When USinternetworking was launched in April, 1998, investors swarmed like yellow jackets around a honeypot. The outfit was a new kind of company—dubbed an application service provider—and it promised to transform the way software had been used by corporations for more than 30 years.

Instead of selling customers large and complicated packages, USi would provide them with instant access via the Web to the software packages from such established software makers as PeopleSoft and SAP. No fuss, no muss. To venture capitalists and Wall Street investors, it seemed like a blockbuster idea. They bet nearly $500 million on the company.

Unfortunately, USi was almost as good at spending money as it was at raising it. By last October, only $60 million was left and the company was burning through a hair-raising $80 million a quarter. USi’s stock, which had once topped $73 per share, had skidded into the single digits. The fate of the company rested on winning a $50 million loan from General Electric Capital Services. It got it, along with $270 million in additional private financing from the likes of Microsoft.

USi lives, but its near-death experience is symptomatic of an entire industry that popped up in its wake. Spurred on by analysts’ projections that the ASP market would be worth more than $6 billion by the end of 2001, more than 500 companies were funded with a mind-numbing $10 billion in venture capital. The analysts, as it turns out, were wildly wrong. Concerns about the security of company secrets and the reliability of the Internet scared off many potential customers. At the same time, the ASPs faced huge costs for building data centers and licensing software packages from publishers. The result: Their money started running out before revenues kicked in.

If this keeps up, the potential exists for techdom’s biggest belly flop since the pen-computing fiasco of the early 1990s. The ASP market is expected to drum up only $600 million in sales this year, according to IDC, less than 1% of all information-technology spending—not nearly enough to support the horde of competitors. Market researcher Gartner Group predicts that 60% will go under in the next year.

True believers

By all rights, the money tap should have shut down for ASPs. But it just keeps flowing. That’s because some of the leaders in the first generation—including USi—seem to be getting their acts together and a new generation of ASPs is being born. Rather than buying packages from established software companies, these new contestants are building software from the ground up to run on the Web. That makes the services more efficient for them to run and easier for customers to sign up for and use. In the fourth quarter of last year, well after stocks of the few publicly traded ASPs had tanked along with the rest of the tech industry, venture capitalists pumped $1 billion into these companies. Crosspoint Venture Partners in December announced plans to invest $350 million in new ASPs that target specific industries, from groceries to banks.

Indeed, plenty of people still believe that the wave of the future is offering software as a service that’s delivered over the Web. Corporations have been complaining for years about the expense and trouble of computing systems. They have to pay millions of dollars for the gear, then pony up again each year to maintain and update it. With application service providers handling these tasks, they can concentrate on running their businesses—and simply pay the ASP a monthly fee. Carey Eisenhower, Internet marketing manager for the Hershey Direct Division of Hershey Foods, says he’s saving at least 20% per year on software-management costs because he’s a customer of USi. There is an added plus: "We didn’t have the expertise to build an e-commerce site. USinternetworking did,’’ says Eisenhower.

In spite of the early glitches, the basic ASP concept is compelling for software companies, too. Today, they depend on selling enough software packages each quarter to meet Wall Street’s expectations. It’s not unlike the movie business, where studios’ fortunes depend on at least one megahit a year, creating spikes and valleys in their revenue streams. By delivering software as a service, their revenues should be more predictable. And when new technology is ready, it can be instantly included in the software and piped to the customer. While the first round of market projections were way off, researchers still see a sizable opportunity: IDC, for instance, estimates $7.3 billion in sales in 2004.

By Jim Kerstetter with Jay Greene in Seattle in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc