The Software Paradox by Stephen O’Grady

O’Reilly has released a free 60 page ebook by Stephen O’Grady called The Software Paradox – The Rise and Fall of the Software Industry. You can access it here.

So what is “The Software Paradox” according to O’Grady? The basic idea is that while software is becoming increasingly vital to businesses, software that used to generate billions in revenue is often now available as a free download. As the author says:

This is the Software Paradox: the most powerful disruptor we have ever seen and the creator of multibillion-dollar net new markets is being commercially de- valued, daily. Just as the technology industry was firmly convinced in 1981 that the money was in hardware, not software, the industry today is largely built on the assumption that the real revenue is in software. The evidence, however, suggests that software is less valuable—in the commercial sense—than many are aware, and becoming less so by the day. And that trend is, in all likelihood, not reversible. The question facing an entire industry, then, is what next?

The ebook is well researched, well thought-out, and worth a read if you work in the software industry.

O’Grady describes the software industry from its early beginnings to today, and considers the impact of open source, subscription models, and the cloud on many aspects of the industry. His conclusions and his summary are very interesting. However I think he as overlooked, or under-stated, two aspects.

The Drift to the Cloud

O’Grady identifies cloud computing as a disruptive element and provides details on the investments by IBM, Microsoft, and SAP in their cloud offerings, as well as the impact of the Amazon Cloud. He does a good job of describing who did what and when, but does not really get to the bottom of the “why”, other than pointing to consumer demand and disruption in the traditional sales cycle.

Here is my take on why the demand for hosted and cloud-based offerings is increasing and will continue to increase. Consider the evolution of a new business started in the last 5 years. As an example let’s use a fictitious grocery store called “Locally Grown” that cooperates with a farmer’s market to sell produce all week long instead of just one or two days a week.

• Locally Grown opens one store in San Diego. It uses 1 laptop and desktop-based software for all it’s software needs including accounting, marketing etc.
• Things go well and the owner opens a second Locally Grown across town. The manager of the second store emails spreadsheets of sales data so the accounting software can be kept up to date.
• When the third store opens, the manual process of syncing the data gets to be too much. The company switches to Google Docs and an online accounting system. This is an important step, because what they didn’t do was to buy a server, and hire an IT professional to setup on-premise systems, and configure the firewall and the user accounts etc.
• As the company grows a payroll system is needed. Since accounting and document management are already hosted, it is easiest to adopt a hosted payroll system (that probably already integrates with the accounting system).
• Soon an HR system is needed, and then a CRM system. As each system is added, it makes less and less sense to choose an on-premise solution.

You can see from this example that the important decision to choose hosted over on-premise is made early in the company’s growth. Additionally, that decision was not made by an IT professional, it was made by the business owner or line-of-business manager. Hosted application providers aim to make it easy to set up and easy to migrate from desktop solutions for this reason. By comparison the effort of setting up an on-premise solution seems complicated and expensive to a business owner.

I love me a good analogy, and Amazon’s Jeff Bezos has a good one for the software industry by comparing it to the early days of the electricity industry (TED talk here). I think the analogy goes further than he takes it. In the early days of the electricity grid, the businesses most likely to want to be connected were small ones without electricity, and those least needing the grid were large businesses that had their own power plants. This same effect can be seen with cloud adoption as small businesses with no server rooms or data centers are the most likely to use the cloud for all their needs, and large businesses will be the slowest to migrate.

In their Q1 2016 annual report Salesforce announced $1.41 billion in subscription and support revenue. They don’t release information about their customers or subscribers but it is generally know they have over 100,000 customers. But consider that in the USA there are 28 million small businesses (less than 500 employees). These are the next generation of medium sized, and then large businesses. Even if we are generous and put Salesforce’s customer count at 200,000 in the USA (by ignoring the other 20 countries), it means that Salesforce has a market penetration of less than 1% and still generates $6bn a year. So just within the hosted CRM space in the USA alone the market is more than $600bn a year.

So, in my opinion, the current demand for hosted and cloud-based offerings is largely (or at least significantly) fueled by the latest generation of small businesses that will never have an on-premise solution. This trend will continue relentlessly, and perpetually (until something easier and cheaper emerges), and the market is vast.

New License Revenue

O’Grady does a lot of analysis of software license revenues over the past 30 years and compares it with subscription models and open source approaches. But he is missing a fact that might alter his opinions a little. Most people are unaware of this fact, because traditional software companies have a dirty little secret.

It is rational to think that when you buy a piece of software from IBM, or Oracle, or SAP, or Microsoft, that the money you give them pays for your part of the development of the software, the cost of delivering it, the cost of running the business, and a little profit on top. But this is unfortunately not the case. When you buy a new software license the fee you pay typically covers only the sales and marketing expenses. In extreme cases it doesn’t even cover those. In the past, Oracle’s sales and marketing departments were allowed to spend up to 115% of the new license revenue. Oracle was losing money just to acquire customers. In the latest Oracle quarterly report they state that new license revenue was $1,982 million and sales and marketing expenses was $1,839 million. So 92% of your license fee goes towards the sales and marketing expenses needed to get you to buy the software, and the remaining 8% doesn’t even come close to covering the rest. As a consequence, a traditional software company is not at all satisfied that you have just purchased software from them because they have made a loss on the deal.

So if the license fee does not pay for the software, what does? It is the renewals, upgrades, up-sells, support, and services that generate the income that funds the development of the software and keeps the lights on.

In The Software Paradox O’Grady talks about the massive rise in software revenue license in the 1980s and 1990s, and it’s subsequent decline. But if you consider that software license revenue is really just fuel for sales and marketing, maybe the decline can be partially attributed to innovation in the sales and marketing worlds (evaluation downloads, online marketing etc) as the heavy and expensive enterprise sales model has changed over time. Maybe the 1980s and 1990s was a sellers market and expensive software of the time was overpriced. O’Grady describes many contributing factors for the Software Paradox, maybe this is yet one more.