Rules of the software game

"Round and round
What comes around goes around."
-Ratt

Although the software industry is careening towards its fiftieth birthday, in many ways it is an industry that has not quite matured, still finding its way in terms of business model and pricing.

While Microsoft seeks to move corporate users to a subscription model for Microsoft Office, many ASPs (application service providers), are working frantically to return to a pricing model where more cash is collected up-front--for example, "away" from the subscription model. How can an industry so old have such schizophrenia about something as simple as a pricing model?

From the beginning, the software industry has had one key distinguishing characteristic from all other businesses--variable costs are at or near zero. Economic theory suggests that to maximize profits, you want to pick a price whereby marginal revenue equals marginal costs. However, with marginal costs always equal to zero, this formula obviously breaks down.

Different types of software companies have used different approaches and theories. At the high end, enterprise-software strategists say to price as "high as you can" to reap the maximum profit, and to help offset direct sales costs. On the other hand, companies such as Microsoft favor entering the market at a low price with the objective of taking a huge portion of market share. If your research & development dollars are spread across the most customers, no one else can afford to keep up.

Prior to 1995, most enterprise software companies followed a pretty consistent pricing strategy: Charge as much up-front as you can. Typically a number north of at least $250,000 is needed to justify direct sales costs, if this is the chosen sales model. On top of this, the customer is asked to pay about 18 percent of the original purchase price in "maintenance" which basically covers customer support and access to minor product upgrades. Then, every three of four years, the vendor will release a "major upgrade" which requires all customers to revisit the big-ticket investment again.

In the mid-1990?s, this model started to show signs of wear, and most enterprise-software companies found themselves in an awkward position. Each quarter, the company?s sales force would work as hard as they could to close as many customers as possible in these mega-software sales that were fast approaching $1 million per deal. However, when the quarter ended, the company had to start again from ground zero, and the entire game began again.

As customers caught wind of the game, many began delaying purchasing until the exact end-of-quarter, when the vendor was most eager to close a deal. As such, the monthly allocation of revenue in a typical enterprise software company across a quarter could be as lop-sided as 10 percent, 10 percent, 80 percent, with the majority of revenue being closed in the last two weeks of the quarter.

Birth of the ASP
This model is not for the faint of heart, and as such, many stressed-out CEOs began to search for a new model that might alleviate the end-of-quarter rush and the ridiculous amount of uncertainty inherent in such a model. About this same time, the rise of the Internet gave birth to the idea of an ASP--a model where software would be delivered as a service over the Web, and customers would "subscribe" to the software.

Analysts raved at the genius of the idea. With this model, the customer would pay an incremental fee each month, therefore eliminating the "start from zero" sales game inherent in the software model. Assuming no loss of customers, the revenue from last quarter is already booked for this quarter--all new sales theoretically represent incremental growth.

Alas, the grass is indeed greener on the other side. For all the theoretical advantages of the subscription model, one key challenge makes it extremely difficult to execute. Let?s assume I have a small software company that sells enterprise software the old-fashioned way for a $1 million base license and 18 percent maintenance. With this model, the company will book and collect cash flow for $1 million in year one.

Now let?s take the amount this customer would spend over 3 years ($1.36 million) and spread it over 36 months in a subscription model. If the company closes 10 accounts in year one, spread evenly across the year, the recorded revenue and collected cash flow for year one will only be $2.26 million, compared with $10 million in the old model. This is why many ASP players backed off their original pitch and are attempting to sell traditional licenses.

The problem, you see, is capital availability. If you ever make it to break-even, then the subscription model is clearly preferred. However, the capital needed to grow such a model is tremendous, as the customer payments have been pushed out--for example, the start-up is providing vendor financing. When the ASP model began to buzz, many of the enterprise software vendors did this math, and criticized the model as "unobtainable."

Ironically, the difficult economy has created a situation where the customer seems to prefer the subscription model. Capital budgets have been cut, and everyone would prefer to buy by the drink instead of in one up-front lump payment. This has caused even the licensed software vendors to enter into financing agreements whereby the customer pays out over a period of time instead of up-front. Once again, schizophrenia is the only consistent theme.

So what?s the best model?

Perhaps it?s a blend of the two. Recognize revenue on a subscription basis, but try to collect as much of the cash flow up-front as possible. This will give you a conservative brace from the trials and tribulations of the license model, but at the same time will not leave you starved for capital to run the business along the way. Of course, this model will require enormous patience to reach accounting profitability, but in the long run (forgive me Mr. Keynes), you will be much better off.

J. William Gurley 2001. All rights reserved. Above the Crowd is a monthly publication focusing on the evolution and economics of high-technology business and strategy. This column can also be found on CNET online and in Fortune magazine. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Benchmark Capital, a venture capital firm in Menlo Park, Calif. Benchmark Capital and its affiliated companies and/or individals may, from time to time, have positions in the securities discussed herein. ABOVE THE CROWD is a service mark of J. William Gurley.