As the market grew, a couple of those startups would fail, a couple would emerge as strong players and maybe one or two would go public. It was a good balance which allowed all of the companies and investors to make a fine return.

But today, when a sector gets popular, you might see VCs fund fifteen companies in that segment. Each of these will blow lots of marketing money to secure a few big customers, and none will gain critical mass. Right now, both the social networking and Business Intelligence areas are getting a bit crowded. That makes it harder for companies to have a good shot at getting beyond the noise, reaching customers and becoming successful. Still, the VC demand seems healthy because we haven't yet seen crazy excesses in valuations.

New Software VC Economics at Work
But a look at the average funding level for software companies shows a decline over the past few years. It's possible that VCs may be investing less because they have become a bit more conservative after being burned by "bubble" deals.

But a more likely explanation is that software companies have become more "capital efficient." It used to cost $7 - $10 million to build a product. You started with a blank slate and built it all - the tools, the middleware, the databases - with languages and no pre-built components.

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. That would be coupled with a big-budget, BMW-driving salesforce.

Today, software companies have fewer highly-paid salespeople. And when was the last time you saw a software ad on TV? Software companies "pay per click" for qualified leads from Web ads. They are leveraging online, "viral" methods such as marketing through developers, word-of-mouth and pass along - especially true for open source companies who can simply give the product away for free.

Is it working? I can't be sure. But you certainly aren't seeing young software startups spending as much on marketing anymore, which decreases the amount of money VCs need to invest.

A Flight to Quality
Within enterprise software, certain sectors are "hotter" than others. Business intelligence is still going strong. Security has been and may always be a mainstay investment for VCs. New threats are always emerging. There continues to be quite a bit of security M&A activity by good acquirers, for good money.

Open source financings have exploded over the past year. A look at the the biggest software VC deals of 2005 finds open source players such as, SpikeSource and Code Green at or near the top of the list (see Top Software VC Deals.)



But 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.

Continued...

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