• Chart: How Microsoft Defines the SMB Market
• Sidebar: Competitors Aiming at SMBs

Widespread adoption of information technology by enterprises has fueled IT vendor growth for the last decade. But slowing economies, greater reliance on outsourcing, and market saturation have slowed enterprise spending. In an effort to keep their business growing, enterprise vendors are eyeing small and mid-size businesses (SMBs), a market segment in which they are increasingly likely to collide with Microsoft products and services. The trend is forcing Microsoft to maintain or even reduce prices, ramp up partner programs to ensure that enterprise vendors don’t poach Microsoft partners, and reorganize its sales team to focus on this newly competitive market.

The Market Opportunity

How big is the SMB market opportunity? Depending on how one defines SMBs and how one defines technology spending, the numbers range from merely large to colossal. For enterprise vendors like IBM, which defines a "mid-size" business as having less than US$1 billion in sales, the market for technology among SMBs is more than US$300 billion annually. Microsoft’s more granular definition of the SMB market (shown in the chart "How Microsoft Defines the SMB Market") is limited to companies with less than US$50 million in annual sales, and puts the financial opportunity at about US$30 billion a year.

Enterprise vendors are taking unprecedented interest in the midmarket because their traditional large customers are no longer spending like they did on technology, and the enterprise market for technology is believed to be relatively saturated. The SMB market, which did not even begin substantial investments in technologies until the 1980s, lagged behind and as a result is still fertile territory for new computer technology. IBM research forecasts that SMB spending over the next few years will increase 20% faster than that of Fortune 500 companies.

The consequence: Microsoft and its partners have steadily advanced upmarket, applying inexpensive Intel hardware and commodity software to meet business requirements that formerly required Unix and mainframe systems. Meanwhile, enterprise vendors have moved downmarket, applying their integration and enterprise software experience (along with that same Intel hardware) to mid-size businesses and to creating hosted solutions that run in large data centers but that are accessible and affordable for small companies. These two trends collide in the midmarket.

Both the market opportunity and the new competition are likely to have a significant impact on Microsoft. According to Orlando Ayala, who heads Microsoft’s Small and Midmarket Solutions & Partner Group (SMS&P), the SMB segment accounts for about half of Microsoft’s overall revenue. Thus, while Microsoft is well-positioned to benefit from any growth in SMB spending, new competition from enterprise vendors could have a substantial impact on its revenues and competitive position.

Characteristics of the SMB Market

The promise of the midmarket will be only a gleam in an analyst’s eye, however, if IT vendors don’t adapt to the characteristics of the SMB customer.

These customers are very different from traditional enterprise customers in many ways, and are often different from each other: many midmarket companies have IT requirements similar to those of large enterprises, while other companies of the same size may be several generations of IT behind. Even Microsoft, though strong on the small-business desktop, has sometimes had difficulty adapting its products and marketing to the requirements of this disparate group of businesses. Several factors distinguish SMB customers from the enterprise market.

Lack of IT expertise. Small businesses typically have no dedicated IT staff; even midmarket firms typically employ IT staff to run only their existing systems, and often lack the resources to tackle new IT initiatives. Many SMBs rely heavily on either internal staff who are not dedicated full-time to IT or consultants whose expertise is limited to setting up financial systems and general-purpose networking and desktop management.

Price sensitivity. The cost of new IT systems in smaller businesses literally comes out of the pocket of the business owner. As the proprietor or sole shareholder of the business, the owner’s income correlates closely to the company’s bottom line, and IT purchases have both a personal and business impact.

High sales costs. Vendors who want to sell more advanced systems, such as customer relationship management (CRM) or supply chain management (SCM) software, to SMBs must play a larger role in educating customers, such as providing a business case; enterprise customers, on the other hand, can often develop business cases internally. Without the resources to test new projects in a preproduction setting, small business customers may also need more assurance that their existing business will not be harmed by unforeseen integration, migration, or training costs. This dramatically increases the vendor’s costs for a sale that may be only marginally profitable to begin with.

Focus on ownership costs. Small and midmarket firms are rarely impressed by benchmark wins or compliance with international standards. These firms might work with only a few other vendors, and as long as those relationships are functional, they are likely to show little interest in platform or standards battles (such as Linux vs. Windows or C# vs. Java), or in keeping up with technology that has only indirect relevance to their core business. Instead, smaller businesses care mostly about how well their systems work and how costly they are to manage: if the company needs to hire one person to manage and troubleshoot the system, the deal can fall through. Scalability is also an important issue for small businesses with growth ambitions, as growth can be stymied by an expensive and time-consuming migration from low-end systems that no longer meet the company’s needs.

