and applications together and make better use of the information available within the enterprise.

What did all of that get us? From an investor perspective, Morgan Stanley reports that while there are now more than 3000 public and private software companies, only about 100 are over $50 million in revenues. Furthermore, most of those under this revenue threshold are not growing. As Jim Lussier of Norwest Venture Partners says, "there are a lot of software companies out there, but very few real players. There will be a wave of consolidation, where the big will get bigger and the small will either sell out, niche or go out of businesses." The recent acquisition skirmishes involving Oracle, PeopleSoft and J.D. Edwards – and the travails of companies like Baan – are just the most public display of what is going on regularly across large and small software and services companies alike.

Most small software companies are not growing

The game has also changed radically from a customer perspective. Software now represents 45% of capital dollars spent on technology, 3x the share it held only 20 years ago. However, average software sales prices are now in the range of hundreds of thousands rather than millions of dollars.

Beyond the very real effect the economy has had on reducing capital budgets, two fundamental changes have driven this new buying approach:

• First, large enterprise software platforms and applications are in place in most companies. The need now is to make them work together and allow the user to extract the right information to make timely management decisions. Roughly half of the spending today is on software that integrates and extracts value from existing software.
• Second, after the excessive software buying of recent years, business leaders (who now own the IT budgets) are demanding that ROI thresholds be hit on average within 6 months after the software is acquired.

Focus on very specific customer pain points and address those that fill gaps in large software company offerings

The net result of these changes? An enterprise software company that wants to grow revenues and build value has very little choice: it must focus on very specific customer pain points and address those that fill gaps in large software company offerings.

In light of this, four business approaches are playing dominant roles in today's growing companies and must be adopted by all of those that want to be successful in the "market of niches" environment:

1. Focus on the business pain, not the technology solution – Operating, enterprise, applications, web services, and messaging platforms, standards and applications already exist. Forget about technology innovation as your primary differentiator. Instead of creating a "technology disruption," provide a "pain reduction." Customers are trying to simplify operations, reduce complexity, eliminate costs, and improve returns on what has already been spent. Focus on building a deep understanding of all aspects of the pain, its causes, effects, alternative remedies, their potential side effects, etc. before beginning to develop the technology solution. Figure out how simple approaches leveraging existing standards, and built on current platforms, can be uniquely applied rather than pursuing costly, lengthy new technology development.
2. Go-to-market indirectly – Channels already exist in mature markets, and software is a mature market. Why spend a ton of money and time building your sales and marketing organization, especially if a potential acquirer or partner already has its channels developed? While you may need to prime the channel pump by selling and marketing your offering directly for a while, it is likely that you can find a more cost effective, higher leverage channel that is already built.
3. Join early with strategic partners – Going forward, 9 of 10 successful exits in enterprise software and services will likely be through the M&A route, rather than through the IPO market. In addition to laying the groundwork for a potential exit, finding the right strategic partner early on will provide you an initial market for your products, a good channel, and a view of the business landscape difficult to achieve within a small company. While many corporations have formally exited the corporate venture capital business, the best software companies have very active channel programs and will make investments in early stage companies that can fill their offering gaps.
4. Change the conventional business model – The tried and true approach to growing a new business – develop a unique product technology, build the sales force, establish brand position, expand and globalize the business platform – has become too expensive, too slow and too inexact in delivering customer value and minimizing investment risk. Emerging and growing enterprise software companies these days should instead:
   • Focus on solving very specific, pressing needs of customers in vertical sub-segments.
   • Outsource software development to international workforces for 1/3 the cost.
   • Piggyback off of established sales channels.
   • Maintain minimal management teams and staff sizes.
   • Take more money from customers and less from investors than start-ups historically have during the development stage, and plan on taking less money from investors pre-exit.

If you think these rules apply only to enterprise software, consider that many emerging semiconductor companies have gone fab-less, network equipment companies are selling increasingly through large OEMs, and wireless companies are providing narrower equipment and software solutions. Even managed applications services companies are making a mini-resurgence due to customer "pain reduction" focused offerings.

Change the conventional business model

Clearly, these rules increasingly apply across the information technology and communications industry. And both later stage private companies and IPOs that were originally venture backed and built on some of the business models of the 90's are reshaping their businesses with these approaches in mind.

Today, and for the foreseeable future it's a market of niches in the emerging business world. It's really a win-win situation. If you define and can solve a very specific customer need, you reduce your development and sales cycle and improve your customer's business value and ROI. Most large companies do not have the business model or entrepreneurial approach to do this.

The economics are quite clear. Find a poorly addressed $250 million market need, invest no more than $20 to $25 million, capture 20-25% of that market, and then do it again and you'll make a lot of people happy and rich when you exit in 5 to 7 years. Shoot for a market five times as large with three times the capital requirements and you probably won't get too far off the ground.