Divine Inc now down and out

Now that it has run out of cash and seems set to be broken up at the behest of its creditors, at least the arguments about Divine can finally stop. Was the brainchild of Silicon Valley mogul Andrew ‘Flip’ Filipowski a software company, a web incubator, a venture capital firm or a plain old bottom-feeder? Ultimately, not even Divine seemed to know.

The company burned through more than $1 billion during a buying spree that at its peak included 40 acquisitions in 24 hectic months. It bought some admired technology along the way, including Content Server, a mature web content management product, but it was never properly integrated. Some units are now preparing to do legal battle with the parent, while angry creditors vow to block any ‘sweetheart’ deals between insiders.

It is an inglorious, if predictable, end to a grandiose vision. But it is not only Divine’s investors who will suffer. Customers also have much to fear from the shakeout, not least over future levels of product development and support. In fact, many customers are being advised to hire the company’s departing employees.

If this kind of advice becomes popular, then IT departments are about to get a whole lot bigger.

For it is now becoming clear that the turmoil in the IT industry of the last two years or so has been more than a mere blip or a temporary correction.

Insurance policy

If there is one sector that booms when IT busts, it’s escrow services – the insurance policy for worried IT directors.

The idea of escrow is taken from a French verb that means to securely deposit something with a trusted third party. It was first applied to the software market in 1981 by NCC Group, says Rob Cotton, the company’s managing director of escrow services. Under the escrow model, a software supplier would meet with its customer and an escrow ‘agent’ (NCC) to draw up a three-way agreement that specifies how the source code will be stored by the agent and under what circumstances it will be released to the customer.

Cotton says that NCC Group, which claims to be the biggest escrow agent in the UK, has seen a sharp increase in demand as consolidation in the IT industry gathers pace. Last year, he says, the company released source code to licensees on a “record” number of occasions. He would not disclose the precise number, but it was in the hundreds and represented an increase of 180% on the previous year.

Under NCC Group’s charging model, licensees are charged an annual fee of between £485 and £590, depending on the nature of the agreement. The supplier pays a one-off fee of £735 and sends a readable disk of the application to the escrow agent, which stores the code in a high-security facility. Other agents use different charging methods, sometimes charging an annual fee of about 1% of the value of the software licence.

Although the fees to the supplier and licensee may not seem particularly steep, many companies prefer the alternative to escrow: cross fingers and hope. A hard core of small and medium-sized enterprises either do not bother with escrow or wrongly assume its provision is included in all software licensing agreements. Even many large enterprises do not have escrow arrangements covering all their business applications. The shakeout may be permanent. One view that is gaining popularity among IT industry veterans as well as many analysts and commentators, is that large sections of the technology industry have matured and that the consolidation that has taken place so far is a mere foretaste of things to come. Hundreds, if not thousands, of IT suppliers look set to be acquired or disappear altogether.

That growing realisation is forcing IT directors to face up to the unthinkable: will one of their key suppliers be next? Many are starting to draw up contingency plans as they seek to diminish the possible damage to their own businesses.

It is not all bad. As a result of the downturn, many buyers have regained negotiating control and IT directors have found, to their satisfaction, that IT consultants are slashing their rates. But while all this is going on, suppliers’ credit ratings are being cut and profit warnings – and accounting scandals – are becoming commonplace. Struggling suppliers are discounting heavily. Customer finance deals are becoming more creative. Spending on research and development (R&D) is being scaled back, slowing the rate of innovation. And there has been a sharp increase in demand for software escrow services.

Hard numbers are emerging too. From Scotland to Massachusetts, tens of thousands of jobs are going at former IT manufacturing centres. Unemployment in Santa Clara county – the heart of Silicon Valley – has risen to 20%, only slightly better than California’s jobless rate became during the Great Depression.

The stock market as a source of funds is dead, at least for now. Frankfurt’s new economy index, the Neuer Markt, is closing, and January 2003 was the first flotation-free month since the bear market of 1974. More than 800 companies were delisted from the technology-laced Nasdaq Stock Market between 2000 and 2002. And of the 204 Silicon Valley companies that were taken public between 1998 and 2001, 82 were described by a San Jose Mercury News report recently as either ‘dead’ or in ‘dire straits’.

