Applications

Software: No longer business as usual

Microsoft's eyeing free, ad-supported products while companies dump "big beast" software projects in favor of hosted.

The software industry, already reeling from consolidation, is grappling with a new problem: finding the right sales model.

The old, traditional model of selling software, either through up-front fees or long-term licenses, is increasingly under strain as both consumers and big businesses demand change.

The latest sign of turmoil: an admission by Microsoft's top executives that ad-supported Web-based services pose a risk to the company's traditional business. Other internal memos show that Microsoft is worried by the growing reluctance of consumers to spend money on software.

The business software market has been wrestling with changes for several years now. Many companies, like PeopleSoft and Siebel Systems, have been acquired. Some have simply gone out of business. And all of the big software makers acknowledge that it has become harder to sell new software licenses. Oracle, SAP and others now rely on selling ongoing maintenance contracts.

"There are some seismic shifts happening" in all areas of the software industry, said M.R. Rangaswami, an investor and software industry consultant. "It's not going to be a complete shift to open source, software-as-a-service or build-your-own. Will (this) have a major impact on the market? Absolutely."

The growing popularity of open-source software, particularly for server software like databases, has shifted strategies at Microsoft, Oracle and other large companies, which now offer free or low-cost products.

Similarly, hosted applications like Salesforce.com that allow companies to switch to a recurring monthly charge instead of a large capital outlay have forced Microsoft, SAP and others to offer similar products.

The confluence of these factors and others is causing dramatic changes in how software is bought, said analysts and company executives. Rather than just charging customers for a CD stuffed with code, providers are increasingly turning to the Web, and to new licensing models, they said.

"Finding new revenue streams is really important so (vendors) are looking at all kinds of contract models," said Joanne Correia, an analyst at Gartner. "When markets become really mature, what happens is people fight for customer control, and that is done via contracts."

In particular, big companies are demanding the ability to buy on an annuity basis, where they pay in smaller increments rather than shell out large sums up front, analysts said.

"It's not going to be a complete shift to open source, software-as-a-service or build-your-own. Will (this) have a major impact on the market? Absolutely."
--M.R. Rangaswami, investor and software industry consultant

With tight IT budgets and slim increases projected for the coming years, corporate customers are eyeing shorter-term contracts--or no contracts at all--rather than pay a perpetual license fee and maintenance costs.

For instance, Joe Drouin, the global chief information officer of TRW Automotive, is taking a look at Salesforce.com, which delivers its product as a Web-based service, in part because of the economics. Drouin said TRW is already an SAP customer. But for new applications, he's looking to cut costs.

"You know, you go in and you spend millions of dollars in software and hardware and you put a big beast in place...The idea (with software-as-a-service is) that you wouldn't have to do that right up front. You can pay as you go," Drouin said. "It's a very compelling model."

Microsoft faces big changes
Customers like Drouin are pushing software makers to keep pace with a rapidly changing industry. One of the most visible transformations is taking place at Microsoft, the world's largest software maker.

Bill Gates, the company's chairman, sees the shift to online services as a "sea change" on par with the company's embrace of the Web more than a decade ago.

The recent launch of Microsoft's Live.com Web-based service, along with a major reorganization in September underscored the company's stepped-up commitment to deriving revenue from services, rather than strictly software licenses.

In addition, the company has mulled the introduction of free, ad-supported products, such as Works and Money. According to an internal strategy paper, consumers' unwillingness to pay for desktop programs is forcing Microsoft's hand.

"The outlook for the packaged consumer retail software market is poor," the authors of the paper, seen by CNET News.com, wrote. "The size of the market is shrinking, and consumers appear less willing than ever to buy software applications off the shelf."

Meanwhile, Google is expanding its array of Web-based products funded by advertising. Although Google's applications are limited to e-mail, photo-sharing and consumer-oriented services, George Colony, CEO of Forrester Research, expects to see much more.

"Google is also leading a pricing revolution," Colony wrote in a recent column. "Google's programs are free, funded through advertising and syndication. This is a prescient move. I foresee a world in which even enterprise applications like financials, ERP (enterprise resource planning), and supply chain software will be advertising-funded."

The growing viability of open-source products is already accelerating a shift in pricing models for businesses, analysts noted.

IBM, Oracle, BEA Systems and other infrastructure software providers have each shifted from a completely closed-source business and increasingly embraced open-source infrastructure software products. IBM even bought Gluecode, an open-source alternative to its WebSphere Java application server, and adopted its of monthly maintenance fees.

Open-source advocates argue that open-source software, such as databases or business intelligence tools, is cheaper than existing products. Also, by giving away software--at least, initially--open-source companies do not need to invest as much in sales and marketing, according to analysts and industry executives. Commercial software makers spend on average 82 percent of new license revenue on sales and marketing--that is, finding new customers--according to a Goldman Sachs report. That's up from 66 percent in 2000.

Open-source sales application SugarCRM, for example, does not employ direct salespeople, who are typically highly paid. Instead, the users of its open-source product are the primary source of sales leads, according to SugarCRM CEO John Roberts. A smaller sales and marketing budget allows it to divert its resources toward engineering, he added.

Larry Augustin, the founder of VA Software who sits on the board of a number of open-source companies, said that the rising cost of sales and marketing business software is driving up prices for customers.

"The traditional enterprise software business model is broken," Augustin wrote in a recent column. "A rabid search for new customers and revenue growth has caused sales and marketing costs to spiral out of control...We're charging the customer more to sell to them."

Still, some corners of the software world have been able to maintain the status quo.

Adobe Systems, which sells popular desktop software like Photoshop and Illustrator, has stuck with the model for consumers and has even been able to raise prices in recent years, noted Gene Munster, a financial analyst at Piper Jaffrey. But Adobe will likely explore different models, he said.

"The traditional enterprise software business model is broken."
--Larry Augustin, founder, VA Software

"I think you'll see companies move to different (pricing) models over time," Munster said. "I could see Adobe, like Microsoft, look at ways of charging less up front, have a subscription fee, and (have) products supported by ads."

Gartner's Correia said that the products that are most likely to be funded by advertising are those that are sold in high volume, such as consumer products. A subscription model, where customers pay a regular fee in place of one up-front purchase, are best suited for applications such as e-mail or customer relationship management, rather than custom-built applications, she said.

Rangaswami said that alternative pricing models and other larger industry changes, notably less-expensive offshore development and modern service-oriented architectures, ultimately benefit an increasingly demanding customer.

"The power has shifted to the buyer," Rangaswami said. "Five years ago, (vendors) could sell a million-dollar piece of software and run off to the next deal."

CNET News.com's Mike Ricciuti contributed to this report.