In an interview with Financial Mail for their October 24th issue, John talked about the emerging trend of "software as a service" (or Saas) as opposed to the traditional way of selling shrink-wrapped products. Here is an excerpt from that article:
"[John] believes software companies don't need to start panicking - yet. In the long term, though, their profit margins will be eroded as the industry moves to a service model, he says. 'Software businesses have gross margins in the range of 80%-90%, while services businesses are in the range of 60%-65%. A well-run software company will have pretax operating margins of 25%-35% and a services business of about 15%. It's a very different model.'
Thompson says software companies have to reinvent themselves as services businesses, which will be difficult for many. But if they don't do it, they could find their future in doubt.
'Some company, without a legacy-installed base or a legacy revenue stream, is able to run up and take your business away from you,' Thompson says.
But the shift will take longer than many in the industry assume, he says. This will give the big software players time to adapt.
'The revenues of Saas companies will not overtake the revenues of [traditional] software [companies] for a long, long time," Thompson says. "It's not a big threat to the profitability of software companies in the near term.'
He says the annual turnover of the world's largest dedicated Saas vendor, Salesforce.com, is dwarfed by Microsoft's yearly revenue. 'If [Salesforce.com CEO] Marc Benioff were sitting here, he'd say software's dead. That's just crap. Marc's a good friend of mine, but Marc is just promoting what he's doing.'"
Back in the days before companies could afford their own mainframe computers, people would connect up to somebody else's system and pay for the time they used it. Software vendors would install their applications there and let different customers access it on the shared system.
The 1970s relationship between Tymshare and Information Builders is a good example of how BI software was offered as a service at an early point in computing history. When platforms became affordable, vendors began selling products to each company individually.
John is right that software pricing models will definitely need to change. For example, Information Builders still prices their BI product based on the size of the hosting computer. Never mind that the development costs are the same for Windows, UNIX, and System z and that they only have a single code base now anyway. If you want to run their BI on your Windows box, the price tag is about $40,000, but tell them you want to run it on your mainframe and their number goes up to probably around $1 million.
Their pricing model is based on the assumption that the bigger your computer, the more business value you will get, so therefore you should pay more. They offer you a perpetual license, so you pay them 20% of a purchase price every year for annual maintenance ($8,000 for Windows and $200,000 for the mainframe) which allows you to always have the latest release. If you get a bigger machine after the BI software is installed, you are going to be found out and have to pay the infamous "upgrade fee."
Pure software vendors will pay attention to certain financial ratios, one of which is "revenue per headcount." They want to divide their annual revenue by the number of employees and come up with a ratio of about $250,000, but the higher the better. To improve their score, they only have two choices: either increase revenue or reduce the number of employees. If they have challenges on the revenue side, they will get rid of unnecessary employees (some go so far as to convert employees to partners or subcontractors so these individuals no longer impact the official ratio).
Software consulting firms are going to have much lower revenue per headcount ratios as they are limited by the number of hours in the year that any given employee can bill for services. Unlike the software vendors, the services organizations might be happy with a ratio of $150,000 to $180,000. Because Saas companies are not necessarily pure services businesses, they may be able to achieve a high ratio here, although they may have troubles attaining the high figures of today's pure software businesses.
For the sake of their customers and their own employees, hopefully legacy software vendors will pay attention to John calling out in the desert, "Repent!"