The gloom extends to privately run start-ups. Venture capital (VC) tracker VentureOne says that 15% of the roughly 4,000 technology companies that started up between 1999 and 2001 had gone bust by the middle of 2002 – a proportion that seems set to rise, since more than a quarter of the survivors have not gained additional equity funding for more than a year. In addition, private equity investments in European software companies fell by a third to ‘only’ EU1.3 billion (£880m) in 2002, according to Windmill Reports, a VC deal tracker. Most of those were later-stage investments, rather than seed or first-round funding deals.

All this means that customer choice is decreasing. There are simply not enough start-ups coming through to replace the failures, significantly reducing the total number of companies in the IT industry.

But the shakeout is not just affecting start-ups and smaller public companies. By the end of 2004, says Gartner, the IT analyst, at least 50% of the most-recognised IT companies in the world will merge, reposition or disappear altogether.

There will be more merger activity, as strong companies pick up technologies and new client bases relatively cheaply. No fewer than 1,087 VC-based Internet companies were acquired during 2002

How a struggling company keeps its clients

When System Software Associates (SSA) filed for bankruptcy protection in March 2000, there seemed little to suggest that the IT bubble was about to burst. Yes, there was a hardcore of doomsayers who had consistently been predicting the industry’s imminent downfall, but IT failures were still rare, as demonstrated by this contemporary analysis of SSA’s troubles on the CNET news service: “Yes, it’s true, even high technology companies go belly up once in a while,” wrote the surprised columnist.

Well, such cases are not unusual anymore. What is still rare, however, is for an IT company to go ‘belly up’ and then emerge from bankruptcy protection in sound financial health and with a loyal base of customers. System Software, which became SSA Global Technologies during Chapter 11 restructuring in the US, managed precisely that.

One thing that helped SSA hold on to so many of its customers, according to Graeme Cooksley, SSA’s executive vice president, was the fact that it sells enterprise resource planning (ERP) software. Customers of ERP vendors simply do not keep buying more and more software: it is a once-in-a-decade, or even a once-in-a-lifetime, investment. Many clients of SSA cut back on short-term maintenance contracts, but generally they did not see the need to tear up long-term licensing agreements and talk to SAP, say, during the five-month period when SSA was in Chapter 11. “Customers did not leave in droves, because they didn’t need to,” he says. “We spoke to our large customers and asked them what they wanted from us. They told us they wanted financial viability, product direction and growth. We set out to give them that.”

Another factor behind SSA’s success was the now private company’s willingness to open up its financial accounts to existing and prospective customers. Sales people were happy about sharing financial information with clients because cost-cutting measures and strong backing from investors had quickly begun to solve some of the company’s underlying problems.

As a global software company, SSA also had to convince its customers that the Chapter 11 process only affected the US side of the business. Cooksley, who was president of the company’s Asia/Pacific unit at the time, admits this was no easy task. “We certainly had a very difficult time convincing our customers in the region that we were not in Chapter 11 but that our parent was.” As more examples emerge of global technology companies filing for bankruptcy protection in the US, it is a case that will have to be made to worried customers time and again.

But the main lesson to be learnt from the SSA story is this: no matter how far a supplier falls, its demise is not certain until the moment that it files for liquidation. Although Cooksley is reluctant to admit it, it seems certain that many customers of SSA went to the trouble and expense of switching ERP supplier. They may have come to rue their decision, while those that ignored the ‘red flags’ may have been the lucky ones. It is a lesson that will be reassuring to some IT directors and worrying to many others.

