Navigating this Software Paradox

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The business of selling billions of zeros and ones in exactly the right sequence – the business of software – has generated billions of dollars and revolutionized industries at least since the 1980s. Indeed, the richest man in the world – Bill Gates –  got that way from selling software. Furthermore, as Marc Andreessen noted in 2011, “software is eating the world.”

Almost every commercial endeavor and, indeed, almost every human undertaking, has software at its core.  Our digital lifestyles, along with marketing and commerce, government, transportation, medicine, consumer electronics, and even our social relationships, are increasingly facilitated by complex and sophisticated software programs.

With software at the core of so much of our society, it’s surprising to realize it’s getting harder and harder to actually make a living selling software.  In his recent book, “The Software Paradox,” Stephen O’Grady - co-founder of analyst firm RedMonk - provides a cohesive and persuasive analysis of what those of us in the software business have been experiencing for several years – it’s getting increasingly difficult to generate revenues selling “shrink-wrapped” software.

In the earliest days of computing, software was simply provided along with the hardware products. IBM and similar companies made their fortunes selling hardware – mainframes – with software thrown in as a necessary ingredient to make the hardware work. But, as standardized hardware platforms and operating systems such as UNIX and the IBM PC emerged, a distinct market for software emerged along with them. Hardware had become commoditized, and software thrived.

Over the last 10-to-15 years, however, the price that can be demanded for software has dropped significantly as a result of several factors.

First, open source software provides “good enough” alternatives to a lot of commercial software.  It’s true that MySQL and PostgreSQL do not have the features of Oracle’s flagship database, nor is OpenOffice a technology match for Microsoft’s office suite. However, it’s increasingly hard to charge premium pricing when there is a free alternative available, even if that free alternative is not on par with the premium product.

In addition, the ability to consume software-as-a-service over the Web also has disrupted the desktop deployment software model. A lot of what we get on the web – Facebook, Twitter, etc. – is provided free and subsidized by advertising.  When we do pay for web-based software, nominal subscriptions rather than massive upfront charges are the norm.

Finally, although mobile apps initially created a boom for smaller independent software vendors, mobile has also had the effect of driving down the price point a software vendor can charge.  Mobile apps typically sell for under $10, making it harder to charge hundreds or thousands of dollars for desktop applications.  

Clayton Christiansen, author of “The Innovator’s Dilemma,” says that when a technology becomes commoditized, value shifts to products that are built with the commoditized technologies.  Increasingly, we see that while software is often the magic ingredient for a successful product, it is embedded within the product and not independently monetized.  So, while Apple’s vertical integration of hardware and software seemed an inferior business model compared to Microsoft’s software-only model during the 1990s, that vertical integration today allows Apple to be the most profitable company of all.

Perhaps over time, the pendulum will swing back towards commercial software.  Most dominant open source software currently is funded by commercial companies or venture capital backed start-ups.  For instance, the open source darling Hadoop is supported by companies such as Cloudera that have yet to make a profit.  If these companies do not create a viable long-term business model around open source, funding will dry up and open source may lose momentum.

But for now, most software companies need to pivot towards SaaS, subscription or vertical integration, and reduce their reliance on traditional upfront software licensing revenues.