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The Opportunity is Soft
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
March 26th, 2004

By Brent Holliday
Greenstone Venture Partners

“People talkin' about is,
they got nothin' else to do,
When it all comes down we will,
still come through,
In the long run” – Eagles – Long Run

The undisputed king of software investments, from and angel or venture capital point of view, is, well, you guessed it… Microsoft.  Investing in 1975 in a fledgling start-up of pimply-faced teenagers (who made a software tool that interpreted BASIC on a new Intel 8080 chip for a fledgling desktop computer market) would have been a good idea.  They made $16,815 in revenue that year in royalties from a New Mexico company called MITS. Definitely a seed deal.

Two years later, bailing out the same company when it ran short of cash because it ran into a legal dispute over licensing rights (!) with its key partner would have been an even better investment opportunity.  The employees hadn’t been paid and Bill Gates was desperate.  Unfortunately for the guy who did bail them out, saving Microsoft from imploding that summer, he and his company didn’t take equity, but paid them up-front for a year’s worth of licensing royalties for their computer platform.  Seems this guy was flush with cash from his investors and probably, in hindsight, blew the best and most interesting equity partnership in history.  His name was Steve Jobs and his company was Apple Computer.

Assuming you bought 10% of the company as a VC in 1977 in those desperate hours, for $100,000, you would have had roughly $100,000,000 worth of stock at the 1986 IPO.  In nine years, Microsoft went from $381,000 in revenue to over $200,000,000, the best hockey stick in history.  One thousand times your original investment is a pretty good return.

Where are the best investment opportunities in software today?  Before we go there, it is an interesting sidebar to look at what a software company actually is today.  Software is ubiquitous.  At its most elemental form, it is a set of instructions that moves electrons and magnetic polarities in silicon and a variety of other mediums.  Companies like Spectrum Signal Processing and PMC-Sierra could, at the most elemental forms of what their products do, be called “software” companies.  A lot of hardware companies, making boxes (e.g. assisting in moving VoIP traffic) like Convedia, have some of their intellectual property tied up in “software” algorithms.  But we don’t categorize these companies as software companies because, although they have software developers working at their facilities, their products incorporate the software into a hard good that they sell.

Venture capitalists like to taxonomize their opportunities.  It helps us enter the deals we see into a database… (anyone see the irony there?)  These categorizations change over time as technology innovation forces us to look at new categories.  Currently, software companies fall into three major categories at Greenstone: Applications, Tools and Systems/Control. 

Applications are the easiest to understand and, by far, the most opportunities that we see in software.  Applications companies are those that sell software products or services where an end user derives benefit without (usually) writing any software code.  The software has been abstracted far enough away from machine code that it is easy to use and understandable in its utility.  Local companies successful at software applications are numerous (Electronic Arts, Business Objects (Crystal), Fincentric, MDA, Pivotal etc., etc.)

Tools are a bit more esoteric as they are companies that sell software products or services typically used by developers or hardware manufacturers making applications.  These are the development environments, interpreters, data access, compilers, test and measurement, quality assurance, optimizers, database tools and middleware, XML, web services and open source tools to name a few sub-categories.  Local companies making (or made) Tools include ActiveState, Flowfinity, MAKE Technologies, Simba, XML Global and others.

Systems/Control software is the most esoteric and “hard” area of software.  Usually, it is a sub-group of a hardware or semiconductor company making the control systems or operating instructions for their end products.  So there are very few opportunities to create entire companies here.  But sometimes companies can emerge here because we include things like operating systems, drivers, libraries, embedded software and algorithms in this category.  Algorithms pop up a lot in areas like compression, network communication, authentication, encryption etc.  Sometimes the company morphs into a DSP or ASIC company as the algorithms are interpreted in silicon.  Other times, the company licenses their intellectual property and lives and grows off royalties.

