Software has long been the lifeblood of the Valley. So why are VCs just now remembering this?

By Sarah Lacy , written on October 16, 2012

From The News Desk

Investors have spent much of the last year talking up a resurgence in enterprise software companies, and Workday's monster IPO on Friday was -- they hope -- this movement's mini-Netscape moment.

Part of the motivation in cheering for enterprise is rooted in the disappointment of Facebook's IPO, which was meant to buoy up the other members of the consumer Internet's billion dollar valuation club and instead acted like a soggy wet blanket. There's a reason Workday keeps being touted as "the anti-Facebook." Before May, no one could have conceived of that as compliment.

But the desire for a resurgence in enterprise goes well beyond Facebook. Software has historically been the lifeblood of Silicon Valley: No other sector has led to more exits, been more consistent in the size of those exits, and spread the wealth so widely around the Valley.

But if software is so great, why is Workday such an anomaly? Let's look in detail at the promise of this much-touted next wave.

Sexy numbers for an unsexy industry

Who gives a shit if fanboy bloggers find enterprise software boring? The Valley is here to build great companies and make money, not entertain mid-20-somethings who can't get enough of their Instagram feeds. Personally, I find billions of dollars fascinating.

Consider a few numbers the NVCA recently dug up for me:

  •  In the 1990s, there were 248 software IPOs and 196 Internet IPOs. Sure, that includes some years before the Internet was commercial or widespread, but it also includes 1999 when 134 Internet companies went public.
  • Overall from1990 until today, venture capitalists have taken 367 software companies public versus 338 Internet companies. But take out 1999 and 2000 and the gap is far bigger: 367 software IPOs to just 156 Internet IPOs. And that includes a comparative fall off in software IPOs in the past ten years.
  • Internet IPOs are far more binary than software IPOs. The Internet gives us huge hits like Google and Facebook. But it tends to be a winner-take-all game. If you look at the sum of post-offer valuations for Internet IPOs, the NVCA shows some $309 billion. But the IPOs of 1999, 2011, and 2012 alone make up some $188 billion of that number. Those three years are skewed by the bubble in the case of 1999 ,and in 2011 and 2012, they are skewed by several very large exits in Facebook, Groupon, Yandex, and Renren. These four were massive issues, compared to the market as a whole, making up almost two-thirds of all shares sold in Internet stocks from 2011 to 2012.
All or nothing

More anecdotally, the fall off in software IPOs -- there have been just 119 in the last twelve years -- has coincided with some other worrying trends for the Valley. There's been a widening gap in the size of exits, with an increase in companies getting sold for less than $100 million. That hasn't been disastrous for the industry, as companies cost less to get started in the Web 2.0 age. But it certainly isn't doing much more than returning cash.

On the plus side, the small handful of consumer Internet home runs have been truly gargantuan -- disappointing IPOs not withstanding. But they have taken huge amounts of money to get there, at very high-priced valuations, and have taken far longer than Internet companies have historically. Even the home runs have not been unqualified successes for all investors. And between these two categories, there's been very few. There's a huge decrease in "base hits" -- or companies that exit in the range of $100 million and $900 million.

Some have argued this gap has to do with the changes in the IPO market, making it much harder on sub-$1 billion market cap companies to exit and all but impossible for sub-$500 million market cap companies to exit.

That's definitely a factor. But I'd argue it's also born of an over-reliance on the consumer Web to provide those big exits. Because the consumer Web generally relies on massive audiences to build large businesses, it tends to be an all or nothing proposition. Sure, the "all" has gotten much bigger as the Web's dominance and reach has grown. Even with Facebook's disappointing IPO, it's still a massive company. But the entire Valley ecosystem that pumps some $20 billion or more a year into companies cannot subsist on a handful of Facebooks, even if we were lucky enough to have a handful of them.

Web 2.0 and the new venture capital ghetto

With returns becoming such a lottery ticket game, how do VCs get in one of the few mega-winning Internet companies? There are a few paths to success, but most of them won't work for the everyday VC who made his career in Valley's glory days of telecom, software, and chips. They take a massive risk when the market isn't frothy, as Greylock and Accel did back in the early to mid 2000s. Or they have the best deal flow, as firms like Kleiner Perkins and Sequoia Capital have historically. Or they out-innovate (or at least out-market) on what they'll do for entrepreneurs as Andreessen Horowitz has in the last few years.

Basically they do a deal no one else would (in terms of timing or price), or they win the deal everyone is chasing based on celebrity. That's dollar-signs-in-the-eyes great for a handful of firms, but the venture industry is made up of thousands. And as software deals have been out of favor, many of those firms have just been reeling.

As a result, the venture world has widened more than ever into the haves and the have nots. Are we in a bubble? Most of the venture funds in Silicon Valley would laugh at the suggestion. For all of the negatives of bubbles, at least they tend to raise all boats for a time. The Web 2.0 wave has raised a relative few.