Late adopters of technology. SMBs are champions of the "good enough" attitude toward technology, an attitude that Microsoft CEO Steve Ballmer has identified as one of Microsoft’s greatest challenges. Windows 98 and even Windows 95 running Office 97 may serve an SMB’s immediate requirements adequately, making spending on upgrades unnecessary. SMBs are less likely to be involved in volume licensing programs or to purchase Software Assurance (SA) upgrade rights with their software because they don’t upgrade frequently enough to justify the cost. The advanced collaborative capabilities that mark the Office 2003 System are of less interest to companies with all or most of their employees working at one site.

Overestimating the Market?

In sum, vendors and analysts focusing on the SMB market may be overenthusiastic about this purported mother lode of IT spending, while ignoring caveats about its special requirements.

Sales techniques that work well in the enterprise—a direct sales force that communicates with corporate IT decision makers—bear too much overhead to be cost-effective in the SMB market. While SMBs may spend a relatively high proportion of their budgets on software licenses, and less on consulting and integration, companies dependent on licensing revenue—Microsoft, for example—cannot expect SMBs to upgrade licenses routinely. Piracy, particularly of older OS and productivity applications that are not affected by new product activation technology, is more common among small businesses, where antipiracy campaigns may be less convincing and more costly for vendors to implement and enforce.

Blurring of market segment boundaries could also confuse vendors and partners, leading them to focus development and sales initiatives on the wrong market, or to overlap with products aimed squarely at the enterprise market. For instance, some of Microsoft's SMB initiatives are aimed at the upper end of that market, sometimes known, somewhat incongruously, as the "small enterprise." Ayala, discussing Microsoft’s efforts in the market for enterprise resource planning (ERP) software, told a German interviewer that Microsoft’s does not plan to compete against enterprise ERP vendors, but will focus on smaller firms with between 2,000 and 8,000 employees. But those numbers do not describe the SMB marketplace—aside from being off Microsoft’s own SMB chart, they are characteristic of some Fortune 500 companies with sales in excess of US$3 billion, exceeding even IBM’s definition of a midmarket business.

Microsoft Advantages and Challenges

Going into this contest, Microsoft has several significant advantages, but also some weaknesses in its product line and services that could be exploited by competitors. (For a list of key competitors and their efforts in the SMB market, see the sidebar "Competitors Aiming at SMBs".)

Microsoft Strengths

Microsoft’s major strengths are its brand recognition among consumers and small business, pricing and licensing oriented to small companies, a broad product line, financial strength, a large and successful partner program, and organizational readiness.

Brand recognition. Most small business owners and employees already use Microsoft’s software on their home computers, which gives the company immediate recognition in the small business desktop market and reduces training costs for customers who use its software at work. Enterprise competitors, on the other hand, are viewed as specialists in products that are too powerful, expensive, and complicated for small business computing—when these companies are recognized at all.

Pricing and licensing. Because it has grown its customer base from the bottom up, Microsoft has traditionally enjoyed a substantial volume and price advantage over enterprise competitors, even as its products have begun to scale to the point where they can meet enterprise requirements. Although IBM and Oracle are the leaders in the important business database market, for example, most of their revenue comes from enterprise customers. Microsoft's server application market share, in contrast, is focused largely in the SMB segment, where the company’s SQL Server database dominates.

Microsoft’s licensing programs are also keyed to small business requirements: even firms at the bottom of Microsoft’s SMB taxonomy, the "lower small business" segment, with one to ten employees and software budgets below US$1,000 a year, can benefit from participation in volume licensing programs.

Broad product line. No competitor has a product line as broadly suited to SMBs as Microsoft’s. Many small firms can (and do) build computer systems that rely on Microsoft products for about 95% of their work. Aside from its dominance in the desktop OSs and applications, the company’s file and print networking, e-mail, Web-authoring, and Web site solutions are popular with small firms because of their ease of use and low prices. With the release of Small Business Server (SBS) 2003 at a base price of US$599, which includes a copy of Windows Server, a copy of Exchange, and other services, such as systems management tools and a collaboration portal, the company has staked a claim at the low end of the business market that will be hard to budge, even for low-cost competitors such as Linux.

SBS can also serve as the foundation for Microsoft Business Solutions products, which offer financial, inventory, human resources, and other applications, and SBS has features that are best accessed with recent versions of Office, such as the Small Business Edition. Firms that grow out of SBS can move with relative ease to the full Windows Server environment and more advanced versions of Exchange and SQL Server.

Even as Microsoft expands its own SMB product line, the company is laying the foundation for other software vendors to build Microsoft-compatible software. For example, the Microsoft Business Framework will provide low-level functions useful in many types of business applications (such as standard ways to record transactions). Other vendors will then be able to use this Framework when building their own applications.

Financial strength. Microsoft’s solid balance sheet allows the company to offer financial incentives that can attract small business customers. SBS pricing is remarkably aggressive—it will be cheaper for most small companies to purchase SBS, which includes both Windows Server and Exchange, than to purchase Windows Server by itself. Microsoft’s Total Solution Financing program aids companies in the purchase of Microsoft Business Solutions products and covers hardware purchases, implementation costs, and licenses for associated products, such as Office. Available for purchases of as little as US$10,000, this and similar programs smooth the way for small IT investments that traditional lenders are often reluctant to support.

Partner program. Microsoft’s 750,000 partners are a critical element in its SMB campaign: the SMB market contains so many small companies that vendors cannot profitably use a direct sales force to reach it, and in many cases, SMB software sales are only profitable when they are part of an ongoing relationship that includes revenue from troubleshooting, maintenance, and integration services.

In 2003, Microsoft boosted spending on its partner program by 50%, from US$1 billion to US$1.5 billion, and that spending level is likely to continue in the future. In 2003, Microsoft began offering its first financial incentives for partners who influence SMB volume licensing purchases. The company’s new partner program in 2004 has many features aimed particularly at the needs of small partners who are most likely to be selling to small businesses.

In addition, partner satisfaction is now a significant factor in the bonuses and incentives that Microsoft’s sales force receives, which encourages them to include partners in their own sales efforts.

The result is one of the strongest partner programs in the industry, giving the company the front-line troops it needs to get the attention—and dollars—of SMBs.

Organizational readiness. In 2003, Microsoft announced a major change to its sales organization. Ayala, previously the head of Microsoft’s worldwide sales organization, was named head of the SMS&P unit, which focuses specifically on the SMB market. Reflecting Microsoft’s understanding of the SMB market, the company has divided its focus into a unit focused on small businesses (headed by Steve Guggenheimer) and another focused on the midmarket (headed by Lindsay Sparks).

The SMS&P change echoes throughout Microsoft’s sales organization: Microsoft subsidiaries around the world, and even regional offices within the United States, now have SMS&P units that focus on selling to small and mid-size businesses in their regions, while the SMS&P business unit focuses on companywide sales strategies.

Although many SMS&P staff are doing much the same jobs that they did before—dealing with regional partners, channels, and companies—the reorganization still signals a new focus on the SMB market. In the past Microsoft singled out enterprises for special treatment, with the assumption that other staff were focused on "non-enterprises." Today, the focus on the SMB market is deliberate and purposeful.

Microsoft’s goals for this part of its business are ambitious. According to Ayala, the company wants to grow annual revenue from its Business Solutions division from about US$550 million today to US$10 billion in 2010.

SMB Gaps

Microsoft’s focus on SMBs is not seamless, however. In particular, the company’s product line has some gaps, and it appears to be moving slowly to provide some important services, such as hosted applications.

Product gaps. Although the acquisitions of Great Plains, Navision, and other firms since 2001 have given Microsoft a substantial presence in financial management software for small businesses, it bought its way into a competitive market. The products gained in these acquisitions, sold under the Microsoft Business Solutions banner, are best suited for the core and upper midmarket SMB segments (using Microsoft’s taxonomy). But Microsoft lacks a successful product for low-end financial management, which is largely dominated by Intuit's QuickBooks. Such a product would play an important role for small businesses that grow out of simple accounting solutions and want a smooth migration to Business Solutions products.

Although Office is the dominant suite for document creation, the company has yet to develop compelling document management tools, and document security is still problematic. Adobe Acrobat remains the standard—even at Microsoft—for certain types of documents, and Microsoft's latest workflow and document collaboration solutions require a major investment in server and client licenses for workflow orchestration and document rights management.

Hosted applications. Although the highly touted application service provider business, which gave companies access to common business applications over the Internet, imploded in the dot-com bust, hosted applications are reemerging as an important SMB technology. These applications require reliable and fast WAN connections and comprehensive management tools that give customers more control over their data and application configuration; on both counts, the situation has improved significantly since 2000.

