In the OnStartups blog is a very perceptive piece on the state of the enterprise software market.  The post Y2k dotcom bust has had some deep effects on the industry.  In a backlash against the vendor bull market of the late 1990s large companies reined in IT budgets and revised their procurement processes.  Deals that previously would have needed one signature now need five, or eight.  Buyers have become ultra-conservative, falling back on the giant vendors to the exclusion of purchasing from smaller companies. This can be seen in the margins of Microsoft (25%) and Oracle (24% net margin) compared to everyone else.  Most other enterprise software companies, even the successful ones, have operating margins in the teens.  The five year average net margin of public application software software companies is 13.6%.  Even a company like Business Objects has a five year net margin of just 7%.

Venture capital firms, seeing this, have moved on to funding “Web 2.0″ ventures, which typically require a lot less capital (Flickr reputedly needed around USD 200k in capital to get going).  Why bother funding companies which need millions in R&D and expensive enterprise sales forces when you might find the next Myspace for a bargain?

This is unhealthy, and not just for small enterprise software companies.  As I have written before, innovation rarely comes from industry behemoths, so by creating an environment where companies are buying only from “safe” companies they are in fact damaging the ecosystem which will bring them their next new and exciting software application.  By sticking to the giant software vendors CIOs are creating an environment where smaller companies struggle, which causes VCs to invest less, which means that fewer and fewer enterprise software companies get started at all.  This in turn allows the giant vendors to charge whatever they want in upgrades (witness those margins) as they now lack serious competition.  Cartels are never a healthy thing for customers, and yet in this case the customers are bringing it on themselves by creating the conditions for a cartel to effectively exist.