When IBM Chairman and CEO Sam Palmisano touts his ‘On Demand’ strategy, HP’s Chairman and CEO Carly Fiorina hits back, “Our competitive solution to on demand is utility computing. Utility computing is one piece of the Adaptive Enterprise.” On demand, adaptive enterprise, utility computing and the other terms like, real-time enterprise, grid computing and Organic IT is making rounds in the marketplace.

Whatever the jargon, computing as a true utility will radically change the way IT services are delivered to business. Over the last few years, software vendors are seeing erosion of revenues because of competition. At the same time enterprise customers are demanding applications that are cheaper, less complex, and easier to install. Hence software vendors are looking at new ways to penetrate new markets and grow their customer base.

The venture capitalists’ community is cautiously watching the developments in this space. Some VCs see products delivered as utility as a long-term vision for computing. However, there are many VCs who read this whole phenomenon as just the return of the old ASP model.

Shape of Things to Come
In 2001, many VCs who were skeptical about the ASP model were ‘predicting’ that ASPs wouldn’t be around. However, quite a few VCs believed in the model and continued to invest. Today they are celebrating. For others who hadn’t invested, it is a lost opportunity. Any new startup in this space may struggle to attract funding because venture capitalist believe that it is too late for a startup to experiment with the new model. “To start a hosted business is an expensive and cash consuming proposition,” says Ted Schlein, Partner, Kleiner Perkins Caufield & Byers. From an implementation perspective, the On Demand model may require more upfront infrastructure investment or new distribution partners that can alter the typical operating expense structure.

In fact Schlein hasn’t seen any new business plan in this area for the last three years. “I don’t see any major investment initiative by the VCs. Most of the investments happened in 1999 and 2000 when there was a lot of capital available,” he says.

Deobrah Magid, director of strategic alliances at IBM’s Software Group has a different viewpoint. “On Demand is already hot. It is clear to me from my conversations with VCs here in the U.S and Europe that many VCs are active in this space.” She does not deny that a few VCs out there are skeptical. “The skepticism is mainly because it is hard for them to pin down what is on-demand and what is not,” explain Magid who oversees Venture Capital Relations by strengthening ties with VC firms and their portfolio companies to cultivate a pipeline of new technologies and partners.

Switching to On Demand
It takes longer to profitability with an On Demand model. “Because companies defer the revenue instead of getting it all up front, it takes time to be profitable. Once you are profitable, you will have money pouring in from past subscriptions on a monthly basis,” says Schlein.

Unlike in the traditional model where software is sold for an upfront license fee, in an On Demand model vendors sign contracts on a subscription basis. The two business models are entirely different. Any company trying to build a hybrid model will be like mixing oil and water. “Traditional companies will continue to sell traditional license software. I don’t think any investor can take a traditional software company and make it on demand. The expense model makes it prohibitive,” observes Schlein.

His observation stems from the fact that many traditional software vendors who attempted to try their hand in the On Demand pool burnt their fingers to varying degrees. Companies like Oracle, PeopleSoft, SAP and Siebel have all tested the waters, and met with little success. This has made the investor community more cautious. The changes to the software business model could have deep consequences; the financials will look entirely different. As a result, normal valuation metrics such as price-to-earnings and price-to-sales may not be appropriate. One has to take a close look at deferred revenue. It so happens that operating expenses-to-total bookings may prove to be better methods of evaluating the underlying operations of businesses built around the On Demand model. Siebel failed in its first attempt but yet continued to seriously invest in the on demand market. Siebel’s acquisition of UpShot, a company specialized in delivering hosted CRM service over the Internet, along with IPO filings by Rightnow, Salesforce.com and a renewed focus on an ‘on demand’ strategy by Oracle and PeopleSoft have made the VC community to take a second look at this space.

In futurity, two trends—a strong buyers’ market and the push to On Demand computing—will significantly alter the On Demand landscape. VCs who have invested in this space will closely monitor the developments to cash in on a good exit opportunity. A large number of VCs who have invested in traditional software firms do not believe that the On Demand wave will threaten the existing model.

Segments where On Demand works
Schlien does not believe that the entire software industry is moving towards the on demand model. “There is a limited subset of software applications that customers will purchase on a subscription basis,” explains Schlein. Business processes that aren’t mission critical like pay roll management are most likely to move toward the On Demand model. Companies like USi, Corio, Ketera that are delivering non-core business applications in an ‘on demand’ model continue to find success today. “Applications like supply chain management, which are critical to the business, will remain to be sold on a licensed model. The list of applications that will be delivered in a traditional model is longer than those that can be delivered ‘on demand’ way,” he says. Technology to deliver application in the ‘on demand’ way is already there. But many companies are still hesitant to run mission critical applications in a hosted or in an on demand manner. Only when there are some success stories to read about will enterprise adoption gain momentum. Although the first wave of “on-demand” was application-focused, recent attention has centered on infrastructure delivered as a “utility.” Schlein says that companies that offer enterprise infrastructure solutions as ‘pay as you use’ basis are more likely to succeed in this space.