IT Still Matters, But Investors Need A New Strategy –

Nicholas Carr, editor-at-large for the Harvard Business Review, recently created quite a storm by publishing an article entitled “IT Doesn’t Matter” (HBR, May 2003). The piece postulates that information technology, while indispensable to big business, has become ubiquitous, standardized and affordable to all; and that like railroads, telecom and utilities before it, IT has ceased to be a source of competitive advantage for corporations.

Amid the cries of protest that have erupted from the IT community, two important points have been overlooked. First, Carr is at least half right. Certain IT-enabled functions such as payroll have been so sufficiently commoditized that no company will ever again create competitive advantage there. Moreover, IT is no longer a reliable platform for creating long-term strategic advantage in many mature applications. On the other hand, IT obviously matters in the sense that you couldn’t conduct business without it, and differential value can still be created, at least temporarily, if you can master the application of IT. But it’s not a reliable platform for beating up on your competitors over the long haul. In the long haul it may still be strategic because of its dynamic, evolving nature and the ability of companies to build differentiated competitive advantage from it is not evenly distributed across all management teams.

The more important point, however, is that in the short term, and in such challenging IT markets, it really doesn’t matter if Carr is right or not. His viewpoint accurately reflects the mood of many chief executives and IT buyers. Having spent too much in recent years and often gotten too little in return, IT buyers are slashing spending and pushing more of the risk onto vendors. Buyers are leery of both new technologies and startups in general.

This doesn’t mean IT and IT investing are dead. Information technology is still an exciting, innovative sector with plenty of entrepreneurial and investment opportunities. But in the short term, the dominant formula for creating economic value has changed, and VCs need to adjust their approach accordingly.

Most large corporations are done (at least for now) building out vast new IT infrastructures or placing big bets on nascent technologies. Instead, the IT startups that thrive in the near-term will be those that help customers squeeze more out of existing assets, and that simultaneously master the fine pointsbasics of business execution. Because most startups will have to wait longer for a liquidity event, it is more critical than ever-for entrepreneurs and investors-that startups build themselves into viable, self-sustaining businesses.

The first part of this equation requires finding spaces in IT that can support entrepreneurial growth, even in the technology slump’s midst.

Following are a few fields and companies we think are encouraging, in part because they capitalize on the new mandate for IT executives: maximizing performance from assets they already own. In the spirit of full disclosure, it is important to note that all the companies below are part of Focus Ventures’ portfolio.

Security, Anti-Spam & Application Downtime

These are real, tangible problems that cost CIOs real dollars. Companies that bring no-nonsense, cost-effective solutions to bear on these well-defined pain points’ can thrive, no matter what’s occurring in the broader IT market.

Oblix Inc., for example, develops identity-based security systems that allow companies to control which employees, customers and suppliers have access to corporate files and systems. A 2003 winner of Network Magazine’s Product of the Year Award for its Netpoint software, Oblix has been able to generate strong revenue growth, despite the sluggish IT market.

Wily Technologies Inc., a pioneer in the Java enterprise application management field, develops software that allows IT managers to identify within hours the source of bottlenecks within Java-based enterprise applications, something that used to require weeks of work from highly skilled technical staff. In an environment where IT buyers are having to do more with less, Wily’s economical approach is paying off. The company tripled its revenue in 2002 and is on track to double that amount this year.

Convergence, Integration & Universal Connectivity

We see numerous exciting technologies and companies emerging in these fields. Zeevo Inc. makes wireless-enabling microprocessors, a field expected to explode in the next 10 years as pervasive computing becomes a reality. The company sells processors to HP (among others) for next-generation wireless PDAs, and expects to more than triple revenue in 2004.

Vertical Networks Inc. combines voice services, LAN/WAN data networking, high-speed Internet access and IP telephony into one easily manageable platform for small and medium-sized businesses. For branch offices that don’t have the budget to manage complex communications networks, these integrated communications platforms offer a cost-effective solution that helps companies more fully utilize their legacy communications infrastructure.

BPO

Corporate IT departments aren’t the only ones with a mandate to boost asset productivity-nearly all corporate departments face the same challenge. Partly as a result, outsourcing has picked up steam across the board. Exigen Inc., which specializes in automating high volume transactions like loan original applications, is benefiting from this trend. Founded in 2000, the company is rapidly growing a recurring revenue base, and is cash flow positive.

