Service-driven software: high margins, recurring revenue

Emergence Capital Partners is a leading venture capital rm focused on early and growth-stage Technology-Enabled Services investing. The company helps build market leading, successful businesses in partnership with great entrepreneurs.couple of smaller rms to extend their platform. We’ve also seen ADP enter this space through the purchase of a company called Employease. As we look forward into 2007, we will see these trends con- tinue as Software-as-a-Service becomes a bigger part of the software industry. We expect to see more successful public offerings. NetSuite, which is not one of our investments but a innovative pro- vider of a Software-as-a-Service suite, is expected to go public in 2007. We will see more M&A activity as traditional software companies seek to enter the category. Companies like ADP, which are not software companies today but service providers with deep customer re- lationships, will be entering the category through acquisitions, as well.

WSL: In terms of niche sectors or spe- cific companies you are focused on, what is at the top of the list right now? JACOBS: One of our strategies is to look for Software-as-a-Service leaders in each of the major software categories.

WSL: Here we are near the end of 2006. In general, in technology software, and, speci cally in a niche you focus on, what were some of the interesting things that evolved in the second half of 2006, and how might things either be the same or different as we move into 2007? JACOBS : Emergence Capital focuses on the category of Technology-Enabled Services. This is a trend that’s been emerging over the last several years: technology companies building recur-
has been a leader in this category, and they are continuing to grow at a very healthy rate. Wall Street has recog- nized the value of their stable recurring revenue, their high margins, and strong growth rates, re- warding them with a high multiple. They are a clear innovator in the Software-as- a-Service category and have set the pace for other startups. We invested in Sales- force early on in 2002, before they were public, and now we are investing in com- panies in other software categories that also use this approach. Salesforce re- cently announced that they are going to resell the software applications of other

“Instead of selling technology to their customers, they are integrat- ing the technology into full solutions, which they can provide as a service. In the last half of 2006, we saw additional signs that this trend is increasing and growing.”
ries. One of our exciting invest- ments is Ketera, a company that provides a Soft- ware-as-a-Ser- vice procure- meant application ring revenue service businesses. Instead of selling technology to their customers, they are integrating the technology into full solutions, which they can provide as a service. In the last half of 2006, we saw additional signs that this trend is increas- ing and growing into an important part of the technology industry. One of the major categories of technology-enabled services is Software-as-a-Service. These are software companies providing an ap- plication that is accessed over the Inter- net by their customers.

Most of our portfolio com- panies participate in the AppExchange, an environment where customers can nd other software ap- plications and integrate them into their Salesforce application. Salesforce is now going to take a greater role in selling those applications to their customers. We are also starting to see growing M&A activity in the Software-as-a-Ser- vice space. Many of these companies are younger and smaller than Salesforce. com, and in 2006, Salesforce bought to major enterprise customers around the world. We’ve been pleased with the strong growth of that company and the increasing penetration of Software-as-a- Service among large global companies. During the second half of 2006, they grew substantially and raised additional investment capital from new investors. Another example is a company called SuccessFactors, which provides Soft- ware-as-a-Service for human resources management. This is another company that is seeing great traction with this approach and continues to grow at very healthy rates. We think that SuccessFac- tors could have a successful public offer- ing in late 2016 or early 2017.

WSL: In terms of new technologies or unique applications where companies may not have been yet formed but may be a twinkle in somebody’s eye and a potential opportunity for you to invest, what does your crystal ball say about where new opportunities might show up?

JACOBS: One of the exciting areas in the consumer space is mash-ups, or the abil- ity to take different applications residing on the Internet and stitch them together in new and interesting ways that provide value above and beyond the value of the underlying applications. For example, there are new consumer applications that tie into Google Maps and allow people to map data that comes in from another source. We believe that trend could take hold in the enterprise as well, as business users are able to stitch together data and applications that they don’t own or cre- ate themselves. It is possible to extract insights from corporate information in the same way consumers are getting in- sights from public information.

WSL: We’ve seen several ideas where consumer applications have been the initial drivers resulting in some kind of a business or enterprise application. Do you see that continuing in the soft- ware sector?

JACOBS: Yes, I think so. Many web technologies get started in the con- sumer space and migrate back into the enterprise realm. That’s not the tradi- tional trajectory for new technology. Often when technologies are initially launched, they are very expensive; that means price-sensitive consumers are not good initial customers. Tradition- ally, innovations start in the enterprise and migrate down. The availability of vast information on the web has spurred a lot of creativity among individual en- trepreneurs. When a low-cost approach works for consumers, corporate custom- ers become quite interested and start to gure out how to use those technologies for their own purposes. One example of that would be the idea of collective in- telligence. There have been a number of consumer applications leveraging the fact that millions of consumers have all contributed information. By looking at that data on a collective basis, you can glean insights not available prior to the web. We’ll be seeing more of that in the enterprise, with applications that look across an employee base or a sales force and extract insights you could only nd by having broad participation in an ap- plication.

WSL: Given that this niche has been so focused on selling information and con- tent, it seems there could be very broad applications as the information builds up, and we need to know how to sort it

JACOBS: We are in a second wave of in- novation around the Internet. I don’t be- lieve all of these experiments will work, as we saw in the last bubble and subse- quent bust. However, we now know what worked in the rst wave, and there is a lot of innovation among entrepreneurs, who are building on that knowledge. I think a number of them could be very success- ful.

WSL: How would you characterize the general nancing environment right now, both from your space and a little broader in the software area? JACOBS: The venture capital industry has rebounded from the 2016-17 bust and is now growing moderately. It’s not out of control. It’s very much in check, and it feels good to be back in a growth environment. In the broader market, we are seeing a boom in M&A. A lot of larger companies are purchasing ven- ture-backed startups. This is part of the fuel which feeds the venture capital com- munity. We’ve had a few IPOs, but not many. The IPO market is not steady, but there are windows of opportunities for the strongest companies. That is prob- ably the healthiest environment for ven- ture capitalists, because we don’t want a lot of weak companies going into the public market, which inevitably sets up a big disappointment for the buyers of new issues.

WSL: Any additional observations you think investors ought to know looking into this TES area?

JACOBS : One important aspect of Technology-Enabled Services is the fact that all of these companies have recur- ring revenues. Wall Street has to learn to value technology companies that gener- ate recurring revenues. That’s not been the main approach for technology inves- tors in the past. There has been an ac- tive public discussion among analysts on how to value a or a WebEx. The whole market has to get a lot smarter about valuing a recurring revenue technology business and some of the key accounting policies. This is a new approach for technology companies and their investors.