Updated from 4:26 p.m. EST

At a price of $10 million or so, Google's ( GOOG) acquisition of privately held Writely wouldn't normally be on the radar screen of tech investors. But it should be.

Writely is a tiny start-up that makes a rather cool Web-based word processor that runs inside a browser. While it lacks many -- and probably most -- of the features found in Microsoft Word, it does allow users to collaborate on documents and publish them to the Web quite easily.

Why should you care? Friday's purchase represents a small, but potentially significant, repositioning of Google onto Microsoft's ( MSFT) home turf. And more broadly, Writely is emblematic of the new wave of software entrepreneurship that is creating opportunities for investors while challenging the conventional wisdom that only the biggest players will survive.

There was a huge buzz a few months ago when Google and Sun Microsystems ( SUNW) said they were teaming up. Speculation quickly centered on the notion that Google would start hosting Sun's OpenOffice suite and go head-to-head with Microsoft. As it turned out, the announcement was nothing of the sort, much to the disappointment of the blogoshpere and its legions of Microsoft haters.

But Friday's announcement that Google will buy the little start-up is different. While Writely will never be a replacement for Word, let alone Office, it does offer some users an alternative to Microsoft's products. Google already has G-mail and will soon have a Web-based calendaring application. So, if it goes a bit further and -- as some have speculated -- purchases another popular start-up called NumSum, which makes a Web-based spreadsheet, the company suddenly has a nifty little office suite.

Let's be clear. Microsoft isn't seriously threatened by these moves. Even if Google were unbelievably successful in wooing consumers, the obvious targets of Web-based productivity applications, Microsoft's worst-case exposure isn't all that great, points out Goldman Sachs analyst Rick Sherlund. Sales of Office to consumers only accounts for about 6% of the company's overall revenue, he estimates, and 7% to 8% of earnings. Goldman Sachs has an investment banking relationship with Microsoft.

Business users, he notes, aren't likely to be happy with a suite that requires an active Internet connection -- so much for working on an airplane -- and places sensitive documents outside the firewall.

Still, the move will no doubt get Microsoft's attention, and it could spur the company to enter the on-demand market, a move it has so far resisted. (Office Live, despite its name, is not a Web-based suite. It's a collection of tools to run a small-business Web site.)

Timing Is Everything

Remember Orson Welles pitching the line, "We will sell no wine before its time?"

Technology is like that, too. It's no accident that companies like Writely, or Salesforce.com ( CRM), which sells its software as an on-demand, Web-based service, can succeed today, and not six or seven years ago.

That's why the application service provider, or ASP, model, which sounds very similar to what Salesforce does, failed in the late 1990s. It failed because the bandwidth wasn't there. It failed because Java and XML and SOAP -- languages and standards that let disparate systems and applications work together -- had either not been widely accepted or weren't there at all.

Although CEO Marc Benioff hates to use the word software, Salesforce really does lease (not sell) software applications over the Web -- and is making a good business out of it, as are other on-demand providers such as RightNow ( RNOW), or Ultimate Software ( ULTI).

IBM ( IBM), which stopped selling software applications years ago, is taking the on-demand concept a step further. At a gathering of its customers and partners in Las Vegas next week, it will unveil SOA (software as a service) Business Central, a repository of software code written by thousands of companies, as well as other intellectual property, designed to automate complex business processes.

The code will be for sale, of course, and that creates an opportunity for small companies to piggyback on IBM's vast network of customers, distributors and partners. For its part, IBM will derive revenue by selling services to the buyer -- and the seller -- of the code.

Think of the code as a building block, or a component of a larger software system. These components can be "bolted in" to the system, or activated on the fly when needed. In effect, they become services delivered over the Web.

Reactivity, a start-up funded by Accel Partners, makes a security and processing engine for XML, the language of Web-based commerce. One of its biggest customers is a large mutual fund that wanted to give employees of a large software firm immediate access to their 401(k) accounts.

Software components written by Reactivity's programmers made that happen without extensive rewriting of the systems, something that would have been impossible five years ago, says Accel Managing Partner Peter Fenton.

Fenton says he and other venture capitalists are looking hard for companies that understand software as a service, and companies that have solved the problem of software distribution over the Web. "This is one example where the money is chasing the startups," he said.

Because those companies typically lease software by the month (or other time period) rather than selling a perpetual license, revenue growth tends to be slower than that of conventional software companies -- at least initially. "You don't see a lot of overnight successes," he adds.

IBM isn't alone in the pursuit of software as a service. SAP ( SAP) brags that it has created 300 or so services and expects that number to increase rapidly by the end of the year. SAP and Microsoft are developing an SOA system that will link Office applications on the front end to SAP's heavy-duty enterprise applications in the back-end.

And Salesforce has its AppExchange, which as the name implies, is an online marketplace for small applications written by third parties to run on the Salesforce platform.

As always, new technologies like SOA and software-on-demand are surrounded by welters of hype and nonsense. But there's more to this than hot air. And there's more to the tectonic shift in the software landscape than splashy billion-dollar deals.

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