The Software Company Business Model

In my last post, I suggested that the beleaguered major Learning Management Systems companies like Saba and SumTotal Systems might do a lot better if they behaved like real software companies. What do I mean by a "real" software company?

Here is how the software company business model works. You invest in R&D and create a great product. You then leverage your R&D costs by selling lots of copies of that product. You make lots of margin on each sale because your cost of making each copy is very low. You add an annuity stream to your profit and grow a revenue base by selling updates to your product, which you assure customers want by providing constant meaningful improvements. Then repeat. This magical model  has powered almost every successful software company. Those with other models may develop software, but, as we shall see later, they are not really software companies.

It does not matter if your product is sold as a service (the increasingly popular, web-enabled, software-as-a service or SaaS model) or as a product (software-as-a-product or SaaP). The difference here is primarily delivery, that is, how you get the software's benefit to the customer. In SaaS, you deliver a virtual copy over the web through a browser, and the software itself resides on your server. In SaaP, the software is physically installed on the customer's computer (server or client). Either way, virtual or physical, you are delivering a copy of the software to the customer. What drives the business model is the same: very low cost to deliver each "copy" of the product to the customer.

Do not confuse subscription pricing with the SaaS versus SaaP debate. Either model can use subscription pricing. That's a phony issue. There are some important differences between a SaaS business and a SaaP business, but these do not change the fundamentals, though they can be used to confuse the SaaS-SaaP debate. True, SaaS is typically subscription priced. But in SaaS or SaaP, a subscription price means an update is realized through a subscription renewal, rather than a maintenance contract renewal or an update purchase. That is merely form, not substance.

Another consideration in the business model is the role of marketing versus sales. Some markets call for a high-touch, sales driven scheme; others call for a low-touch, marketing driven scheme. But this is mainly about which way the marketing and sales dollars get apportioned and does not change the business model fundamentals.

But there is another very important thing about the software company business model: professional services are kept to a minimum. Why? Because professional services are low margin and the ability to annuitize is at best dicey.  

Professional services include customized software development, along with consulting, training, implementation and so forth. Great software companies let others perform these services around their products. They grow by the resulting network effects. They keep their own margins high and stick to what they do best: developing great software that delivers value to customers. They are rewarded for this discipline by high valuation multiples because they are so profitable. In fact, much of the productivity gains that the tech industry has pumped into the economy over the last few decades have been because of the efficient use of all varieties of capital by practitioners of the software business model.

In a future post, I'll look at how the major LMS companies (and, in fact, most so-called enterprise software companies) fail to follow the software business model and thus are doomed to low profits, or none at all, and low valuation multiples.