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Understanding Software Business Models

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Which one is the right one for you? Lately all of us have been trained to say that we have or will, if we are “traditional” software company, be a “Software as a Service” company with a “SaaS” business model. Sure, that has become the de facto and comfortable response. But what is a business model? Most of us assume that we know, but have you asked yourself that question lately if you are a software company or a software startup? 

What is a Business Model?

The term, business model, is thrown around a lot these days. In fact, in many industries, it has become a bit of a buzzword. Folks now say, it’s not about the technology, it is about the business model. Sure, true and not so true. I would argue a great product, great leadership and execution are much more important, but that is not to say business model is not an important expression of smart decisions on how a business views itself and structures itself for execution and deliver of value.

Let’s take this notion of value, because I think it is important to begin our business model with it. A business model describes and in implementation is how an organization creates value as an enterprise. If a business model is well tuned into the needs and preferences of the target customer segment or segments, you have a better chance of being “successful”, whatever that ends up meaning to you and your organization. This is why getting your business model right is more important than many of us think. I find that many companies have not done a great job of profiling their business model or having a full, common understanding of what their business model is. This lack of perspective often lends to a slew of issues from corporate identity crises to disconnected and inconsistent marketing and communications.

It’s also important to have a clear understanding of that a business model is as it is frequently confused with go-to-market, corporate or marketing strategy; even value chain, supply chain structure as well as operating or organizational model. That being said, a business model definition is a great way of simultaneously informing and expressing all these things that business models get confused for. 

Business model canvas
Business Model Canvas (source: “Business Model Generation”, Alex Osterwalder

One good framework that I have used quite a bit in the past and still use today is the Business Model Canvas.  If you haven’t seen one before, it’s actually pretty simple. It’s a 9-sector asymmetric grid that plots out the key aspects of business model. The business model framework includes:

  • Value Proposition – Probably the most important aspect of a business model that serves as the anchor for everything else. It articulates the nature of the value that they business will offer through its products and services to meet customers or market needs. Value propositions can be quantitative such as price and efficiency, or qualitative such as customer experience.
  • Customer Segments – The set of customers in a market that the business will target with their value proposition through its products and services. 
  • Customer Relationships – The type of relationship that a business wants or needs to establish with its target customers to in engaging with and delivering value to them. Is it a self-service model? Consultative?
  • Channels – How will the business distribute/deliver its products and services (a.k.a. value proposition)? Is it through online, physical stores, SI partners or VARs?
  • Key Activities – The most important activities in executing a company’s value proposition.
  • Key Resources – The resources that are necessary to create value for the customer. They can be human, financial, physical assets and intellectual. 
  • Key Partners – JVs, strategic supply chain and go-to-market alliances that spread the risk of business across partners as well as to accelerate and scale value creation, delivery and capture. 
  • Cost Structure – What is the financial structure  and costs strategy for the business? Will the business be cost-drive (minimize all costs such as Target or Costco) or will it be value-driven (premium value such as Apple or LV).
  • Revenue Streams (operative word, “revenue’) – Simply the way that a business generates revenue from its customers. I consider this the wrapper for the revenue model discussion. 

A great primer for the business model canvas and source of templates invented by Alex Osterwalder is  his book called “Business Model Generation”. It is a great reference and the business model canvas is a great tool that I have used a great deal in the past on previous consulting engagement and today as I advise startups and businesses on business model design, analysis and innovation.

How is the canvas and the business model generation approach useful?

It’s a great tool and method for startups to brainstorm their business and create an initial framework for where you want the business to start and where you would or might have to take it in the future. I use business model ideation and the canvas quite a bit with the startups that I advise. We regularly come back to this exercise because things are so fluid for startups and I find that founders need the exercise to distill their thinking as they learn more about the market and the opportunity they are positioning for their company. 

It’s also a great tool for established enterprises that want to reinvent themselves for their core business or for new businesses that they are incubating. It’s a great way to establish a baseline understanding for what the current business is and articulating what the business would look like if they changed or pursued new markets. 

It’s also a really good framework for competitive analysis. I’ve used business model canvases as the basis of competitive analysis work I have done in the past. The comparative data provides great insights into how competing companies are going to market and approaching different customer segments. 

Quite honestly, the utility and value of business model canvas frameworks is limited only by your imagination.  I’m a big fan and it has been one of my favorite and most valuable tools in my consulting/analyst toolkit.

Archetypical models for a software business

Now, that we all know what a business model is, let’s talk about the business of software.  Specifically, let’s talk about the business model archetypes of the business of software and discuss how they have evolved over time. 

Something about archetypes, you only have a handful. A good rule of thumb is no more than four. Anything more is just a permutation of a far smaller number of archetypes. I’ve seen folks claim that there are a dozen, twenty, fifty business models for any particular industry. For software, there are only four in my book. I base this on actual experience helping some very big conglomerates rationalize their portfolio of business models.

