Thursday, November 03, 2005

Look before you leap, but look in the right place

How should customers go about "due diligence" prior to buying software? Certainly enterprise software is a major, multi-year commitment, and the overall costs of it will be many times the actual purchase price, so it is worth looking carefully before you leap. However many companies seem to look in the wrong place.

Firstly there is an assumption that if you buy software from an industry behemoth, then this is "safe", whereas buying from a smaller vendor is inherently more dangerous. This is not necessarily the case. While the actual finances of an industry giant are rarely in doubt, the question to ask is not the the size of the balance sheet, but how committed are they to this particular product? When I was working at Exxon in the 1980s we discovered that the "strategic" 4GL called ADF that IBM sold was to be dropped in favor of another tool they had built called CSP. The fact that we were a big oil company and they were ultra-safe IBM did not help us one bit. Migration? We could hire their consultants to help us rewrite all the applicatons: thanks a lot. Or consider all the technologies that Oracle has acquired over the years and quietly dropped when theyfailed to perform. When looking at products from large vendors I believe the key to risk assessment is to see how far the vendor is straying from its core competence. For example, Oracle is hardly likely to abandon its core database product, which still accounts for a huge share of its profits, but just how committed will it be to something a long way from this core area of its expertise? SAP has come to dominate the ERP space, but its execution on products away from its core competence has been shaky, to say the least. The most recent example was its dropping its MDM offering after two years, now promising a new product based around an acquisition. Cold comfort to those loyal customers who pioneered SAP MDM thinking that it was the "safe" choice. Vendors tend to misfire the further they stray from their core area of business, and customers should factor this into their risk assessment.

Assuming the software you are interested in is not from an industry giant, then how do you assess the risks then? Small software vendors always dread the following sentence: "We like your software but we will need to bring in our financial due diligence team before we go any further". This is partly because large corporations frequently lack experience in understanding how software companies are financed, and end up asking the wrong questions. Financial analysts used to dealing with large, stable public companies are often surprised at how small, and how apparently shaky, the balance sheets of privately held software companies are. This is partly because most are venture funded, and venture capital firms are careful to dole out their capital as their portfolio companies need it, rather than investing cash just to bolster company balance sheets.

Before looking at the right questions to ask, here is a true story to illustrate the wrong way. When working at Shell I was asked to look at a small company called Dodge Software (the name in itself did not inspire confidence), a general ledger vendor with some innovative technology that a subsidiary of Shell had already purchased. Before making a deeper commitment it was decided that due diligence should be done, so I was teamed up with a banking type with a very posh accent to look at the company. The company was very reluctant to share its accounts, but as it wanted the business it had little choice. There was a clear problem in terms of cash, with the company having less than six months of cash left at the rate it was burning. The finance analyst called the companies VCs, who hardly surprisingly sang its praises and its rosy future - well, what else were they going to do? The banker then met with the company CFO, who assured him that everything was fine and that further funds could be raised as needed. This actually comforted the banker, but not me, because I could see that, while the company had built up 16 customers with good names, there was no momentum: there were few recent customer names. This meant that the company in fact was stalling, and so would very likely struggle to raise another round of capital. Even if it did, why would the market situation improve for this company? It was pig-headedly selling a best-of-breed general ledger package at a time when broad integrated finance packages were all the rage, and it seemed unlikely to change this mind set. Consequently I wrote a negative assessment and the banker a guarded but positive one. The company duly folded about six months later, unable to raise new money.

The key here is not to focus entirely on the cash position of the vendor. If the company is growing fast and acquiring prestigious customers at a steady clip then it will very likely be able to raise more cash when it needs it. However there is a saying in venture capital: "raise money when you don't need it, because it is hard when you do need it". When things are going well then VCs flock around, but when they are problems then they stay away on droves.

The message is that there are certainly risks in buying software, but a risk assessment should be carried out even if buying from the largest vendors. For smaller vendors their market momentum is critical, and needs to be assessed just as much as their cash reserves.

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