Industrial companies have been trying to evolve to be more like software companies for years. In 2011 General Electric launched GE Digital, and in 2015 Jeff Immelt announced that GE was on track to be a “top 10 software company.” Today GE’s stock price is 40% of what it was when that statement was made, nowhere near software company valuations. In 2015 Dave Cote stated that he wanted Honeywell to be the “Apple of the industrial sector.” In 2016 they launched two software centers of excellence and hired hundreds of people. Honeywell has made some significant changes in their portfolio, and while software plays an increasing role in their offerings, their success in the stock market is due to business performance, NOT a software company valuation.
There is a strong appeal to becoming a software company, but is it really the right answer for your business? As these two examples show, the answer is far from clear.
Why Is it so Appealing?
First and foremost, it is what all the cool kids are doing. Who doesn’t want to be Elon Musk and turn a car into a drivable tablet? It harkens back to 1967 when we were told “the future is in plastics,” in the movie The Graduate.
Next, is the profitability of software. Three of the top ten largest businesses in the US are software companies and five of the most profitable companies are software companies. The gross margins of successful software companies are among the highest around, and making it even more attractive, the software business model is readily scalable.
Finally, you have the valuation multiples. Software companies occupy four of the top five companies in market cap valuation. The average multiple on EBITA for a software company is close to double that of the total market average.
The Harsh Reality
The allure of the successful software company masks the reality of the software industry. Low barriers to entry, difficulty differentiating themselves, and the ongoing cost of software maintenance lead to some unfortunate results for most software startups.
The failure rate for start-ups is high, and software companies fail at an even higher rate than startups in general. In the first year 20% of startups fail, whereas 50% of software startups fail. After ten years 90% of software companies have failed, while only 70% of all startups fail. Our perception that software companies excel is partly a result of ‘survivor bias’ – we remember the highflyers and Wall Street darlings, but no one remembers the dozens more that burned out without leaving a noticeable mark on the world.
Some of the reasons software companies fail are the same as any business: They didn’t have a clear understanding of the market. They didn’t have a clear target segment with a compelling value proposition built on differentiation. The leadership wasn’t adequate, often with a product-forward vs. market back perspective. Or they underestimated the fixed cost of creating a marketable software product and ran out of money before they can achieve success.
Key Ingredients of Software Success
Successful software companies are very agile, not just in their software development practices, but in their entire business. They adapt quickly to customer and market requirements. They do not have processes in place that slow innovation. They have an overall vision, but often an incomplete product ‘roadmap’ – this prevents the ‘perfect from being the enemy of the good.’
Most software companies start small and fail fast. They are looking for the Minimum Viable Product and then test new features and capabilities before investing in their complete development. If the market responds positively to the changes, then they rapidly build it out. If the market ignores the new features, then they scrap them and move on.
They also think in terms of total customer lifetime value, rather than just initial selling price. This goes beyond just shifting to a SaaS pricing model, because to retain those SaaS customers, they need to continually deliver more value to those customers. They live the reality of “what have you done for me lately” every day to ensure that they are continually delivering more value.
Lastly, they understand the economics of the software business model. Yes, software is inherently scalable, but the fixed costs can be high as can ongoing maintenance and development costs once you have competition. Further, costs for customer and technical support are often less scalable, and if not anticipated, can eat you alive.
Can Your Business Be Successful as a Software Business?
There are several attributes that to be in place to truly shift to a software business.
1) Agile Business Practices – you must either have or be seriously willing to adopt agile business practices. The software lifecycle can’t survive hurdles like stage gate reviews.
2) Leadership Philosophy – your senior leadership needs to be nurturing an evolution of success and not looking for the immediate home run. Small successes need to be recognized, but even more so quick failures need to be celebrated. Since software businesses often take years to be profitable, a clear view of leading indicators is usually needed to keep confidence high and investments flowing
3) Legacy Infrastructure – you must be able to overcome the momentum of legacy infrastructure, such as installed base hardware. If your current business is dependent on a physical product, is the installed base capable of handling the changes required to make changes through software? Or will you need to replace the entire installed base or only sell the new capabilities to new customers?
4) Cashflow Implications – often a shift to a software business model is accompanied with a shift to a more subscription type of pricing model or XaaS. We wrote a post a couple of years ago titled Should You Jump on the XaaS Bandwagon? that highlighted some of the requirements to shift to a subscription-based pricing model.
5) Sound Strategy – you still need to maintain a sound strategy. This includes understanding the problems you are solving for target customer segments and how that creates value in a way that you can capture some of that value. The fundamentals of business strategy don’t change just because you are a software company. A me-too software product can be just as disastrous as a physical product without differentiation.
Even if moving to a true software business model isn’t right for your company, there are still many things you can do to leverage software and software practices to enhance success. You can migrate your product development practices to be more agile with MVP, rapid testing and feedback, and projects that are measured in weeks, not years.
You can also leverage software to enhance your customer experience. Use digital channels to add more value for end-users. Provide apps, both internally and externally, to automate tedious or knowledge-driven processes. You don’t have to be a software company to deliver a best-in-class end-to-end customer experience.
Some B2B companies have even figured out how to incorporate software to change their business models. For example, you might deliver services virtually changing the scalability of product support, or you might use software to dramatically lower the cost of product configuration enabling a semi-custom business model (reference blog).
Although the idea of being recognized as the next Amazon or Apple may be attractive, becoming a software business may not be the right answer for your company. In fact, it could consume disproportionate resources and distract you from more attractive opportunities in your core business.
But adopting software industry practices and philosophies may help your company to be more successful. You should evaluate the best practices and see what applies to your business, but don’t throw out the baby with the bathwater because “the future is in software.” Successful companies stay focused on sound strategic principles, continually evolving to create more value for their customers, and their businesses. If software is a piece of that equation, great! But as always, there is no magic bullet and beware of anyone who promises one.
How can Amphora Consulting Help?
- Evaluate your business model to see if there are better ways to server your customers and capture value
- Help you understand customer value and unmet needs and the role that software could play in enhancing customer value
- Evaluate your pricing model to help you move towards value-based pricing