SSA Global Technologies

Early 1996: Stock hits peak of $120 a share

August 1999: Losses of $89m on sales of $316m in fiscal 1999, missing sales target by distance

March 2000: Files for bankruptcy protection

August 2000: Emerges from bankruptcy protection, sales slump but many customers stay loyal

April 2002: Acquires some products from Computer Associates, fuelling growth

August 2002: Revenue in fiscal 2002 up 39% to $187m

October 2002: Acquires Infinium Software

November 2002: Projects fiscal 2003 revenue up 50% to $281m

January 2003: Publishes wish list of acquisitions


many in some form of financial distress, according to Webmergers research. And, in a strangely symbolic sign of the times, SSA Global Technologies, an enterprise resource planning software company that is on much sounder financial ground since it emerged from bankruptcy protection proceedings in 2001 (see box), has taken the unusual step of publishing on its corporate web site a shopping list of the types of companies it wants to buy. “We are getting calls daily, but we will not rush in, we will take our time,” says the company’s executive vice president, Graeme Cooksley.

Partnerships, too, are becoming more common. Gartner talks about the creation of ‘business service value chains’ – consortia of IT suppliers and service providers that will pool R&D and marketing resources and bid jointly for private-sector projects. If Gartner is correct, there will be substantial changes in the traditional supplier/customer relationship.

Meanwhile, some investment companies are taking advantage, buying up failing technology companies and raising product prices while reducing the workforce, selling non-core assets and cutting back on R&D. For customers, especially those with long-term contracts, this spells danger. The investment companies’ view: without us, the products would have disappeared completely.


While consolidation in the IT industry is hardly a new phenomenon, commentators say the current shakeout is on an unprecedented scale. This is shown by Infoconomy’s global IT index. In January 2003, the industry was 24% smaller than in January 2001, representing a real loss of revenue for the top 200 companies of some $40 billion. The silver lining: Infoconomy’s figures show a small upturn since the low point of June 2002.

But the industry is still structured as if a rapid recovery is expected. While cuts have been made, overcapacity is still widespread. Ask 10 high-tech executives when they expect things to improve, and the odds are that nine will say ‘the next quarter’.

That optimism is not completely unfounded. Following past difficulties, Silicon Valley, and the technology industry at large, has always embraced new innovation and come back stronger. As military spending slowed in the early 1970s, for example, the semiconductor industry took off; as Japanese competition threatened US chip makers in the 1980s, the industry shifted to microprocessors and personal computers; and as the PC became a commodity in the 1990s, the Internet provided new growth.

But things will be different this time, says Richard Holway, director of IT analyst Ovum Holway. The IT industry has now reached a mature phase, he says, bringing it in line with other established sectors of the economy.

That view is supported by one simple truth: customers have bought too much IT in the last few years. So-called ‘shelf ware’ is endemic, says SSA’s Cooksley. Indeed, technology capacity utilisation in the US was just 60% in the middle of 2002 – its lowest ever figure, according to data supplied by the US Federal Reserve Board and investment bank Merrill Lynch.

On the two previous occasions when utilisation dropped below 70%, the fall was triggered by deep industrial and consumer recessions. This time, excess technology capacity is not just a result of falling economic activity, but is itself a key driver of the recession. Today, large portions of IT budgets are being spent on the kind of IT consolidation projects that seem unlikely to drive new growth cycles. And ‘Y3K’ is almost a thousand years away.

Yet Holway’s argument has one important flaw: it treats the global IT industry as a single entity, rather than a highly fragmented series of sectors. It has been true that, for several years, only a handful of companies have been able to compete in the markets for personal computers and enterprise resource planning software, for example. Yet the security and storage software markets are not yet halfway through the cycle of growth and consolidation and IP networking and web services technologies are still at the early-adopter stage. But Holway and his supporters are probably correct in one key respect: there will never be another industry-wide boom.

Even if things improve to the point where overall IT industry growth is maintained at levels of, say, 4%-5% a year, there will almost certainly be too many companies chasing too little money. In the middle of 2002, with consolidation already underway, there were still twice as many technology companies in operation as in 1995, according to Merrill Lynch. Something had to give.

Waving or drowning?

But understanding the concepts of overcapacity and boom-and-bust economics is one thing; the real trick for IT directors will be identifying the survivors.

