Enterprise Software Startups Make a Comeback

After funding a boom in sketchy startups targeting heavily hyped consumer categories such as social media and mobile, smart venture capitalists are returning to their senses and investing in companies that emphasize solid fundamentals, like paying customers and profits. That’s why enterprise software companies are finally getting the attention – and dollars – they deserve.

Venture capitalists are armed to the teeth with analytical tools. And they should be. Their careers depend on making intelligent investment decisions. And yet, against reason, VCs often behave like teenagers, throwing their money at companies simply because they’re in fashion.

Me-Too Investing

Lately the trend has been toward consumer internet companies: “Hey, that venture firm has a social media play in its portfolio, we should have one, too.” For too long, that’s been the thinking at a lot of VC outfits.

Not any more.

Venture capitalists placed $2 billion with IT startups in the first quarter of this year, according to a survey by Dow Jones VentureSource, a 14% increase from the first quarter of 2011. Meanwhile, investors put 76% less investment in consumer internet companies. Software companies attracted the most funding, $1.3 billion, which is a 61% bump from 2011.

Social Is Overcapitalized

“I see some people looking at the enterprise space again, probably as a reaction to areas like social being overcapitalized,” says Bob Ackerman, managing director at Palo Alto-based Allegis Capital. “The logic in the venture herd seems to be, ‘If five companies in an area are gaining traction, let’s create 500.’ But at some point reason prevails and people say, ‘Hang on, that’s not going to work out. What are other areas that are not as excessively capitalized?’ There’s some of this phenomenon from a venture perspective as it relates to the enterprise.”

Allegis Capital has long invested in enterprise startups, whether they’re trendy or not, targeting companies aimed at business problems that require high-value, technology-based solutions. These companies may not be sexy but they pay the bills, because enterprises have problems and they will spend money for solutions.

Avoiding the Herd Mentality

“Part of the challenge in the venture world is that people want to hitch their wagon to the fastest-moving star,” Ackerman says. “The problem with that approach is that when you see the herd moving in a given direction, it’s probably too late. So we tend to be counter-cyclical at Allegis. We don’t want to be running with the herd because it tends to pull down returns.”

It’s not only VCs who travel in herds, he adds, but entrepreneurs as well. Ackerman has watched a lot of talented engineers shift their focus to social media and other consumer internet startups in the past few years. Enterprise software is hard, and a lot of entrepreneurs these days are impatient.

Fighting Immediate Gratification

“This is a change,” he says. “Go back 15 years – people were more studied about identifying an opportunity and building a company for the long term. But when you get into these boom-and-bust cycles, with people trying to capture the boom, it’s driven by a desire for immediate gratification. That has sucked some of the air out of the enterprise space.”

There is innovation going on in the enterprise arena. One of the most-talked-about business-software startups right now is Asana, which was founded by two guys from Facebook. The company makes task management for teams.

Building Real Businesses

Another reason Enterprise startups don’t get as much attention is because “they’re not flashy,” Ackerman says. “But they are building real businesses and what we’ll see at the end of day is that many of these enterprise companies that have been slowly building their companies and succeeding, you will see a tortoise-and-hare scenario. In many cases they will prove to be more sustainable.”

Look, for example, at the $60 billion IT security market. It’s a real problem with real customers looking for real solutions. And as they find solutions, ROI-driven startups are already grabbing a significant piece of company tech budgets.

The Laws of Physics Still Apply

As the investment data indicates, VCs are once again recognizing the fundamental strength of enterprise startups – and putting more money into them.

“Some investors left the enterprise for the promise of faster returns,” Ackerman says. “But you will see more people waking up to the realization that the streets aren’t paved with gold, the laws of physics still apply, and let’s go back to doing things the old-fashioned hard way.”