Elance Inc. helps corporations coordinate and optimize third-party service agreements: for instance, eliminating duplication among service vendors, and standardizing bid protocols. In a typical engagement, Elance can generate savings of 10-20% of the client’s services procurement spend management budget and deliver an ROI in excess of 100%, a welcome payoff when every penny counts.

These represent just a few of the opportunities in IT today, although there certainly are countless more. Despite the economic doldrums, we believe that by focusing on technologies that help customers better leverage their existing assets, investors can have a fighting chance in the current IT environment.

More than ever, just picking the right investment space isn’t enough. The most fruitful IT arenas will likely support only one or two winners, and even for them it could be a long haul to liquidity. As a result, VCs need to adjust their approach for evaluating candidate IT companies. Instead of asking, “What does it take to go public?” we need to start asking, “What does it take to build and run a sustainable business until the IPO market rebounds?” and then, “Who is going to win in this space?”

Below are some characteristics and metrics that we think have gained importance as the IT market has cooled. These criteria are not revolutionary, nor are they exhaustive. Because we primarily invest in expansion-stage companies, these may not be the same criteria that our early-stage venture brethren choose to apply.

Grow Up Faster

In the boom, many startups could get by with a few stars developing and selling all the company’s key products. Often, this was enough to carry a startup to IPO. Now, companies need to develop standardized, repeatable business processes much earlier in their life cycles.

Before we invest, we look for formalized, efficient processes in product development, sales and implementation. For instance, is there an organized approach to how development resources are allocated? Are development resources proportional to the product’s importance? Are milestones consistently met on time?

Similarly, startups need a deployment process that works across varied customer environments. More customization means more bodies and more time for each install, limiting the ability of the company to expand.

Meet the Customer All The Way

Most IT buyers now are much more demanding of their vendors: for instance, requiring multiple referenceable customers and a demonstrated ROI before they’ll consider a large purchase. Rather than fight the tide, IT startups need to be creative in accommodating buyers. Wily Technology developed a proof-of-concept demo that could be installed and demonstrated in just half a day. This allows the buyer to see in real-time the bang for their IT buck.

Creative pricing approaches can also help. Exigen now offers its outsourcing service on a utility basis, charging customers on a monthly or, per-transaction or value-based basis. This reduces the upfront expenditure and allows buyers to shift some of the purchase cost from capital to operating budgets.

Partnerships with established blue-chip IT companies also can help startups clear the hurdle with skeptical buyers. Vertical Networks, for instance, established partnerships with AT&T and MCI, giving the company credibility and access to many new accounts.

Finally, plug-and-play technology is a must. Because most IT buyers are still struggling to optimize their existing infrastructure, meeting the customer on their terms means providing solutions that can be easily integrated with existing technology platforms.

Finally, on the sales side, we look for a balanced contribution from the sales force. If the CEO or VP of sales is required to close every deal, the model probably isn’t scaleable.

Target Best-in-Class Sales Metrics

In an increasingly competitive market, the right sales metrics can be revealing about what companies will win. Today, vendors are likely to encounter all of their major competitors in a beauty contest, rather than just a few; there’s little wiggle room for second-tier players. Accordingly, we look very closely at win rates vs. key competitors for our candidate companies.

Repeat sales are also telling. We track revenue by quarter by customer for our prospect companies to see if customers are coming back for more. And because sales cycles have lengthened, we now look for pipeline “coverage” (the ratio of prospective revenues in the pipeline to actual revenues needed in the period) of 4+X, rather than the old rule of thumb of 2-3X.

The game has changed for IT startups, at least for now. Whether Nicholas Carr is right or not, “IT Doesn’t Matter” represents the zeitgeist of most corporate IT leaders. That doesn’t mean the end for VCs and entrepreneurs who have staked their careers on the future of IT. By focusing on companies that help customers squeeze more out of existing assets, and by applying stricter, more pragmatic criteria to investment candidates, VCs can salvage opportunity from this otherwise bleak IT landscape.

Jim Boettcher and George Bischof are general partners at Focus Ventures, a Palo Alto-based venture capital fund.