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Software's Eve of Destruction

Kevin Kelleher

Remember creative destruction? The brainchild of economist Joseph Schumpeter was an unavoidable buzz word in the bubble years. But a few years later came the actual destruction -- of wealth, of companies, and of aging or half-baked business models -- and the term fell out of favor.

A Factiva search of the phrase found it in 433 news stories in 1998, peaking at 724 in 2000 before dropping back to 494 mentions in 2003. This is odd because 2003 was exactly the point at which Schumpeter's idea -- that innovation spurs long-term growth by tearing down the established order -- was especially relevant.

So, a shrewd investor would have spent his time in 2003 searching for new innovations that would create the next wave of disruptive technologies. One venture capital firm -- Burlingame, Calif.-based Emergence Capital Partners -- took this contrarian approach, and the partners set up shop in the darkest hours of a bear market. They decided to focus on an area -- services -- that other venture firms had long shunned.

VCs generally favor companies that can grow quickly without a lot of overhead. Traditionally, a service company like a call center or a business-outsourcing outfit would involve a lot of capital to take care of the necessary labor. Much-better returns came from investing in a couple of entrepreneurs who created a new software product that could be sold off after a few years.

Salesforce.com(CRM Quote) challenged that thinking by presenting software not as a product but as a service. Its trick was, as the company is fond of saying, to make customer-relationship management software as easy and accessible as buying a book on Amazon.com.

Anyone who has ever had to enter or retrieve data from a proprietary CRM software program -- or worse, who's had to install and maintain it -- can imagine the need for easier software.

Salesforce.com's browser-based, pay-as-you-go software offered a starkly simple alternative to the complex, costly and daunting software platforms from giants like SAP, Oracle and Siebel. With that change, Salesforce.com pioneered a new market called, for better or worse, software as a service.

"The whole software industry is being disrupted by the software-as-a-service approach," says Gordon Ritter, an Emergence partner and a former vice president at IBM. Ritter says that the rise of Salesforce.com came shortly before the decline of Siebel, and its subsequent purchase by Oracle -- and it's no coincidence.

"Salesforce.com is taking down Siebel and pulling biz from it. You have a giant coming to its knees with a start-up disrupting them with a better value proposition," Ritter says. "We see new entrants coming in with this software-as-a-service approach. We see a giant industry with disruptive forces hitting it."

Late Wednesday, Salesforce announced that third-quarter revenue nearly doubled to $82.7 million from $46.3 million a year earlier. While its fourth-quarter EPS outlook was below Wall Street estimates, many investors took it as a sign of overcautiousness and bid the stock to $29.80 -- its highest level as a public company. The shares were recently up 9.5% to $29.50.

Salesforce.com grew without venture backing, but Emergence bought a 1% stake from an ex-employee for about $1 million. That investment, Emergence's first ever, is doing well. Today, a 1% stake in Salesforce.com is worth about $30 million. For now, that investment is the crown jewel of the contrarian strategy Emergence took three years ago, when it bet that services represent a good VC investment if they are leveraged by technology such as Salesforce.com's disruptive software.

Since that investment, Emergence has sought out similar start-ups that could shake up other software sectors, such as human resources and marketing management. One is SuccessFactors, which broadens the use of HR software to every employee in a company, not just the few who can endure a grueling two-week software training program. Another is Visage Mobile, which uses software as a service to allow nonphone carriers branded cell-phone service.

Of course, many of these companies will be off limits to public investors for a while, but it may be worth keeping an eye out for existing software giants to do the best job at adapting to the new software-service model. Most have spent decades building up vast sales, service and engineering teams to exclusively handle their aging proprietary software systems.

"It's a lot of things to change if you're going to move over to this new approach," says Brian Jacobs, an Emergence partner who previously spent a decade as a partner at St. Paul Venture Capital. "Siebel saw the writing on the wall and tried to make the change, but it was just too hard."

"Some of the larger companies will figure out how to do this, but it's not clear which ones will," says Jacobs, whose firm is working with IBM as it makes the transition. "Just as Cisco(CSCO Quote) was the big buyer of the 1990s, IBM and other software companies will be the big acquirers for this generation of technology."

If Jacobs and Gordon are right, they and others investing in this new breed of software companies will be among the winners as they sell pieces of their portfolio to the giants. And the losers? Start with the hundreds of thousands of employees whose jobs are tied to the old model of proprietary enterprise software.

Software as a service may turn out to be a bigger threat to tech jobs than the often vilified trend of outsourcing jobs overseas. That means pain for a lot of workers -- and no end in sight to the destructive part of Schumpeter's pet idea.