Updated: Apr 25, 2019
As we continue our exploration into different industries and business models, this week I'd like to discuss one of my personal favorites: software.
You might be wondering what the big deal about software is. But is it a coincidence that the four most valuable public companies have software at their cores? Yes, we're even looking at you, Apple. Creating iOS is much harder than making the iPhone.
One of the main reasons software as a business model is so powerful can be pulled from last week's post: the idea of negligible marginal costs.
Here's an example because this is a key concept.
Let's say you loved shoes. You loved the design of them, the creation, the process, everything. In other words, you were a total sneaker-head.
So one day you set out to create the next great shoe company.
You get 100 pre-orders for $100 each. Not bad, $10,000 up-front (pre-orders are similar to subscriptions where you get cash up-front, then provide the product).
Anyway, you make 100 pairs and ship them out. In total, it costs you $70 per pair.
Therefore, your profit on each pair is $30, or $3,000 in all.
After the pre-order window closes, you get another order. Your incremental cost, or the cost for each additional pair you sell, is still $70. And that's what it will always be unless you off-shore the labor or find another way to lower your costs.
On the other hand, if you started a software company…
Once you create the software, your marginal cost of distributing it is essentially zero.
In other words, it costs you about the same to distribute it to 1 person as 1,000 people.
Since the software has already been created, you don't need to re-create it every time you get a new order. Whereas, with the shoe company, each new order you get, you have to make a new pair.
But to break it down further, software is usually sold in two different ways.
Tale of Two Models
One is called a license and maintenance model.
Think back to the days where you had to burn Microsoft Office from a disk to your hard drive. Or more recently, if you've ever had to download Adobe Flash player to watch a video.
In this model, the software is hosted "on-premise" meaning it is directly downloaded into your computer (hardware). You, as a customer, buy a license to use the software but you also have to pay more every time you want to upgrade or have bugs fixed in the code.
These licenses can be sold in perpetuity (forever) or in terms (typically ranging from 1-5 years).
This licensing model differs from the second way, through the cloud. This is where the popular term SaaS, or software-as-a-service, is derived. Here, the software is hosted on a bunch of servers, and then distributed over the internet.
For example, take Google Docs. You can type a document in Google Docs just as you can in Microsoft Word. The difference is you don't physically have Google Docs downloaded on your computer. It's being hosted in a collection of computers called "the cloud."
The benefits of this are two-fold.
First, the hardware doesn't matter. You can type that paper from your friend's house even if you forgot your laptop. Just sign into your Google account.
Second, updates are seamless. Rather than re-downloading the software to get a new update, Google can automatically push out a new feature and boom, you'll have it. Other SaaS companies leverage this capability to up-sell customers with the latest and greatest features.
But there are even more benefits of the SaaS model.
Third, it simplifies the sales process. Typically, licensing agreements are expensive, especially in perpetuity but SaaS can lower the initial costs. This is because it can be sold on a monthly basis. As a result, the sales cycles are much shorter.
Fourth, on-premise software can be a headache because you might need to hire more IT people, buy more servers, and deal with expensive maintenance contracts. Though SaaS may be more expensive in the long run, some companies will bite the bullet to eradicate the extra headaches.
Fifth and finally, since the software is not hosted "on-premise," SaaS companies have access to see how customers interact with their products. This means a deeper understanding of customers and therefore, a more personalized sales and marketing process in the future.
As you can see, I'm a fan of SaaS as a business model. It seems to solve a lot of the problems associated with on-premise software.
Middlemen at It Again
However, the story isn't over. You see, a lot of software is sold B2B, meaning business to business, as opposed to B2C, business to consumer (you and me). Dealing with enterprises is more difficult because they usually have more specialized needs.
Therefore, the world of software sales gets even a little more complex. Most B2B software companies employ a huge network of consultants, resellers, and integrators. This network is called a channel.
If you ever want to impress a software CEO at a dinner party, just ask something to the effect of, "So, what's your go-to-market channel strategy?"
The components of this network act a lot like distributors in our pharmaceutical post a couple weeks back. There are system integrators (SIs) who work with the end customers to implement the software, value-added resellers (VARs) who package software together for different verticals (healthcare or finance, etc.), and original equipment manufacturers (OEMs) that can bundle software into hardware systems.
It's confusing but the important thing to understand is how nuanced the sales process is. The software company, just like the drug maker, markets to their end customer, but may not even be directly involved with them. Rather, the middlemen of the channel, are just responding to the demand and buying the product from the software company.
However, not all companies use the channel extensively. Bigger ones have direct sales forces and SaaS has actually gone a long way to disintermediate (cut out) this network of resellers. But it just goes to show you that middlemen are still alive and well.
With the explosion of the internet, it seems that middlemen are becoming futile.
Think about how Netflix creates its own shows and distributes them.
Or how Amazon creates hardware like the Echo and sells in on its website.
But, after looking at different business models, middlemen are still crucial. One of the lessons from this might be that it is very difficult to sell direct-to-customers; vertical integration takes a ton of time. It's easier to just outsource sales and distribution to a middleman.
But more on that another time.
Software, like everything, is not a perfect. Competition is fierce and the tech landscape is always changing. Hiring good developers is hard because Facebook and Google snatch up a lot of the good ones, and the really good ones are creating their own companies.
Nevertheless, there are some inherent advantages to software as a business model, especially with SaaS for distribution. While it's complicated, it's an extremely interesting industry, packed with growth and potential.