Software VC Outlook

Matt Miller posted a very interesting article on this subject. I am posting some excerpts:

The mood among VCs remains hesitant about enterprise software startups. Competing against today's megavendors is tough. Perpetual license models are a slowly dying business model, but the much-hyped Software as a Service (SaaS) model is still more conjecture than reality in the core software sectors.

Yet software companies received $4.7 billion in venture capital investment during 2006. That's more than biotech, alternative energy, or any other sector.

2006 looks like it will be a solid year for software investment for two reasons. One, we aren't yet seeing a bubble that is funding a lot of unworthy companies. And two, we aren't yet overfunding hot categories.

New Software VC Economics at Work: A look at the average funding level for software companies shows a decline over the past few years. A more likely explanation is that software companies have become more "capital efficient." It used to cost $7 - $10 million to build a product. Today, software companies can leverage open source components and offshore development to decrease development budgets significantly. A decent piece of enterprise software can be built for $5 million or even less.

On the marketing side, significant cost-effective methods have also emerged. During the Dotcom Era, a software company would spend 10%-15% of its gross revenues on "big-blast," brand marketing aimed at building awareness through advertising.

Open Source: Open source is tricky. The barriers to entry are quite low - you and I could start an open source software company this afternoon if we wanted to. That means the scale needed to have a successful open source company is dramatic. In the "old days," we could close five large sales deals and be in good shape. An open source startup might need 100,000s or millions of users to generate meaningful revenue on maintenance. Few open source companies can quickly achieve the scale needed to be successful.

SaaS: CIOs speaking at a recent conference I attended agree that the perpetual license model is dead, but few have committed any big dollars to subscriptions. Aside from Salesforce.com, what other successful companies have you heard of?

The 2005 data suggests that VCs do have an increasing preference for later stage investments, which now account for one-third of all deals and nearly one-half of all dollars invested (see Company Stage investment chart).

That's why areas like open source databases are looking extremely popular with investors this year. The area is ripe with early adoption and strong contenders. It looks like there will be quite a shoot-out in that market in 2006. Areas that combine two trends are also trendy - open source security or BI play anyone?

Tags: Startup, Funding, VC