Can you describe the three principal business models used by software firms? Before you invest in a software firm, buy products from one, or decide to work for one, look at their business model.
In this industry overview, we adopt a case study approach to incorporate data from NetSol Technologies. They were founded in 1996 and are listed on NASDAQ as NTWK.
NetSol is an enterprise software products firm that develops and sells financial services software to banks, lease finance firms, leasing agencies and consumer financing firms. Information for this case study was gathered over the last 10 days at their new 270-seat development facility in Lahore, Pakistan.
‘Bank in a Box’
NetSol has extended its market reach into nine countries. China and the U.K. are the newest locations. Their newest product is a “bank in a box” suite called inBanking that is being launched in a phased manner. It is built with Microsoft’s .NET technology and is designed to provide all software and transaction management tools needed to operate single and multi-location banks.
NetSol’s original product suite is LeaseSoft, a client-server software system built with the PowerBuilder rapid application development tool from Sybase. LeaseSoft is used by vehicle-leasing companies and wholesale lenders in that industry. Its baseline clients are Daimler Chrysler’s lease-financing subsidiaries in East Asia. In Australia, NetSol’s software is used to manage more than 1 billion Australian dollars in assets.
Three Business Models To Choose From
One of the distinguishing characteristics of any software firm is the choice of business models. In the following description of the three types of business models available for software firms, you should be able to spot the business model or models used by software firms that you might have been associated with as an employee, investor or customer.
The three business models that software firms can choose from are:
- Software Product Firms. Software product firms earn at least 60 to 80 percent (depending on which definition you prefer) of their revenues from developing software, licensing it for sale and receiving maintenance fees for updating that software. Seventy-five percent of NetSol’s revenue comes from product development and from customizing its own software products for users.
- Services Firms. Services firms provide customization, installation, integration and maintenance of other firms’ products, along with consulting and other services. They might also develop customized software applications. Under the service firm business model, such customized software is owned by the clients.
- Hybrid Firms. Hybrid firms develop products and perform some services work. This model is attractive because it enables hybrid firms to leverage their core technologies to distinguish themselves from their competitors. Almost all software product firms eventually provide some services and drift towards the hybrid business model.
Twenty-five percent of NetSol’s revenues come from customized development work where clients own the software outright. This is a small percentage by industry standards, since most software companies are service firms. Service firms might experience dramatic revenue fluctuations. Revenue per employee and profit per employee are usually lower at service firms than at successful software product firms.
It is easy for software firms to transition from the product business model to the hybrid one because they already have a client base to whom they can market. The alternative for a product firm is to go out and find new software customers to purchase their products. It costs 10 percent as much for enterprise software firms to develop new business from existing customers than to bring in new customers.
Hybrid firms need to decide whether to stress products or services. Firms with a higher percentage of revenues from software sales have higher potential for growth and profits, particularly during good economic times.
Business Models Compared
The attraction of the business model used by software product firms stems from the fact that software is often easy and cheap to reproduce, once it has initially been developed. Profitability from each employee can be very high once sales begin to take off. The risk is that an economic downturn or other factors outside of the control of a product firm will cause clients to suddenly stop purchasing software.
Software firms that are in the best position are often those that produce their own software and have a solid base of clients willing to provide it with a recurring revenue stream from maintenance fees, updates, customization and other services.
Unless there are extreme price pressures within a product field, enterprise software product firms (those selling business software) can often charge high prices for each license. With NetSol’s products, for example, software prices of US$1 million or more per client are their target.
By producing multiple copies of the same software product at little more than it costs to produce a single copy, software product firms can gain an economy of scale that enables them to increase revenues without substantially increasing their costs, thereby becoming very profitable within a short period of time. Service firms, in comparison, find it harder to scale up rapidly because their revenues are based on the amount of personnel resources utilized to implement each service contract.
Economies of scale are harder for service firms to achieve. The profit margin for each dollar of revenue received by services firms is much lower than the gross profit margin for product firms. In 2002, for example, PeopleSoft reportedly spent only 10 percent of its software revenues on developing and distributing that software.
Recurring revenues are available to product firms from maintenance fees. The terms of maintenance fees differ, but they often allow customers access to newly developed features and patches for bugs.
Maintenance fees are largely profit, once the product is stable. A feature developed for one client (and paid for by that client) can be made available to all customers who pay the maintenance fee for that product.
Since not everyone in the installed base might want or need a new feature, version controls and feature switches might be needed to enable users to opt in or out of new features. The ability of users to set parameters regarding new features is also important in the implementation of maintenance agreements. This is often the case when the installed base spans different countries and where different business processes are used from one location or client to the next.
Back in the 1980s and early 1990s, maintenance fees of 10 to 15 percent were common. Maintenance fees today usually range from 15 to 22 percent of the original purchase price. PeopleSoft was charging 20 percent until January, when its new owner, Oracle, raised it to 22 percent to match the rate that Oracle charges for its own products. Some PeopleSoft customers were considering going off maintenance contracts after that fee hike.
NetSol’s sales contracts authorize it to charge up to 22 percent, but it is currently charging 18 percent. Over the life of each product sold, NetSol will earn more revenue from maintenance fees than revenues received from the initial product sale.
In common with other software product firms, there are four price components to NetSol’s license agreements:
- Core software product.
- Implementation, which includes migration of data from legacy systems.
- Support and maintenance fees.
Once a software firm has chosen a business model that involves the development of a software product, it needs to decide whether to build products for mass markets or niche markets. In the enterprise software field, the safest strategy is generally to target a niche market first.
NetSol initially targeted the front end of automobile leasing software, where lease applications are completed and sent for approval by a finance company. Then it moved up that vertical until it had built up a complete suite of complementary products. Mastery of one market vertical served as a jumping off point for NetSol to enter the banking industry using the same verticalization strategy.
In future columns, the NetSol case study will be used to explore market strategies for software product firms, issues of capitalization and the challenge of gaining domain expertise in targeted verticals.
Anthony Mitchell , an E-Commerce Times columnist, has beeninvolved with the Indian IT industry since 1987, specializing through InternationalStaff.net in offshore process migration, call center program management, turnkey software development and help desk management.