When Do The SaaS Acquisition Games Begin? (A Primer on Cloud Computing Market Segments)
Posted by Bob Warfield on February 12, 2008
The Yahoo/Microsoft business has turned to utter farce. Michael Arrington’s line left me in stitches:
Mathew Ingram calls it “desperation squared.” We have now moved from the factual to the sublime: a sure signal to Yahoo that they need to get on with being acquired. When most of the world is laughing at you, and you are a huge company, it means you’ve lost it. You’re way past the point of return. But this is not why we’re here, for the Giants are thinking of dipping into another branch of the Cloud Computing Tree.
Tom Foremski says that Oracle recently approached Salesforce.com to gauge their interest in a possible $75/share offer. Duncan Riley at Techcrunch finds the rumor plausible, as do I. I won’t spend a lot more time on this particular scenario. It will be a question of Oracle’s resolve to buy versus Salesforce’s resolve to remain independent. But I will say this. Oracle typically spends 7-8x maintenance revenue to buy companies. If the rumor is true, they’re offering 13x trailing twelve months total revenue for Salesforce. It just goes to show the awesome financial power of a good SaaS business. It’s likely worth that much. After all, if Oracle is ever going to get started on the road to SaaS (yes, I know, they have a SaaS business already, yada, yada, but not really), starting from a seed as close to $1B a year as possible would help accelerate things. That’s a real problem, BTW: there just aren’t all that many SaaS properties out there yet for acquirers to choose from. The space isn’t very far along, and is still very young.
And yet there are machinations going on as various players try to position themselves for the coming battles. Some of these manuevers are visible, some are just off the edge where the light is pretty dim. It’s important to segment the Cloud Computing and SaaS market to gain a better understanding of the terrain. We’ll leave aside the Web 2.0 world of Facebook et al, though the infrastructure at the bottom of the market segmentation model I present is the same for the Consumer/Web 2.0 world. Markets tend to consolidate from the bottom of the technology stack up. The reason is that the bottom layers have been around a lot longer, there are more big players, and momentum there has often slowed. These are sure signs that a consolidation is in order. It’s important to know where you are in the stack because it equates to where you are in the M&A food chain. Consequently, VC’s often try to evaluate how near the bottom an idea is versus how late in the day it’s getting. Being too low in the stack when the market is very mature is usually a bad thing. Being high up early is oddly almost never a bad thing. The very top of the stack is apps, and it takes apps to propel the other layers forward.
All things considered, if you have a killer idea for an app, that’s where you should place your bets. That would be another reason for Oracle to pay a premium for Salesforce. The other thing to keep in mind is that the line of safety keeps moving upward. The snapshot I’ll portray today has that line hovering at the Value Added Hoster level. It won’t be long before it moves up a notch to encompass the Virtualizers.
The Battle for SaaS Hosting and Platform Dominance
At the very bottom of the SaaS stack are the hosters and platform builders. There are several armies on the battlefield jockeying already. There are roughly three market segments:
First are the old-school hosters that basically offer raw machines and Internet connectivity: “A Cage and a Pipe.” These guys are very long in the tooth for the current Cloud Computing era. The trouble is they are experts on the physical plant but don’t add much value otherwise, and their expertise is now heavily commoditized. If they don’t learn to offer more value soon, their days are numbered, hence they’re in the “red” zone.
Next up are the value added hosters. Start with a Cage and a Pipe and add Some Service. Perhaps that’s as simple as providing system administrators and DBA’s. Service can become more elaborate. This group is currently a very popular choice for SaaS startups I talk to. Very few of these companies are considering the Red Zone. But the Value Added Hosters need to move upstream as fast as they can, lest they start to go red too. The services they offer are not hard for the Cage and Pipe crowd to bring on. There is so far minimal proprietary technology adding value. Aside from the problem that others can add services, it creates a secondary problem that the cost to deliver the service is higher. We’ve talked before about how much more efficient SaaS players have to be than conventional users of Enteprise Software. The Yellow Zone is borderline in that respect.
It shouldn’t be surprising, therefore, when we read things like OpSource’s acquisition of billing company LeCayla. It gives them technology and a new service to inch them closer to the Green Zone.
This brings us to the Green Zone, which I have dubbed “The Virtualizers.” Virtualization is their chief technology differentiator, although there is often a whole lot more. These players want to bring on as many generic components as they can to complete a full Platform as a Service offering. This is the most interesting and vigorous space, and I predict it represents the future. If the Red and Yellow Zones can’t find a way to get there, they’ll find themselves increasingly commoditized and marginalized, making their segments very tough businesses indeed. The Green Zone brings a number of essential advantages, although every player doesn’t offer every advantage.
