On-Demand Computing: A Brutal Slog

The tough reality of the on-demand game is taking its toll on software companies hoping to make a mint distributing their wares via the Web

The Internet revolutionized the distribution of software—perhaps a bit too much. The Web brought a new, cheaper method for getting software into the hands of users, but in doing so may have killed one of the best models in Silicon Valley history.

At the outset, the Internet ushered in an exciting new era of corporate software. On-demand computing—its poster child Salesforce.com's grinning, rosy-cheeked Marc Benioff sporting his once trademark "No Software" button—promised low-priced, convenient delivery of applications. Buyers would save on consultants, because vendors would host the applications and just rent access via the Web. No more obnoxious upgrade cycles, because software would be improved and tweaked daily. And if the software didn't live up to expectations? Just cancel. Businesses didn't invest in installing and configuring the software, so there was no lock-in.

Traditional Software Marketing

On-demand represented a welcome break from the traditional way of doing things in the 1990s, when swaggering, elephant hunter-style salesmen would drive up in their gleaming BMWs to close massive orders in the waning days of the quarter. It was a time when representatives of Oracle (ORCL), Siebel, Sybase (SY), PeopleSoft, BEA Systems, or SAP (SAP) would extol the latest enterprise software revolution, be it for management of inventory, supply chain, customer relationships, or some other area of business. Then there were the billions of dollars spent on consultants to make it all work together—you couldn't just rip everything out and start over if it didn't. There was too much invested already, and chances are the alternatives weren't much better.

Funny thing about the Web, though. It's just as good at displacing revenue as it is in generating sources of it. Just ask the music industry or, ahem, print media. Think Robin Hood, taking riches from the elite and distributing them to everyone else, including the customers who get to keep more of their money and the upstarts that can more easily build competing alternatives.

But are these upstarts viable? On-demand software has turned out to be a brutal slog. Software sold "as a service" over the Web doesn't sell itself, even when it's cheaper and actually works. Each sale closed by these new Web-based software companies has a much smaller price tag. And vendors are continually tweaking their software, fixing bugs, and pushing out incremental improvements. Great news for the user, but the software makers miss out on the once-lucrative massive upgrade every few years and seemingly endless maintenance fees for supporting old versions of the software.

Software as a Service

AMR Research's Bruce Richardson calls it the "hidden cost" of software as a service (SAAS) and says Silicon Valley is uncovering it the hard way. "The challenge is you have to spend 50% to 100% plus of revenue in sales and marketing cost," he says. "You need this [limitless] amount of cash to forever feed the growth machine."

No one's saying on-demand software isn't the future. Software sellers can no more cram that genie back into the bottle than the music industry can go back to selling CDs for $15. In the years I covered venture capital and enterprise software, I wrote a good deal about the transformational power of online software, explaining why incumbents would have to react. Many, including SAP and Microsoft (MSFT), have. One that hasn't is Oracle. The Redwood City (Calif.) company has offered a "hosted" version of its software for about 10 years, and CEO Larry Ellison clearly foresaw the on-demand wave, personally funding Salesforce.com (CRM) and NetSuite (N). But spreading any kind of on-demand religion throughout his own company is another matter.

Nowhere was this more clear than on Oracle's most recent earnings call (BusinessWeek.com, 6/26/08). Why isn't Oracle a bigger player in on-demand software? It doesn't want to be, Ellison told the analysts and investors. "We've been in this business 10 years, and we've only now turned a profit," he said. "The last thing we want to do is have a very large business that's not profitable and drags our margins down." No, Ellison would rather enjoy the bounty of an acquisition spree that handed Oracle a bevy of software companies, hordes of customers, and associated maintenance fees that trickle straight to the bottom line.

Higher Maintenance Fees

In fact, the elimination of competitors enabled Oracle to raise its maintenance fees to the tune of 15% to 20% for U.S. customers in June, according to a July 17 Wall Street Journal article. Germany's SAP followed suit a month later.

SAP isn't having much more luck with Business by Design, its foray into the on-demand world, I'm told. SAP said for years it would never get into the on-demand game. Then when it sensed a potential threat from NetSuite, SAP decided to embrace on-demand. Results have been less than stellar so far. "SAP thought customers would go to a Web site, configure it themselves, and found the first hundred or so implementations required a lot of time and a lot of tremendous costs," Richardson says. "Small businesses are calling for support, calling SAP because they don't have IT departments. SAP is spending a lot of resources to configure and troubleshoot the problem."

On the day of NetSuite's late 2007 initial share sale, CEO Zach Nelson told me he wasn't too worried about the competition. "This takes 10 years and at least $100 million to do it right," he said at the time. Looks like he was right. Even NetSuite is still not profitable. Dave Duffield and Aneel Bhusri, of PeopleSoft fame, are also in the on-demand game, launching Workday in late 2006 (BusinessWeek.com, 11/13/06). Things appear to be going well, but similarly they expect a hard slog—not an overnight success.

Open-Source Rivals

Software companies in the open-source space are feeling some of the same Web-induced pressures. Most of the largest names—which also use the Web for distribution as well as development—have been acquired, with only Red Hat (RHAT) surviving as a stand-alone entity. When MySQL sold to Sun Microsystems (JAVA) for $1 billion this year, people saw the deal as a great endorsement of open source. Really? MySQL was one of the movement's brightest stars, and after 10 years of building a customer base comprising some three-fourths of the Web, it still hadn't become the next great Web powerhouse. And that $1 billion was a stretch, based on traditional sales metrics. Essentially, Sun paid for the install base more than revenue.

So what becomes of the remaining software companies hoping to make a mint distributing their wares via the Web? Not every startup has the patience—or funding—to stick on demand out for 10 years and $100 million-plus in sales. Those mid-slog are feeling it acutely. Richardson says he increasingly hears about "founder fatigue," entrepreneurs being ground down by the endless travel and ever-ballooning marketing costs. It's worse for the publicly traded companies constantly under Wall Street's what-have-you-done-for-me-lately scrutiny.

I've talked to a few on-demand CEOs who feel like they unspool a great story for Wall Street, only to hear a resounding "That's it?" in response to growth projections. Richardson tells me of one founder he met with recently whose company is growing well but who lives on airplanes, jetting from one sales call to the next. "You get the feeling that if someone came along and said, 'Let us buy you for 50% more than the stock price,' they'd do it," Richardson says. "It's just too hard."

A Raft of Acquisitions?

So will we see a raft of acquisitions as bigger on-demand companies gobble up the small ones? Already Taleo (TLEO) bought its biggest competitor in Vurv this year. Expect more of the same. Of course, whenever you discuss on-demand, the conversation eventually turns to Salesforce.com, the first to get to a million customers. All eyes are on CEO Benioff to see how this market plays out.

Rumors have been rife for much of the last year that the CEO—who spends most of his year at his estate in Kona, Hawaii—is ready to sell while the company is flying high. But most big companies from Hewlett-Packard (HPQ) to EMC (EMC) to Oracle want to buy rivals that are generating consistent profits. Will they still pay a premium for the pioneer of the new generation that sometimes barely breaks even?

I'd love to ask him about it personally, but the once press-adoring Benioff has turned camera shy. Literally. I've had him booked on my Yahoo (YHOO) show, Tech Ticker, half a dozen times only to have him cancel at the last minute each time. Perhaps even the on-demand evangelist is feeling a bit of founder fatigue.

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