Cashing in on software

After years of playing second fiddle to dot-com and telecom investments, enterprise software is taking center stage among venture capitalists. The change is good news for network executives, who could see many new and innovative applications and infrastructure capabilities hit the market in 18 to 24 months as the latest investments start to mature.

A recent survey details the venture community's renewed interest in software startups. In the fourth quarter of 2001, venture capitalists invested $1.6 billion in 211 software companies, according to the MoneyTree Venture Capital Survey compiled by PricewaterhouseCoopers, the National Venture Capital Association and Venture Economics. That's up 60% from the $1 billion invested in 149 software companies in the previous quarter.

Overall, venture capital investments in network start-ups remained flat at around $4 billion in the third and fourth quarters of 2001. But software is garnering a larger share of the pie, accounting for 40% of the total investment in the fourth quarter, up from 25% in the third quarter.

The types of software start-ups getting funding include storage, security, collaboration, customer relationship management and supply-chain management - all designed to take advantage of the Internet infrastructure.

"We're seeing a return to enterprise software development," says Tracy Lefteroff, global managing partner for the venture capital practice at PricewaterhouseCoopers. "Clearly, this was an area that was underinvested during the Internet build-up."

Software joined biotech as the area of investment that grew the most in the fourth quarter of last year, while sharp declines were seen in electronic retailing and distribution.

"We've seen a change in the IT sector moving away from Internet content and retailing, but telecom and software are about the same as where they were before the bubble," says Jesse Reyes, vice president at Venture Economics. "We're moving back to networking, peripherals and the software tools that were used to create the Internet."

"We still see companies that are focused on network applications and software . . . We're putting a lot of money to work in those areas," agrees Jeffrey Harris, managing director at Warburg Pincus.

Among the 10 largest deals of the quarter, four were for software companies:

Callidus Software, which sells enterprise incentive management software, got $40 million in its 10th round. (Callidus was formerly known as Tally Up Software.)

Altogether, 20 software start-ups received more than $20 million each during the fourth quarter.

While promising, the software investment figures are down by nearly half from their peak during the second quarter of 2000. At that time, venture capitalists poured $3.4 billion in 261 software start-ups. But software accounted for only 23% of that $14.7 billion pie.

Enterprise software is becoming more popular among venture capitalists because it targets corporate customers with relatively stable IT budgets vs. the fickle consumer marketplace.

Lefteroff says even though corporate IT budgets are notoriously tight, network executives will purchase software that improves efficiency or cuts costs in a measurable way.

Gus Tai, general partner with Trinity Venture Partners, is bullish on start-ups that offer a fast return on investment by letting companies use fewer IT resources or staff.

"The enterprise software stack within companies has gotten very complex," Tai says. "It's a very heterogeneous environment that's hard to manage, and there's still a shortage of IT professionals. Some of the companies that were being funded in Q4 . . . automate some of the processes of the IT department to make them more efficient."

An example is PentaSafe Security Technologies, which automates security policy management. It raised $10.7 million last quarter in its fourth round.

"Enterprises continue to want to buttress their perimeters," Tai says. "On the software side, there's a requirement to have a control layer to manage all of the disparate elements of [security.]"

But corporate investments in these kinds of tools are likely to be more modest than in the past - tens or hundreds of thousands of dollars instead of the millions of dollars. "We don't think there will be companies spending millions on unproven applications," Tai says.

Consider this. . . Stalwarts and start-ups alike are eyeing today's EDI services market.
EDI incumbents: Who are they? Traditional EDI value-added network (VAN) operators such as GE Global eXchange, Sterling Commerce and Peregrine Systems.	EDI challengers: Who are they? Service providers such as ADX, SPS Commerce and Internet Commerce Corp.
What are they doing? Migrating from proprietary technology and private networks to standards-based services using the Internet.	What are they doing? Offering Internet-based EDI transport services plus project management services that include setting up and managing supplier hookups.
Obstacles? Legacy systems they can’t fully retire. VAN providers “have a lot of long-term customer relationships, so they have to continue to maintain their VANs,” says Geoffrey Bock, senior consultant at The Patricia Seybold Group. “They are not able to adapt to changes quite as quickly and flexibly as some of the Internet start-ups have been able to.”	Obstacles? Establishing corporate credibility. “There’s always risk associated with using an emerging vendor that’s venture funded,” says Meta Group analyst Carl Lehmann. “How much cash do they have on tap and how’s their cash flow? Everyone considering an emerging vendor needs to understand that and ask those questions.”