One of the big advantages is true On-demand computing. With Amazon and many others you can buy servers buy the hour as needed to deal with load spikes of various kinds. This leads to a tremendous savings for most organizations, and makes it possible for startups to pay the big bucks only if they’re successful and have the big bucks. It’s a radical reduction in friction, and that almost always leads to radical growth. So it is here. Amazon recently reported more web traffic going to Amazon Web Services than the rest of Amazon’s properties combined.
Companies like 3Tera (check out my 3Tera interview posts) and Q-Layer offer such virtulized data centers in the form of software. Buy their software and you can create a virtual datacenter. Or you can buy the hosting as well from these companies and their partners. They’re very important players because they represent the means by which the Red and Yellow Zones can become Green.
Sun deserves special mention after their purchase of MySQL. If I were being completely objective, Sun is still very much in the Yellow Zone. I’m giving Sun and Jonathan Schwartz the benefit of the doubt in terms of where they’re going. They do offer Sun Grid, and they certainly have the wherewithal. Whether the organization can really pull together and get it done remains to be seen, but MySQL is a very promising new jewel in that crown.
The level above the platform consists of Tools. First thing to note about this category is that “Tool” is a dirty word among the VC’s and other money mongering intelligentsia. The story goes that nobody ever got rich on tools, the world now expects tools to be given away, yada, yada. BTW, I disagree with that sentiment. There have been lots of very successful tools companies. I think the real issue is that it’s hard for the Money Men to evaluate tools. Everyone promises to be able to turn a noobie programmer into a powerhouse of productivity that can single handedly reproduce SAP’s entire suite over the weekend. Unless you are extremely technical and immersed continuously in the world of Tools, it’s very hard to separate the hype from the reality and the religion from the irrelevant. Nevertheless, this is a real category, and there’s actually a lot going on here.
I break this market into three segments:
At the bottom, just above the Virtualizers from the prior diagram, we have Systems Software, which I’m classifying here as Databases and App Servers. Normally we would include operating systems, but they’re spread all around and largely play in the Virtualizer category. In other words, what’s interesting about Operating Systems vis a vis SaaS and Cloud Computing is virtualization features. This area is dangerously close to the Platforms where most of the Giants are. Sun has already set a big foot down here with MySQL. Amazon is trying to change the game entirely with SimpleDB. There are some players, such as Elastra, that are trying to skate between Amazon and the rest of the world by offering MySQL on Amazon. My take is that such plays need to get big really fast or diversify into other services because the window here has to be closing. There is already so much traffic on Amazon, and so many folks using MySQL there, that it seems likely a single solution will emerge and Amazon is in a good position to dictate what that will be. I can hear Amazon on the phone call now:
Really, you don’t want to sell to us? Well, we’re going to deliver your product on AWS in about 6 months and it will be the preferred solution for the platform.
Or that call could be to a MySQL competitor. There are several, and some say products like PostgresSQL are better for various reasons such as scalability. What would it mean to Sun if Amazon acquired one and built it into their fabric? What does it mean to others lower in the stack if all the good DB’s get bought and incorporated into the fabric of Giants? Definite strategic manuevering possibilities here.
Next up are the Languages. Since the dawn of computing, there have been Language Wars. A lot of this is about separating the religion from the irrelevant, BTW. Nevertheless, we have the new school of scripting languages circling the castle of traditional curly braced languages like Java and C++ (not that the new guys are bereft of curly braces!). Their battering rams are pummeling the iron doors of performance ceaselessly with the promise of productivity. Cheap among these are PHP, Python, and Ruby on Rails. There are successes and failures to point to for all of them. PHP is largely what powers Yahoo and many older web properties. Python, while Open Source, seems to be the one championed by Google. After all, they got Guido. Ruby on Rails is one that I find interesting, because it doesn’t yet have a big power partner. It’s Open Source, but without the partner, it remains something of a Free Spirit. Perhaps that makes it an ideal nucleus for an upstart wanting to take on the Cloud Computing Giants. Heroku would be one such possibility. I’ve seen a demo, and it surely did seem pretty cool. The Ruby brand is still strong, and could propel the right offering far. Zend is working hard to have a go at PHP as well. BTW, I would put Force squarely in the language category. Yes, it is all of the layers below too, but there is a rich set of functionality that adds language and framework, not to mention you must use their proprietary langauge.
I can’t move on from Languages without mentioning Salesforce’s Force either. They view it as a Platform-as-a-Service, but it offers so much more than something like Amazon (so far at least) that it deserves a spot higher in the stack. Force includes a language that is Java-like, but proprietary to Salesforce. Most developers these days have a problem with proprietary. They prefer Open Source. But that’s not even the real Achilles Heel. Force is currently way overpriced to make it practical for ISV’s. As I’ve discussed many times, your Cost of Service needs to be as far below 50% as you can get. With Force starting out at $50 a seat month, customers must charge $100-200 a seat month to achieve reasonable margins. That’s largely not possible for ISV’s, so Force is mostly an IT pheonomenon. That makes it less strategic, but perhaps a better cash cow for Salesforce.