Microsoft started out as a Tools company, bought a “platform” in the Systems/Control area (DOS), created a standard in the Windows OS and then made gobs of money as an Applications company.  Because they are so massive and monopolistic now, and other companies have developed near monopolies in key platforms like databases (Oracle), it is very hard to seeing any software company reaching the scale of Microsoft, ever.  It also makes it hard to envision massive success in any application that can be subsumed into a “bundled” environment, recent legal ruling against Microsoft notwithstanding.  Look at Netscape, Real Networks and soon, McAfee and Norton.  Microsoft can easily put anti-virus, firewalling and spam tools into its Windows giving them 100% market share out of the box.

The result of the domination of the big software companies is that point applications for horizontal markets are not great opportunities.  In other words if you application is part of a broader need by the customer in order to form a solution, you are not likely to win.  Maximizer was a local example of this phenomenon.  It was a great product for contact management in the mid-90’s with growing market share, competing with Act And Goldmine.  But the customer needed it to work with messaging, collaborative work tools and customer relationship/sales management.  Outlook became the category killer because it integrated with the dominant e-mail platform and was bundled with the best selling suite of applications, Office.  So Maximizer was forced to compete in smaller and smaller niches.

Vertical applications are great opportunities.  Top Producer was essentially a contact management application written locally for the real estate market vertical.  With specific hooks, templates and usability for real estate professionals, it worked out of the box better for those qualified users than Maximizer.  There are far less real estate buyers than the broader horizontal market for general contact management, but Microsoft is not going to bother becoming an expert in real estate.  Vertical applications afford the opportunity to allow market leadership and fairly large growth.  The new model of delivering applications over the Net, with it’s inherent advantages in pricing models, upgrading and ubiquitous availability is where most of the action is today. Vertical applications continue to be excellent opportunities as witnessed by local successes like Class Software, Chancery, Fincentric and others.

There are big opportunities in services that focus on integration and processes.  As we emerge out of the nuclear winter of enterprise spending, companies need to make new investments work with existing infrastructure.  Building connections between applications is still a huge business. Extending the life of existing investments is a huge priority in the customers mind today.  Software applications and services focusing on “extensibility” are very popular.  But even bigger in services is the “process” story.  Enterprises are looking for ways to make “best practices” work everywhere in their organizations to improve efficiency.  Software applications and services focusing on compliance with best practices are hot.  Whether these be mandated by government, like HIPAA or Sarbanes-Oxley, or simply by industry standards, the software companies focused on process are getting attention of buyers.

The really big software companies of tomorrow might be in the Tools space.  With Open Source application development gaining significant steam today and Linux getting a foothold as an OS, there is an opportunity to define new platforms (in database, MySQL, for instance) and create the tools that leverage those platforms.  With the PC market essentially in “replacement” growth mode, new hardware platforms are emerging that never see a Windows hegemony.  Devices, especially wireless ones, are a wide open playing field for Tools (and Applications).  Another opportunity in Tools is the development of software moving from bug-prone current practices to quicker, more standardized processes like code generation (MAKE is a local example).  There is a burning need for more efficiency in the development process.

Autonomic computing (a biology term for self-healing), is mostly hype today, but may present excellent opportunities tomorrow.  Secure, instantly updated software running on networks that don’t go down is highly desirable.  Tools companies that “harden” software to this level will likely do very well.

With end-user markets improving, software companies look like good investment opportunities.  They generally require less money to reach profitability, they have extremely attractive gross margins driving higher valuation multiples and they tend to be nimble organizations that can turn on a dime to meet new opportunities or threats. 

We would like to invest in the next Microsoft, but the likelihood of that is remote.  A big company in software going forward will have to strategize around the behemoths in the industry today, which Microsoft didn’t have to do in their time.  But we don’t really need 1000 times our investment to be happy.  Ours is a modest journey…


A month ago I wrote about A Good Place To Be (http://www.bctechnology.com/statics) and mentioned that EA had turned the code bought from Radical Entertainment into its highly successful SSX series of games.  In fact, the SSX project was already under way at EA and the teams merged to bring it to market.  My apologies to the dented egos of that original team.  They make one of the best games out there and they deserve all of the credit.

What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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