There are a number of indicators, or ‘red flags’ in corporate-speak, that IT directors should look out for.

Danger signals: How to spot when a company may be heading for death row

  • Abrupt turnover of senior executives without convincing explanations of why people are leaving
  • Cash-out moves by senior management
  • Restatements of earnings
  • Regulatory/SEC inquiries
  • Regulatory warnings for aggressive accounting
  • Reductions in shareholder equity
  • Special and complex partnerships and financial instruments
  • Elaborate compensation and stock option plans

  • Missed earnings

  • Complex regulatory filings
  • Sudden downgrades in credit/bond ratings
  • Withdrawal by hedge funds

Source: How companies lie, by Larry Elliot and Richard Schroth (2002)

Protecting IT investments

Some advisers talk about the importance of conducting ‘permanent’ due diligence on suppliers, the suppliers’ investors, and even the suppliers’ suppliers. It is unclear how practical or realistic that would be. But doing nothing and hoping for the best is no alternative.

Every customer will be affected in some way. By the end of the decade, say some analysts, there will be only one or two PC vendors, five or six software suppliers and a handful of data services providers. Many analysts maintain that there will be room for niche entrants, or ’boutique’ suppliers, but only if VCs and stock market investors show uncharacteristic patience. Others say that the developer community will continue to cultivate ideas. But all agree on one thing: that the technology industry will look a lot different than it does today.

So who will be the survivors? Bruce Richardson, a senior vice president of AMR Research, the IT analyst company, says there might be only three major software suppliers by 2010, which he identifies, rather mischievously, as ‘IBM’s Oracle division, SAPsoft and the SiebelPeople’. Chuck Phillips, Morgan Stanley’s star enterprise software analyst, says that power is already concentrated in the hands of a few companies: almost half the total revenue from the software industry is generated by just five companies – Microsoft, Oracle, SAP, Computer Associates and PeopleSoft – and one, Microsoft, is worth about 20% of the entire market. It is a concentration of power that seems certain to increase.

Unsurprisingly, many of the world’s great IT companies have sought to capitalise. Bill McDermott, president and CEO of SAP’s US division and a former president of Gartner, says: “Customers want trusted partners with longer track records, sound finances that ensure R&D investment and longevity, broader functionality and the efficiency and confidence that comes with a long-term relationship.” And Larry Ellison, CEO of Oracle, went further in a speech to the database software company’s user conference late last year: “Who will be the last companies standing?” he mused. “An awful lot of smaller companies, like the Aribas, and even some of the larger ones, like i2, are never going to come back. And instead, customers are going to consolidate their spending around companies like Microsoft and Oracle and probably IBM and SAP. And those should be the four big winners of this consolidation.”

Whether it’s with Microsoft or ‘SAPsoft’, however, customers clearly expect to be dealing with far fewer suppliers in the future. A recent Gartner survey found that 42% of companies already planned to consolidate their shortlist of potential IT suppliers. Morgan Stanley’s Phillips has seen it too: “Organisations are trimming their supplier lists,” he says.

But which companies stay on the shortlist? That is the $64,000 question. Ultimately, all that IT directors and their colleagues can do is be vigilant and, if necessary, renegotiate licensing deals and draw up escrow arrangements. By the time their supplier disappears – and all UK companies will be affected by the consolidation in some way – the news must not come as a surprise. If it does, the CEO will want to know why.

Looking ahead, the fact there will be less competition in the next generation of the IT industry implies a greater likelihood that technologies will come along at a slower rate and will cost more than before. But, particularly after the boom-and-bust turmoil of the last five years, some IT directors may be prepared to sacrifice rapid innovation and greater choice if it means there will be more stability and visibility in future.

In any case, any trend towards higher prices may be offset by the fact that the troubles facing the IT industry have made suppliers as weak today as perhaps they have ever been. Suppliers will eventually regain some semblance of negotiating power from their customers, but this may not happen for several years. By then, the IT industry will be unrecognisable from 1999, and customers might just be calling the shots.

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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