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After enduring a brutal six-year malaise following the dot-com implosion, venture capitalists are back on the prowl, investing billions in all types of software companies in the hopes of landing the next VMware.
For the first time in more than a year, software companies garnered more start-up cash than any other industry sector in the second quarter, according to survey findings from the MoneyTree Report issued by PricewaterhouseCoopers and the National Venture Capital Association. Biotechnology investments checked in second at $1.17 billion during the quarter, followed by medical devices and equipment and telecommunications at $995 million and $476 million, respectively.
Before you quit your job to start a software company, however, it's important to understand that the VC environment is far more restrained than it had been during the dot-com boom. In fact, today's renewed enthusiasm among VCs pales in comparison to staggering cash infusions that accompanied the peak of the dot-com frenzy.
While it's true that venture capital firms invested more than $1.5 billion in software companies in the second quarter this year, total venture capital spending in the past year totaled a respectable $27.4 billion -- still about $1 billion less than companies received in the first quarter of 2000 alone.
"We're coming out of an environment where software had been fully funded from about 1990 through 2002," Mark Sherman, general partner at Menlo Park, Calif.-based Battery Ventures, said in an interview with InternetNews.com. "Software companies just continued to be aggressively funded by lots and lots of companies. But that all came to an end when the bubble burst, mainly because there were so many enterprises that suddenly had to rationalize the technology investments they made."
Whether VCs can maintain their present level of moderation will be seen during the next few years. That's because a flurry of innovation in the software industry is expected to transform not just the way companies access and share data, but how venture capitalists evaluate the short- and long-term prospects of companies eager to find their niche in the Web 2.0 landscape.
Sherman said seminal events like VMware's blockbuster initial public offering in August and BladeLogic's promising debut in July may spark VC firms to again loosen their purse strings and spread their investments over a larger number of software and data-management upstarts.
"I think that's one of the reasons [VCs] are so interested in software right now," he said. "There's a lot of liquidity in those deals and that encourages people to start looking for other investments."
Battery Ventures is currently investing in about 10 fledgling software companies, including Bazaarvoice, an SaaS-based social commerce platform, and Applimation, a developer of enterprise data management software.
"We don't really have a fixed number in terms of companies or how much we'll invest in software," Sherman said. "It moves around. We're definitely interested in infrastructure and, personally, I think there will be a bunch of new investments around the concept of data and what you can do with it. Data from places like Salary.com and Payscale.com could be very interesting.
Another key player in the area, Lightspeed Venture Partners, has significant investments in a wide range of software and datacenter management companies. Its portfolio includes Calista Technologies, which develops virtualization software for the desktop; Pivot 3, a storage software provider; and OpTier, which makes systems management software for virtualized datacenters.
"Part of it is just the old technology cycle," Ravi Mhatre, general partner at Menlo Park, Calif.-based Lightspeed Venture Partners, told InternetNews.com. "Many of the key innovations of what we call the first generation of the Web are reaching the end of their lives and getting long of tooth. We're now very much into the second generation of the Web, and software is leading the way."
Ah, but where is the next VMware or BladeLogic to be found?
Not surprisingly, venture capitalists are sticking with a proven formula and focusing most of their attention on software, appliances and platforms that address either data management or the datacenter itself.
Part of the reason those areas are proving so hot is that enterprise software companies like SAP, Oracle, Microsoft and IBM have spent more than two decades giving companies the proprietary software they need to collect and manage their data. And all that data has to be stored and managed somewhere.
Meanwhile, virtualization software is reducing the size and energy demands of corporate datacenters while software-as-a-service (SaaS) (define) and service-oriented architectures (SOA) (define) have emerged as the data-management strategies of the future.
As a result, companies providing the software that give companies flexibility in their IT environments and deliver a nearly immediate return on investment are the ones who are getting the lion's share of VC funding today.
"Large enterprises are looking at all this data and viewing it as a strategic differentiator," Mhatre said. "They need more leading-edge solutions. Because of that, they're more open to doing business with startups that have something new to offer to manage and deploy in their datacenters.
Mhatre said the macroeconomic climate for venture capital is directly impacted by the innovation taking place within the software startup community. Large enterprise customers, he said, also aren't afraid to invest in startups with fresh, well-thought-out ideas.
"If you have the newest technology that allow customers to be more efficient, you'll get investment from the enterprise customers," he said. "More investment breeds more innovation. Innovation breeds more investment from the venture capitalists."
As a result, Mhatre and Sherman both said VMware serves as an indicator of venture investments to come, and as a warning to established software companies: Despite their size and clout, if they don't have something new to offer, you can bet there are startups out there that will.
"VMware pioneered the notion of using software to virtualize a server," Mhatre said. "None of the large technology conglomerates like HP or IBM or Oracle or Sun really have a focused initiative around commercializing virtualization. And you have to ask yourself, 'Why?'"
Established software vendors "need to figure out what's going to give customers that kind of step-function change in their environments and deliver them in a way that's disruptive rather than just incremental," he added.
In the meantime, the third-quarter MoneyTree Report will be released Oct. 22, and there's every reason to believe software will maintain its top ranking.
"Software is a very, very hot space right now," Laura McCaughey, managing director of AMR Research's investment research strategies group, said in an interview with InternetNews.com. "As people try to take their businesses to the next level, they've found that implementing terrific software and processes has a direct correlation to improved profitability."
McCaughey said venture capitalists closed 247 deals with software firms last quarter, the most since 2001.
Of course, today's more restrained investing environment means that few are pegging software investments as a get-rich-quick scheme, compared to the dot-com heyday. Chances are, the next VMware or BladeLogic won't realize an IPO or acquisition until sometime in 2010 at the earliest.
"You have to have a vision," Mhatre said. "The idea is to find a company that can demonstrate where it will be in a three- to five-year timeframe. If they can execute and be dominant, like a VMware, they'll create a huge amount of shareholders and stakeholder value."
This article was first published on InternetNews.com.