Microsoft has been reluctant in the past to promote hosted applications, in part because these applications tend to favor "thin clients"—primarily browser-based interfaces—that benefit neither the company’s Windows nor Office franchises. Because Microsoft hosts few applications itself, encouraging customers to use hosted applications could mean sending their business to a direct competitor.

But hosted applications have emerged as major players in some applications. For example, salesforce.com offers a hosted sales force automation program that is popular with field sales people who value being able to view and edit their sales data from a browser anywhere in the world.

Hosted applications are attractive to the SMB market because the application hoster (now commonly known as a managed service provider, or MSP) handles server management chores and many application configuration tasks, eliminating the need for the SMB to hire staff for routine maintenance or specialized application configuration and management. Hosted applications can be provisioned rapidly and are often licensed by the actual number of users, bandwidth required, or other capacity-based metric. These applications scale well as a business grows; alternatively, customers who downsize and must cancel a hosting arrangement are not saddled with software licenses or hardware that they no longer need.

Microsoft has not been deaf to the appeal of hosted applications, but its strategy so far (aside from a few modest efforts, such as its bCentral Web site for small companies) has been to rely primarily on partners to provide hosting services. A special licensing program, the Service Provider Licensing Agreement, has enabled the company to work with partners to capture some of the interest in hosted applications.

Balancing Partners and Products

One challenge for Microsoft, epitomized by the business management products offered by its Business Solutions division, is the tension between being a horizontal, product-oriented company and offering more specialized solutions tailored to specific business segments.

Traditionally, Microsoft has focused on horizontal markets, producing key building blocks such as its server, database, e-mail, portal, and e-commerce software that can be used in every industry segment. Partners and integrators have then deployed the software and configured it for specific solutions, such as financial services, healthcare, education, government, and a host of other industry segments.

The advantage of this horizontal focus is that virtually any business can be a Microsoft customer, regardless of its particular business niche, and many partners will employ Microsoft applications as the foundation for their own, more specialized software. The disadvantage is that integrating Microsoft’s building blocks into a custom business system typically costs several times more than the software itself, a prospect that frightens many small businesses away.

The acquisitions of Great Plains, Navision, and other vendors solved that problem, giving Microsoft products and sales channels that could sell nearly finished solutions to small and midmarket customers.

The growing stable of MBS products, however, puts Microsoft into direct competition with some of its ISV and integration partners. Companies such as Intuit and Sage, for example, build small business products based on Microsoft components, which puts them in partnership with Microsoft. At the same time, Microsoft aggressively markets Microsoft Business Solutions products to their customers.

The consequence is that Microsoft’s venture into the SMB segment could be harmed if it saps the vitality of ISVs that complement Microsoft’s software or worse, prompts ISVs to build products on and promote non-Microsoft platforms, such as Oracle or IBM databases, Linux, or Web-based solutions built on Java.

For example, ACCPAC, which provides accounting software for the SMB market, is now promoting the availability of its software on Linux, a move the company says is a direct result of ACCPAC’s most important partner, Microsoft, acquiring its largest competitor, Great Plains. The attraction of Linux, which ACCPAC claims has proven more stable than Windows, is that it is "something Microsoft was not likely to embrace."

Need for Focus

Given the forecasts for growth in the SMB segment, Microsoft’s sharpened focus on the market is well-timed. The new interest from enterprise vendors makes it doubly important.

However, this is likely to be a difficult fight. Competitors are targeting Microsoft, and mistakes that reduce partner loyalty or the appeal of Microsoft solutions to SMBs—integration failures, uncompetitive licensing, competition with ISV partners, and gaps in the product line—will show up quickly in the marketplace.

Usually at its best when it faces tough competition, Microsoft will need to consult carefully with its partners and channel, even on issues such as product features, to defend and improve its position in the SMB market.

Resources

The new Microsoft Partner Program is described in "Partner Program Gets Major Redesign" on page 23 of the Dec. 2003 Update.

Total Solution Financing is described at www.microsoft.com/BusinessSolutions/document.aspx?content=/businesssolutions/content/financing_main_page.xml.

Small Business Server 2003 is described in "Microsoft Luring Small Businesses to Servers" on page 19 of the Nov. 2003 Update.

Microsoft Business Solutions are described at www.microsoft.com/businesssolutions.