What’s this Enterprise Tools category?
Enterprise IT is used to having a rich ecosystem that fills in the gaps. When you think about it, purchasing the software application is just a small piece of the overall organism that is created when that app goes into production. There are many products bolstering and augmenting the application’s functionality. Don’t like the reporting provided out of the box? Plug in a Business Intelligence Tool. Need to integrate the application with other applications without writing too much custom code? There’s everything from ETL tools ala Informatica to shift data between tables to complex messaging systems from companies like Tibco. Need help managing logon information and implementing single sign on (SSO)? There’s LDAP, Active Directory, and a ton of other products out there.
Almost all of that is gone with Cloud Computing. As someone quipped, “It isn’t that the data is in THE cloud, it just isn’t in MY data center anymore.” And in fact, THE cloud is really many clouds: one for each data center of each provider you’re doing business with. Even more interesting, a lot of the Old School providers of this stuff have technology that isn’t real relevant to the Cloud Computing Era, and many of them have been bought so they can be milked. Witness all the BI vendors that have been absorbed. Their time of innovation is done.
That’s actually great news. The SaaS Enterprise Tools category is the lowest true Green Field opportunity in this model. Nobody owns it. The Giants are mostly absent. And there are even surprisingly few startups about. Perhaps it just doesn’t seem sexy enough, but there are real problems here that need solving. I had lunch the other day with Mike Hoskins of Pervasive. Among many other areas, they do a good business out of software that pumps data out of Salesforce and into your local data center so you can apply your BI tools to it. I’ve interviewed Ken Rudin of LucidEra for this blog. They provide BI solutions in the Saas model, largely based on data from Salesforce again. Another great example is EMC’s recent acquisition of SaaS backup vendor Mozy.
These are good opportunities in this segment. There are customers with real pain and minimal competition so far. The Giants are ill-positioned to jump in because of the disruptive business model that is SaaS. I would expect to see a lot more action here before it’s over, but there is a very interesting move that just took place that seems to have largely been ignored. Workday, Duffield’s Peoplesoft Version Two, has just acquired SOA integration tool vendor Cape Clear. I think this is really an interesting move. Yes, I’m sure they needed to be able to easily integrate a lot of systems outside Workday to sell their application, but I wonder if there is more going on here? For example, at some point, I expect to see fine grain network effects emerge from the topology of the clouds. These will be a function of the need to shift data between applications to integrate them. There’s a real speeds and feeds issue there that has to be addressed. It will be advantageous to run your software in the same cloud as what it integrates with. This will favor really big clouds like Amazon’s. I could also see it triggering partnerships bolstered by high speed dedicated links between data centers. One example is Joyent’s dedicated link to the Facebook data center, which gives them a real advantage hosting Facebook applets.
Is Workday trying to lock in a part of that future integration pie? Not clear, but there sure isn’t much else beyond Cape Clear in the space right now and Workday’s application is the kind that wants to be the system of record nexus for everything else. Dana Gardner discusses how increasingly, it is the Service and not the Software that drives acquisitions like this. After the merger, you won’t be able to buy Cape Clear except as a Service (now dubbed “Integration as a Service”). Given that it was a very high quality offering, Cape Clear gives Workday an interesting and valuable differentiator, if nothing else. One of the big puzzles of SaaS is how to get the more complex domains installed much more cheaply than conventional Enterprise Software. Integrating with a bunch of Legacy systems can make that really hard unless you have a toolset like Cape Clear to simplify the job. To the extent the tool is bought to integrate other SaaS vendors, it can serve as valuable lead generation to go sell the primary Workday Suite into Enterprises that clearly have SaaS underway. All in all, I would rate this as a canny and highly strategic move that Workday has made.
SaaS Enterprise and Desktop Applications
This brings us finally to the topmost slices of the layer cake, applications. I include here both desktop and Enterprise applications, so it’s everything from spreadsheets and word processors in the cloud to Salesforce.com. That’s a lot of ground to cover, and it has barely been penetrated. There are numerous application categories for which there are not yet any SaaS offerings, and many of the offerings that are available are still in their early days yet. Most of the application companies I talk to are seeing unbridled demand. It seems likely that for early markets there are enough customers out there in the SaaS early adopter crowd that you can go pretty far just because your offering is SaaS, assuming it works, of course.
What’s Strategic and Who’s Being Left Out?