The good ol' days when people paid you for innovation

It's no wonder there's a growing wistfulness for the days of enterprise -- with Workday's successful issue being a stark reminder that maybe those days don't have to be over.

For an industry that has wrapped itself in monetization contortions of late, software is blissfully simple. If it works and solves a problem, people will pay for it. That's it. This is not to say it's quick, easy, or cheap to build a software company. The early wave of software as a service companies were mostly a disappointment.

Building those sales channels are not easy -- despite the talk these days that software is "bought" and not "sold." If you are selling to large companies, competing with SAP, Oracle, and IBM is near-impossible. If you are selling to small to mid-sized companies, you have a bigger base of competitors, or sometimes, you are evangelizing a category for the first time. And the deals are smaller, while the cost of selling can be just as high.

What's more, modern software companies are hardly the cash cows they used to be. Cloud computing and open source have forever changed how much software companies can charge and how they charge. has spent the bulk of its life criticized by the public markets for not being more profitable, Netsuite has yet to turn a profit and Workday isn't profitable either.

But they have precisely the opposite problem Facebook and thousands of less successful consumers companies have: They don't need 1 billion users, because people pay them money. In some cases, it's only some users paying them a little money; in the case of Workday, it's a lot of money.

After over five years of begging the big social networks to go public, Wall Street has suddenly realized there's something beautiful about a clean, simple business model. Workday surged up 75 percent in trading on Friday and was up more Monday and so far, more today. And it's not just the large caps that are faring well. Even Shutterstock -- a company that people pay a small fee to use images -- popped nearly 40 percent. For all the talk of a bad IPO market, it seems it's just the consumer that the market hates.

Sorry, there's not another Workday coming. Here's why.

So since software has long been the lifeblood of Valley, since it has so much going for it, why has it generally been so out of favor for much of the last 10 years?

Part of it is because the past generation software companies have done a far better job of staying dominant. Ripping out your existing company's infrastructure is a brutal -- almost unthinkable -- unless technology has so massively passed you by that you absolutely have to. It's not that no one has thought to fund software as a service companies until now. This is the third wave of them. The timing, and in some cases execution, is better this time around.

Part of it is because the innovation in software has come at the expense of the bottom line. In aggregate, cloud computing and open source software have displaced more revenues than they've created. And that's made building massive companies out of these trends difficult. The easy out is just to sell to a large company that wants to take out a potential competitor and has hordes of cash to make offers entrepreneurs can't refuse.

See Microsoft buying Yammer for $1 billion: A rounding error for Microsoft, and yet an unthinkably large multiple on Yammer's sales. It's easy to see how more of these will happen. The worst case scenario for the Valley and companies: That cloud computing becomes the trophy wife of aging giants the same way life sciences startups have become  little more than the R&D arm for big pharma.

Another big factor has been VCs' seduction with the lie that consumer Web companies are cheap and easy. In reality, they are only cheap and easy to get going. Then they fail, sell for a paltry sum, or are anything but cheap and easy to get to an IPO.

So as much as VCs will spend the rest of the year talking up the great merits of investing in software again, remember, the industry is the one that put itself in this situation. The venture world didn't have to be this binary. Some firms weren't. While Greylock was investing in Facebook, it was also investing heavily in Workday. Even pre-Andreessen Horowitz, Marc Andreessen was a Workday angel, at the same time he was investing in companies like Digg and Twitter. And it's possible -- at least for Greylock -- that Workday winds up being a bigger windfall than Facebook.

For public market investors, there are more Shutterstocks out there. And there are a few nice software IPOs in line to go public that could well top a $1 billion valuation, like Atlassian. More still are building their businesses now and look promising, even if they are nowhere close to an IPO. I'd put Box in that group. It remains to be seen if that group goes the way of an IPO or a juicy Yammer sell-out to an incumbent. But one thing is for sure: Much as there is no next Facebook on the horizon, there is no next Workday either.

Workday was started out of incredibly unique circumstances. It was stunningly ambitious and backed at a time when no VC would invest in building the next great enterprise company -- even the SAAS companies making it were selling to small- and medium-sized businesses or taking on neglected verticals. Without co-founders Dave Duffield and Aneel Bhusri putting in their and their firm's money, this company wouldn't have started. Without a mission of revenge and creating a modern enterprise alternative and a total disregard for a quick exit, the company would have never gotten this far.

As uncommon as it was for Facebook to embark on the series of events that lead to its gargantuan size -- its founding despite a disbelief in social networking, it turning down $1 billion from Yahoo, its adept use of the private markets to finance its growth -- that's how uncommon it was for Workday to get to this point.

Sure, Workday is the anti-Facebook in a lot of ways. But both are stunning examples of why all the money in the Valley can't fund true contrarian risk. Stop asking who is next. We won't see a "next" in either category for years. It may be in a garage somewhere, but I'd argue we don't even know about it yet. And whether investors are lathered up about consumer or enterprise at the moment, you can bet somewhere someone in the Valley is passing on it, only to regret it in another six to eight years.

[Image courtesy Esparta]