Software business model archetypes. neXt Curve
Source: neXt Curve, Leonard Lee

Software as a Product (SaaP) Business Model – In this cloud era we might think that the traditional software business model of selling software as a product is dead. Surprise, it is still happening today. Companies such as SAP, Microsoft, Oracle and others continue to develop and sell software as a product. As a business, software development is the core competency of their business model. Pure play Software as a Product players do not seek to get in the business of software service delivery or the implementation of the software, or IT service delivery.

Many software companies today with traditional software businesses are licensing to SaaS providers or partnering with cloud service providers who host their software as a SaaS offering. The SaaP forgoes overhead and the lower margins of software delivering their software as a service. Historically, SaaP business models have been highly profitable with old school software giants such as Microsoft realizing gross margins on the order of 90 percent back in the good old days of licensed software. This is still a very attractive business model if you can make it work for your software business.

Software as a Service (SaaS) Business Model is not anything new. Companies back in the late 90s were offering private hosted “vanilla” instances of popular ERP software at the time such as PeopleSoft, Oracle Applications, and Siebel. At the time, x86 server virtualization and the idea of cloud-based multi-tenant hosted software services was not widely adopted or had not been invented yet. Just to be clear, “cloud” is not a business model.

Back when I was with IBM, I worked with a number a companies on their cloud business strategies and software business model rationalization, I came to the very simple realization that the SaaS business model was primarily an evolution of IT outsourcing and managed services. It’s about software service delivery. Part of the value proposition of SaaS is hiding the complexity of software support and the IT backend that delivers the value of a software service or application to the end user.

Software as a Platform Business Model – Some software companies develop software develop tools, toolkits and integrated development environments (IDEs). In the software world, these ventures are synonymous with the idea of PaaS or Platform as a Service for software. This category of software-business model boils down to making sense of the mess that having lots of different software of different types, different technologies and generations creates for us as well as the fact that computing is becoming more networked and connected than it was in the past. If you have been in the industry for a long time, you are very familiar with this problem. It’s the systems integration problem. If you are an enterprise, think of all the software you use?

What are some good examples of where this is happening? Some popular areas where this is currently happening is in the IoT space and AI where companies are developing vertically and horizontally integrated software platforms and middleware offerings to create an easy button for complex systems designs and implementations often times involving hardware. Classically, this is all that middleware and broker stuff of old. This business model is geared toward developers and builders of software-based or software-enabled business solutions and applications for end market users.

From a competency perspective, software as a platform businesses are good at integration and knowing how to broker things though they might not do any of these things themselves. They provide the software tools to enable partners to build the applications and integrated systems across a portfolio of software. Often times, when you look at an XaaS hierarchy, PaaS lies between IaaS and SaaS. I would argue that it resides above or next to SaaS. Platforms are about integration. They are not about deliver a single software application or function. Where SaaS might be considered software + services, platform is software + system integration.

Open Source Support Model – While this model might sound like a new one, it is not. It has been popularized for over thirty years by Red Hat. Now we are seeing this model being used in the telecommunications industry in the Open RAN movement and many of the open technology initiatives in that industry. The core value proposition of this software business archetype is to make open source enterprise, industrial or carrier-grade. This means fortifying and enhancing open source code bases and providing support services that are enterprise class. Much like the traditional software licensing business model, this is a high gross-margin model. Red Hat squeezed out 85 percent gross margins from licenses and subscriptions of their flavor of Linux prior being acquired by IBM.

I’ll tell you a little secret. If we were to be religiously MECE, here really are two archetypes; the Software as a Product and the Software as a Service types. If I didn’t add at least two additional archetypes, this section would be really short. That’s not to say that Software as a Platform and Open Source Support are not super interesting sub types and strategies for a software business.  

Now that we got archetypes out of the way, let’s talk about revenue model or monetization model for a moment. Firstly, your revenue model it is not your business model.  It is PART of your business model.  This is a point many folks I bump into, even in industry research and consulting circles, get confused. 

Software Monetization Types

Let’s talk about the basic ways that you can monetize your software and software services. They are:

  • Licensing (per user seat, per processor, per MIP) In software licensing, revenue is typically derived from license and service/support fees. One of the legacy challenges of this model has been issues with piracy, unlicensed use and the cost of audits and litigation.
  • Subscription (periodic, tiered, usage based) In subscription models, revenues is based on periodic or consumption based fees with support baked in. Benefits are “predictable revenue and cash flow”. However, this notion is not necessarily true if your software and the service are not sticky. Bottomline, depending on the kind of software or software service you are going to market with, subscription revenue can be a tough sell, especially if your software offering is niche or narrow. This revenue model works well for comprehensive, integrated and high value software and delivery services. 
  • Ad-based Ad revenue models basically subsidize end user use of a software service through advertising dollars. Understand, there is no freemium model. I’m not a huge fan of this. I consider this the bottom of the monetization barrel, but I also understand that it is a necessity for many software companies and is a common option in service catalogs. The options for ad-based monetization continue to expand especially with the growing prominence of app stores and marketplaces. Business that go too deep with this model run into or contribute to a problem called the freemium.

Freemium Business Model – Pros and Cons?