First, there is an overall megatrend at work here, and that is the move from proprietary to open. Companies will over time be less and less inclined to run datacenters. Giant Cloud Centers like Amazon Web Services will be the new black and the New Open for that world. That Openness will drive throughout the stack in an expanding wavefront, because Open wants to connect to Open. That makes All Things Open strategic in this Cloud Computing Era.
Second, let’s talk briefly about acquisition strategy. If your goal is to acquire SaaS market share and scale, there isn’t much available. Salesforce is the largest pure SaaS vendor and they’re still under a billion in annual revenues, although they’re closing in on it. That means acquisitions at this stage in the market should be more focused on capturing Strategic Choke Points than cubic dollars.
Let’s review potential choke points:
- Hosting and Platforms: Look at the 3Tera and Q-Layer offerings as a means of supercharging data centers into the Cloud Era. There are probably other players I’ve missed, but these guys give a flavor. Be aware that virtualization is all the rage. I personally have met 2 different Entrepreneurs in Residence at major Silicon Valley VC’s in just the last month who are focused on virtualization. There’s a lot of attention here, and we can’t forget VMWare, nor the fact that the OS makers all want to build it into the OS. The nice thing about something like a 3Tera is that its a lot more than just virtualization. The real answer is to recast virtualization as a solution, and thereby move up the stack. Simply Continuous, for example, offers a Disaster Recovery solution based on virtualization. Those EIRs I mention are also interested in solutions more than generic virtualization.
- Systems Software: Sun’s purchase of MySQL signalled that consolidation has begun here. We’re going to see the clash of the Relational DB’s versus the new era SimpleDB-style systems. I have to expect that all the action over at Amazon will flush others out of the woodwork some time this year, especially Microsoft and Google. The former may be overly preoccupied with Yahoo and therefore delayed. As for App Servers, look for Dark Horses specific to the new languages. Someone who does something really great for Cloud Computing may have a leg up, but I’m not sure how long it will last. If you want to hang out in this layer, be focused outside the limelight. LucidEra took over an open source column store DB and focused it around SaaS BI needs. That’s safely out of the line of fire between MySQL and the SimpleDB’s of the world. In fact, there are likely more opportunities in the BI-specific space. Certainly this was very late in maturation for conventional On-premises. I wonder if someone will build a Teradata equivalent in the Cloud, for example?
- Languages: This is as low in the stack as I’d want to be innovating unless I had a serious niche picked out. The world seems to be clamoring for new languages at the moment, so maybe there’s a good shot here. And so far, nobody is very far along at packaging any of the new languages so they’re easy to use for Cloud Computing. Stay away from the crowded niche of proprietary “non-programmer” languages. These are the Bugees, Cogheads, and the like. They’re really more like dBase or Access in the Cloud than they are Languages in the Cloud. If one of these players can really hijack a major language and get a big enough lead, it will be interesting. It’s very hard though, with Open Source. It levels the playing field unless you’re very careful about how you add value.
- Enterprise Tools: Huge opportunity here. There is no compelling generic BI offering for SaaS. Workday just bought arguably the best SOA offering in Cape Clear. Yet many application domains require these tools and a whole lot more. If you are a startup looking to be acquired, think about what services your company could add to the Amazon umbrella. What are the things that would spread like wildfire among the couple hundred thousand developers who have accounts on Amazon? Build your solution so it scales well and takes advantage of Amazon’s pricing for communication within their cloud and you could go far. One thing I think is glaringly apparent and needed, for example, is an OpenID service for Amazon. There are many many others. Deconstruct the current On-premises IT ecosystem and see what makes sense for SaaS.
- Applications: If you want a strategic choke point, you want to own a system of record. They’re the blue chip properties in the Enterprise Suites. That’s because everything else gets its data from some system of record or another. Let’s not be totally focused on the past though. The Cloud is ideal for collaboration. How can you combine a system of record domain with serious collaboration to build a new killer category? Worth thinking about.
I think I’ve provided a decent framework for thinking about the SaaS world in terms of where the action is, what makes sense for M&A, and where the opportunities may be. If there’s one thing I’m certain of, it’s that we’re early days on Cloud Computing and there is a lot more opportunity out there than I’ve portrayed in this brief article. There will also be a lot more change, and market segmentation could be viewed along many more dimensions than the one I’ve portrayed here.
Food for thought.
Just noticed Cote refers to the folks at the bottom of my stack as the “Morlocks”. Remember the nasty troglodytes from H.G. Wells the Time Machine? I don’t think the Morlocks are all that likely to eat the “Blond People” who are apparently the SaaS applications, but stranger things have happened!
I just watched the Google App Engine announcement. It places them at the language level, which is a big leap up the stack I’ve drawn in this post. It really raises the stakes for those playing at the lower levels! See my post for more.