Rise from the ashes

SINCE THE TERM ASP (application service provider) went out of style a couple years ago, a lot of HSVs (hosted software vendors) have washed up on the rocks. Some found that large enterprises didn’t want to give up control over their software or take security risks with their data. Others lacked the financial strength to support a slow-build subscription revenue model.

But a phoenix seems to be rising from the ashes of this early wave of hosted software innovation. HSVs appear to be getting traction in categories as diverse as content management (Atomz), CRM (Salesforce.com, Upshot, Salesnet, RightNow), analytics (Digimine, Whitecross, Eloqua), collaboration (Webex, Placeware), and accounting and expense management (NetLedger, Intacct, Outtask, Concur). It’s hard to tell just how healthy these vendors are because so few are public companies, but it’s clear that the hosted software model is picking up steam.

Vertically focused vendors are also emerging, such as OpenAir (professional services), Realpage (property management), Dorado (mortgages), Instill (food service), and Demandtec (retail). In the human resources category, new entrants such as Employease are building on a longtime tradition of outsourced solutions from companies such as ADP, Paychex, and Hewitt Associates. And in security, offerings range from almost completely hosted (McAfee.com) to hybrids of hosted, packaged software and managed services (Guardent).

What’s driving this rebirth? For one thing, big companies such as IBM, Oracle, and SAP are getting behind the hosted model and helping legitimize it. IBM recently announced plans to resell the hosted subscription-based services of a bevy of HSVs. Furthermore, the hosted model offers lower upfront and management costs, frequent upgrades, and a tighter feedback loop with customers.

At a time when enterprises are putting off large purchasing decisions, hosted applications may be cheap, low-risk, and simple enough to deploy that managers will give them a shot as a stopgap while they wait for budgets to loosen. “It’s fast, cheap, and easy,” says Laurie McCabe, an analyst at Boston-based Summit Strategies. “I think that value proposition has just struck a chord with a lot of customers.”

The hosted model also fits well with the increasingly distributed nature of enterprises and the growth of extended enterprise applications (such as e-commerce and procurement). Furthermore, enterprises’ disappointments with packaged software deployment costs and delays are helping them overlook the deficiencies of the emerging hosted model, such as the difficulty of customizing hosted software and integrating it behind firewall systems.

HSVs must justify their ROI constantly (typically via monthly subscription renewals), leading at least in theory to greater responsiveness to customer needs, and more incentives to make sure customers are trained and supported to get the software’s full value. “It brings them closer to their customers,” explains Amy Mizoras, senior analyst at Framingham, Mass.-based IDC. “They maintain daily contact. … There’s a relationship-building aspect.”

Although the future’s looking brighter for HSVs, they still face a heap of challenges. For one, enterprises that poured a lot of money into packaged software may not be in the mood to scrap it and start over, especially with a solution (and pricing model) that may be perceived as new and unproven. “The outsourcing and hosting message really resonates best where a company’s making a new application purchase,” Mizoras says. “[But] a lot of companies are sort of battening down the hatches,” she adds, and they are trying to get more out of the applications they already have.

Furthermore, HSVs have little brand-recognition and must prove their financial viability to skeptical CFOs and Wall Street analysts. “This model is not as exciting to the financial community,” says David Thomas, CEO of Intacct in Los Gatos, Calif. “It takes so much more capital to build this kind of business. … We struggle with investment bankers who don’t really understand the recurring revenue model.”

HSVs must make a big upfront investment in so-called shared “multitenant” infrastructure (hardware, middleware, etc.). But if they can get a critical mass of customers, their profit margins are higher because they’re only supporting one instance of the software.

Another challenge is that most customers are accustomed to owning, rather than renting, software that runs mission-critical parts of their businesses, and they fear being stuck with a pile of useless data if their hosted software provider should go out of business.

Moreover, companies are used to the control they gain from having software inside their firewall, even if it’s more expensive to support. “It’s more comfortable if you can go kick your IT guy, even if there is nothing [he or she] can do about it,” says David Hsieh, vice president of WebEx Services at WebEx Communications in San Jose, Calif.

HSVs also must contend with the fact that it’s easier to integrate software inside the firewall to existing legacy or homegrown systems, and it’s likely to stay that way, despite their attempts to use Web services and XML for integration.

Another obstacle is the looming possibility that larger ISVs will get serious about the hosting business and use their market power to steamroll the early leaders. Most Net-native HSVs doubt this will happen. “It’s really a fundamental architectural decision to be multitenant,” says San Francisco-based Salesforce.com CTO Dave Moellenhoff. “They would really be faced with a [from-the-]ground-up rewrite.”

Can hosted software continue to grow in the face of all these challenges? “The key is to pick a specific function and know that function very well,” IDC’s Mizoras says. “If [you’re] targeting a particular function or vertical, it’s much easier to develop [software] that needs less customization. … The vertical focus really has potential.”

Some vendors, such as Intacct, are also pursuing a channel strategy, using the Web to privately label their hosted service for distribution partners (in this case, CPA firms) and aggregating upstream services on a single sign-on basis from best-of-breed service providers. “This is not a business where you can go it alone,” says Intacct’s Thomas.

IDC’s Mizoras predicts that these and other approaches, plus low management costs, will eventually make hosted software a big business. “At some point, there will be a tipping point. … This is the direction the software industry is moving in; the question is how fast?”