BA Venture Partners (BAVP) is actively seeking new deals with companies offering software as a service, both for investment and research. We went so far as to issue a press release to this effect late last month, an unheard of tactic in the venture world. But we're big believers that you have to have strong convictions to be good investors so we went out on a limb to publicly state ours. "Software as a service" is an application delivered to customers over the Web from vendor-hosted infrastructure as opposed to traditional software licensing models that put the installation and management burden on customers.
BAVP was the largest shareholder of PlaceWare Inc., the web conferencing provider recently acquired by Microsoft. We initially invested in PlaceWare in 1999 when the "ASP" (application service provider) hype was at its peak-but over the years came to believe that the service provider model is better for both investors and customers for several classes of applications. As we became more and more convinced that the service model works we consistently supported that strategy at PlaceWare, and consistently increased our ownership in the company in each subsequent round of financing.
We Mean It!
We continue to put our money where our hypothesis is; we've made three new software as a service investments so far this year, out of a total of five software investments and eight total new investments. We think of software companies in three big different buckets based on who their target customer is: CIO/IT operations, line of business owner, or end users. [This bucket strategy should probably be the topic of another story-our thought is that the target customer base drives sales and marketing strategy, which drives startup spend, which determines investment outcome. Stay tuned.] In fact, our three new investments have been "one of each" in both target customer and stage of investment:
- Bellamax: We led the first institutional round in this consumer-focused company. Bellamax provides an Internet service to automatically enhance digital images for a low cost ($1-3 each). www.bellamax.com
- Biz360: We led the C round of this line of business service. Marketing execs use Biz360 to analyze and drive their media results, bringing data driven marketing intelligence to the PR world based on the similar quantitative metrics traditionally used by advertising departments. www.biz360.com
- Player to be named later: BAVP led the C round investment in a messaging gateway service purchased by enterprise messaging and security operations execs to block bad incoming mail, primarily Spam, but also viruses and inappropriate content. This investment has closed, but has not yet been announced.
Advantages for Customers
Software applications offered as a service deliver a number of advantages over traditional software licensing models. CIO's are able to outsource standard internet based activities to more experienced specialists and focus their resources on mission critical internal applications. Line-of-business executives do not need to rely on IT to spec, purchase, implement and integrate diverse technologies to deliver a solution. They save money by eliminating maintenance, service and training agreements while reaping the benefits of instant access to the service and flexible, pay-as-you-go pricing plans. Consumers gain access to communities and technologies that are unimaginable as home applications.
These customer benefits have resulted in differentially higher revenue growth for software as a service companies relative to the overall software market. According to IDC, the software as a service market is $2.3B in 2002, growing at 30% per year. The top providers in the sector are growing even faster, at an average rate over 60% per year. This compares with an overall software market that's seen flat to low single digit percentage growth in the past several years.
BAVP Research Project
Our partnership likes primary research-facts come in handy. We like the software as a service sector so much that we are kicking off a significant research project this month that we're excited about. The project has two key deliverables:- A refined view of which types of applications are best suited for delivery as a service.
- Granular best practices on sales and marketing operations within software as a service companies, which we've come to appreciate given our experience with multiple portfolio companies in this sector.
At the 100,000-foot level, our view is applications that derive a lot of value by being "in the cloud" are best suited for services delivery. The first phase of our project will refine and define this view. Examples of "cloud value" include:- Connect many people across business boundaries. PlaceWare's great product differentiator is the ability to connect tens of thousands of participants across many locations, firewalls, etc. The conference "happens" in PlaceWare's data center, not an enterprise server, so there are no connectivity issues. This contrasts with Microsoft's long-standing product NetMeeting, which is crafted to support small internal workgroups.
- Collect and crunch data from many disparate sources. Biz360 builds a giant data warehouse in the sky for its customers every day-they bring in data from content aggregators such as Factiva and Lexis-Nexis, spider the web for proprietary content, and add text translations from broadcast media. This would be a daunting task for any enterprise, requiring complex text processing and data warehousing technology as well as business relationships with dozens of content providers. With the service, all customers have to do is log onto their private URL and run custom reports without worrying about the back end at all.
- Deliver intense image processing power and aesthetic judgement. Bellamax is like having a personal "PhotoShop guru in the sky" who fixes your pictures "automagically," using a lot of complicated image processing algorithms and some human touch to make sure the algorithms deliver the best possible picture quality.
- Block the bad stuff before it gets in. Spam now takes up about two-thirds of business email bandwidth, clogging both mail servers and users' mailboxes. A gateway service provider blocks spam, viruses and inappropriate content before it gets on the corporate net. It takes a lot of refinement in rules and implementation to let the good through, but block the bad, and a service provider can leverage expertise across many shared customers. My recent prior company, an email service provider, had a staff of 5 full time spam analysts, an investment few individual enterprises can make.
Looking to the future, an example of a company that BAVP follows, but is not invested in, is Salesforce.com. Salesforce.com provides sales force automation software via a web-browser. This is especially helpful when trying to manage mobile and remote salespeople since basic connectivity is all that is needed. Salesforce.com charges $125/user/month for its enterprise product, and saw Q103 revenues of $19.1M, double that of 2002. This level of success demonstrates the appeal of the software as a service business model.
