Don’t Be Afraid To Invest in Established Markets –

As the technology market continues its recovery, many of the large incumbent vendors find themselves in a position where reduced spending in R&D over the last few years now threatens their top-line growth. The recent increase in mergers and acquisitions can be, in some significant sense, attributed to this phenomenon. These incumbents have begun to fill their next-generation product requirements through aggressive acquisition approaches.

Many of the companies funded by venture capitalists over the last several years stand to benefit as these large incumbents look to find next-generation products they can sell through established channels or existing customers.

We saw this scenario played out recently with Siebel and one of ATV’s portfolio companies, UpShot. Siebel struggled for years to make the shift to on-demand customer relationship management (CRM), and saw its market share erode in the process to more nimble competitors such as Salesforce.com. In the end, it was more expedient and strategically appropriate for the large, public company to buy UpShot, the No. 2 player in the outsourced CRM market, rather than continue work on its own in-house solution.

There are other advantages to investing in an early-stage company in a well-established market, such as time-to-market. While early-stage companies tend to have a flat organizational structure and an innovator mentality, big battleships can be hard to turn. Finally, sometimes the lack of a track record can be a good thing. New entrants in an established market can take advantage of pent up frustrations that customers have with incumbents, often resulting from failed implementations or inability to keep promises.

That being said, incumbency has its advantages. Many large companies have a stranglehold over customers-think of heavily entrenched players such as SAP and Oracle. Large competitors can also more easily bundle products, which means that a small company’s product could end up competing with a minor feature in a larger application sale.

Large companies also have the ability to “freeze” the market with promises of new products, which may or may not materialize. As they say, if you fly too close to the flame, you’ll get burned. It is a common strategy for companies to slow down competitors’ sales cycle by assuring customers they will have commensurate features or capabilities in the next release. Early-stage companies in established markets have to solve a problem that’s compelling enough that customers won’t be willing to wait.

That being said, there are ways to be successful even in markets dominated by large incumbents. In researching and evaluating companies that will introduce a new technology or a novel approach into an established market, the following are useful criteria with which to judge possible investments:

Novel Thinking

Look for opportunities where the technology approaches a problem in an entirely new way, rather than offering an incremental improvement. An excellent example of this type of company is Liquid Engines (another ATV-backed startup), which has created the first strategic enterprise cash flow and tax management solution. With Sarbanes-Oxley and other legislation, chief financial officers are now expected to align the tax and legal structure of their company with the company’s business operations, as well as provide complete transparency and defensibility for this structure.

Until now, this area had been the province of tax attorneys, not CFOs. Liquid Engines saw that a new way of looking at the problem was necessary in order to empower CFOs. It developed a solution that enables CFOs to model the legal entity structure in a way such that the financial outcomes are optimized while maintaining a corporate legal entity structure that is visible, well documented, and completely aligned with business objectives. Liquid Engines was the first company to automate this extremely inefficient, manual process.

Strategic Partnering

Another strategy is to look for companies that have an excellent shot at partnering with the incumbents to provide functionality as part of a larger bundle. A good example of this strategy was demonstrated by Striva, one of ATV’s portfolio companies, which was recently acquired by Informatica. Striva’s technology enables companies to access the vast amounts of corporate data stored in IBM mainframes. Naturally, this technology was of interest to all the major business intelligence vendors whose analytics depend upon access to data. Striva’s technology ended up in almost all of these companies’ solutions, and Striva was eventually acquired by one of its key partners, Informatica.

Experienced Management

While it’s important to identify companies whose management teams are deeply entrenched in the company’s technology domain, it is just as critical that the experience of the management match the stage of the company. There is an entirely different set of skills required in the pre-revenue stage than there is once a company gets to $10 million in revenue. Few CEOs are able to take a company from zero to $100 million.

Disruptive Macro-Economic Forces

Macro-economic and social trends affect the demands consumers and corporations put on their vendors. The recent explosion in business process outsourcing, for instance, reflects the growing demand for anytime, anywhere access to critical business information and the need to reduce IT infrastructure costs. This trend in turn is having a substantial impact on well-established markets, such as customer relationship management. Thus, while the business problems are well-known and the overall market is well-established, by changing the way the product is delivered, economic benefits are opened up that were not available with the prior model.

Architectural Changes

What we saw with the Web we’re now seeing with wireless: Pervasive, disruptive technology creates enormous needs within existing architectures. Companies now have to accommodate BlackBerries, phones, and wireless computers, which has far-reaching implications as data are being delivered both over wire and air, remotely and locally. All that service provisioning drives the market for the tools and products companies will buy. Radio-frequency identification (RFID) is another new architecture that will require core infrastructure changes within the well-established warehouse management systems market.

Potential for Significant, Intra-Quarter ROI

It is considerably more difficult for companies establishing a new category in a crowded market to gain traction when their sales model calls for a large infrastructure change in the customer. Conversely, the sales cycle will naturally move more quickly when there is pent-up demand to address an unmet need, a quick payback, a clear value proposition, and a fast deployment model that doesn’t require a massive infrastructure conversion.

The benefits of this type of model are substantial. It is much easier to manage a sales force that is working with intra-quarter deals as opposed to facing endless sales cycles. Forecasting quarterly company revenues also becomes a predictable exercise as opposed to an exercise in fortune telling. Finally, success begets success. Having strong reference customers make closing the next quarter’s business easier and faster.

Got Sponsors?

A somewhat counterintuitive strategy for investing in new technologies is to avoid companies selling to the IT department. While a business manager is looking for a solution that will generate measurable results and has a budget to solve the problem, IT is just trying to keep things running and is much less interested in the upside opportunity. It’s hard to create urgency in IT groups. They are more focused on consolidation and managing systems and resources, and are likely to provide some resistance, or at least delay, to the sale because of issues around interoperation, long-term IT strategies, and resource constraints. Having strong business manager sponsors to drive IT department approval can significantly reduce the sales cycle and increase the likelihood the technology will get adopted.

At the end of the day, it is never easy to judge the market or new technology, particularly when you can’t see the product or speak to customers before making an investment. But before there are customers, there are end users with urgent needs. Investors should listen to the end users-not only CIOs, but also people at department levels-to understand the issues the end users are dealing with and will pay someone to solve.

Steve Baloff is a general partner in the Palo Alto, Calif., office of Advanced Technology Ventures (ATV), an early stage venture firm with $1.5 billion under management. Baloff joined the firm in 1996. He focuses on investments in enterprise software and IT infrastructure. Prior to joining ATV, Baloff was CEO and founder of Worldview Systems, which developed travel Web site Travelocity and was later sold to Random House and Ameritech. Baloff serves on the boards of Compassoft, Liquid Engines, Noosh, Black Pearl, Tripwire, and WorldChain. His previous investments include UpShot (acquired by Siebel Systems-SEBL), Striva (acquired by Informatica-INFA), ViryaNet (Nasdaq: VRYA), Velogic (acquired by Keynote-KEYN), and Seeker Software (acquired by Concur-CNQR). Baloff has a bachelor’s in economics from Harvard and an MBA from Stanford. His email is sbaloff@atvcapital.com .