What about the freemium business model?  You might be asking yourself, Is that business model archetype missing from our list? There are a lot of folks who say that their business is based on a freemium business model. Actually, the freemium model is not their business model. It is part of their pricing and customer acquisition/retention strategy which are aspects of a business’s revenue model and go-to-market strategy.

The pros of a freemium strategy is that it CAN, but NOT GUARANTEE, an acceleration in user growth or engagement with your software or software service. These iffy proxies for revenue growth metrics could position your business well to draw in advertisers who might be willing to place ads on free versions or subscriptions to your software or software service. This is particularly helpful in hedging the risk that you may suffer a low rate of converting gratis users into paying customers. 

You might say, well what about Facebook? They have done well with the advertising revenue model. They are one of the most valuable companies in the world. Firstly, I would argue that Facebook is not a software company. They are a multi-media communications company. Some of us just thought they were a software company because some of their employees are really good at coding. They do not selling software or a software service. By and large, they sell ads.

The point I’m trying to make here is that your software and services that go with it or that deliver it are only as good as people are willing to pay for it. As you consider your business model, consider the value your business provides and how it provides it given the growing privacy crisis that we have online.

Business Model Selection Principles

When it comes to business, I like to say that you have to do it the dumb way a few times before you figure out the smart way.

What is the best business model for your business? The answer is, it depends. A good starting point is to understand the basic archetypes as well as the options you can consider for revenue model, cost structure, channel strategy, etc. associated with each archetypes. Honestly, business model selection is more a design art than anything else. It is more than likely that your business model at any given point in the evolution of your business will be a hybrid of conventional and emerging business model “standards”. 

The truth is that you will be adjusting or even completely revamping your business model at the get go as you begin to listen to real customers and test your offering in the market. I don’t know of anyone who has gotten it right at the outset. Ultimately, the best business model for your software business is the one that resonates with the market at any given point in time. Tuning your business model to the market is a tricky thing, especially if you are a startup given that your business will be evolving much faster than a mature company.

It is not uncommon for companies to use all three monetization models or create a blend of the software business model archetypes. Salesforce.com is a great example of a company that has done this from a business model perspective. They are widely known as a SaaS company, but from the beginning, they took on some of the attributes of what we typically see in Software as a Product companies, which is the development of their own proprietary software product. As I mentioned earlier, it is not always the case that a SaaS provider actually develops the software that it delivers as a service.

Many SaaS players deliver 3rd party software as a cloud-based service. This has implications on the cost structure and the resource requirements of a business. More recently, cloud service providers such as AWS have increasingly take the open source support business model and blended it with the more conventional SaaS and SaaP business models for their AI and IoT business segments. This is allowing large players such as Azure and AWS to take what are considered open technologies and create walled software platform gardens to lock their enterprise customers in. 

Partnerships & Platforms

The bottom line about partnerships and platforms – it’s mostly about business acceleration and scaling. These days you hear a lot about ecosystem this and ecosystem that in the software industry. Most software companies are just ecosystem participants. They can merely state their position and don’t have the gravity to do much about it. Like any industry ecosystem there are only a small number of ecosystem leaders.

It’s more important for most software businesses, especially startups, to consider partnerships. One of the important guidelines to consider as you look at partnerships is understanding how and where your business is positioned in the extended value chain to the end market customer. It is, after all, the end market customer who is creating the market and the source of all market participants’ revenues. 

Partnerships and platforms for software businesses. neXt Curve.
Source: neXt Curve, Leonard Lee

Next, let’s talk about platforms. First, there is the cloud. We are all familiar with the big hyperscale cloud service providers such as AWS, Microsoft Azure and Google Cloud Platform (GCP). This is an easy one because most of you will probably agree that public cloud computing has changed how we support our software development and go to market with software as services.

Finally,  I want to talk about the matter of app stores. I wanted to provide some perspective on app stores as they pertain to business models from a software business perspective. The software business is tough. It’s easy to design and build stuff, but it is difficult, like any business, to build a business. If it is easy for you, it is easy for millions of other developers and entrepreneurs or maybe you just got lucky. Maybe your software and your go to market acumen are off the charts. Congratulations!

Many of you know that App Stores are a great way to get your software to market. What you might not appreciate as much if you haven’t examined the various software business models is how the Apple and Google app stores and others have simplified many of the complexities that software businesses used to have to deal with before especially device compatibility, software support, software distribution, mobile network testing and much more.

If you consider the cost structure of any software business model archetype, SG&A, core technology development, software distribution and service delivery infrastructure costs, reduce the gross margins of a software company that licenses their software from 90 percent down to 30 percent. In most instances, it would cost you more than 30 percent of your revenue if you tried to build those operational and integrated capabilities you get from an app store on your own.

Conclusion

In closing, I would like to say that the software business is a difficult one. It is after all a business. Building software is far easier. The software business can also be a very good one. Whether you are a startup or an established player in the software industry, it is essential that you understand your software business model. It is the great first step toward building your software business and competitively sustaining it.

Here are my recommendations for you and our software business.

Software business model design recommendations. neXt Curve.
Source: neXt Curve, Leonard Lee

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