On the consumer side, BAVP is also interested in software as a service. End users are even more likely than enterprises to want information and communication services to be simple and require as little upfront effort and investment as possible. This fits the profile of software as a service perfectly; great example are internet dating sites. According to the Online Publishers Association, match.com is second only to Yahoo in paid online content revenues, beating out the Wall Street Journal Online. The Internet dating sector as a whole made $302M in 2002.
Based on our early hypotheses, key software as a service sectors where BA Venture Partners actively seeks new investments include business applications such as: sales/marketing; collaboration; analytics; and customer service to name a few, as well as applications for end-users such as: communications/messaging; media; games; imaging; and advertising.
The BAVP Software as a Service Survey
The second phase of the project is more about how to drive value in an investment rather than what kind of company to back. We intend to help our companies learn by example from similar companies' best practices. But they're a small sample set so we intend to survey other service vendors. Though we're funding the research we'll syndicate it back in aggregate form (as our portfolio companies will see the results) to participants so they'll profit from participating. If you'd like to participate, contact my colleague Stacey Curry at Stacey.E.Curry@BankofAmerica.com.
Rule number one in a service deal is that if you want "annuity revenue" it has to keep coming back year after year. Customer retention is the single biggest driver of revenue growth and profitability. If the company builds a book of business that grows every month, good things happen. But if there's a hole in the bottom of your bucket and you lose existing customers, the company will be in an even worse situation than a traditional licensing vendor that lives from deal to deal because each individual customer delivers less revenue and more cost.
While the PlaceWare financials are not disclosed, their closest competitor, Webex, is publicly held. The following chart demonstrates Webex's steady, predictable revenue growth and their steady predictable decline in sales and marketing as a percent of revenue. They continue to spend fewer and fewer dollars to deliver revenue because they retain and grow their existing accounts.
Customer retention is the product of many interrelated company operating tactics. But it's also chiefly related to how good the service is-if it fails to satisfy customers, no sales practices engineering in the world will deliver a good result. I've written before for the Sterling Report that "product is destiny." Offering a service and trying to hide ugly stuff from customers will haunt you in the end. Build good features on a robust architecture or die. This view is the key reason we say "software as a service" regularly rather than ASP or MSP-we only target companies built from the ground up as a service, with scalability, security and availability as key deliverables. Offering your standard licensed software, or worse yet-someone else's, as a service doesn't appeal to BAVP.
But given a good service, the providers' internal practices can skew results toward strong retention or not. Here's another brilliant insight: customers will only pay for what they use. Even if a service is theoretically great, the vendor has to work to drive adoption to create an opportunity to retain the customer. This problem is well recognized among traditional data/service providers, but less internalized in the land of hit and run enterprise sales and million dollar shelfware.
BAVP's research project seeks to understand the best practices of successful service providers, including what works and why, for:
- Customer contract structure. Pay up front, or bill monthly. Charge by user or by some other volume metric. Term of typical contract (month to month up to multi year), evergreen, self-renewing, or fixed-term.
- Sales organization strategy. Hunters and farmers, or lifecycle account managers. Who drives new accounts, retention, and account expansion.
- Sales compensation strategy. Pay upfront, or monthly or hybrid. Recourse for early cancellation or not.
- Adoption. Who drives usage and how. What's the right amount to spend at various stages of company/market development.
- Marketing, both to prospects and customers. What best drives business.
BAVP has engaged an experienced BDP (Best Demonstrated Practices) consultant from a top firm to lead this analysis. But we need help from execs in the trenches, so please contact Stacey if you'd like to share your company's expertise and benefit from seeing the results.
Advantages for BAVP
Like most investors, we're doing this to make a buck. The "software as a service" business model is attractive to BA Venture Partners for several key reasons, but mainly because we can make better returns in this sector than others. Portfolio companies can gain customer acceptance rapidly based on low entry costs, relatively fast sales cycles and quick implementations. As fixed infrastructure costs of hardware and software have declined, and as scale increases, companies in the "software as a service" sector benefit from gross margins comparable to the traditional software licensing model, but without the margin drag of costly professional services. Furthermore, the resulting stable revenues and book of business is more valuable to acquirers and the public markets.
The research project we have undertaken does not only pertain to BAVP or our portfolio companies. The results will provide a clearer picture of where the software as a service market is headed and the impact that this market segment will have on the overall software industry and how business is done. The research project is expected to take approximately 2 months to complete. In the meantime, we will continue to keep our focus on investing in new and emerging companies in this space.
BA Venture Partners, a venture capital partnership, leads start-up to expansion stage investments in networking, semiconductor, software, medical technology and biotechnology companies. The firm closed BA Venture Partners VI, a $500 million fund, in 2000. BA Venture Partners' sole limited partner is Bank of America. Visit our website at www.BAVenturePartners.com.
At BA Venture Partners, Sharon Wienbar works with enterprise software and Internet infrastructure and services companies addressing high value business issues. Sharon sits on the board of Stratum8 Networks and works with BAVP's investments in PlaceWare, OuterBay Technologies, and XTRA Online. She can be reached for comment at: Sharon.Wienbar@BankofAmerica.com