Chapter 10: Software Savvy: Taking and Keeping Your Place in the Software Market

John Chen

Basics of the Software Industry

The software industry is built on programming applications on computers and hardware. Software is meant to reflect creative ideas and processes and is probably the most flexible component of the IT world. And because of the intense intellectual property aspect of software, it's hailed as the highest margin business - the most profitable business - if you have a good idea.

The biggest negative of the software industry is the barriers of entry are not high, resulting in strong turbulence. Of the top ten software leaders of ten years ago, probably only half of them either exist independently or are still in the top ten. Software is a game for a lot of newcomers, with many intellectual property and creative challenges. It also tends to have a winner-take-all mentality.

Because so many new ideas keep surfacing, we go through more waves of innovation than probably any other industry. Ford stopped making the Model T about 100 years ago, but we still have luxury cars. In the hardware industry, the cycles for new waves of innovation span between five and ten years. You can be a winner in one wave, but if you blink and miss the next wave, you could be a dog.

The software industry is now a very integral part of the U.S. economy and U.S. productivity.

Pushing to Create a Niche in the Marketplace

Innovation has to be the cornerstone of the industry. Continuous investment and focus are needed. You need to keep pushing to make sure your customers are happy not only with your services of today but with the potential of tomorrow. We talk about standards and compatibility and serviceability. These are the reasons that you are in business and that the customer wants to buy your material and stay with you.

We spend a lot of time innovating not only from the technology perspective. The claim to fame of Sybase is mostly on technology, and we own a lot of technology. We "early lead" on a lot of innovations, including wireless. Those are really the results of many years of investing in research and development and many years of investing in market research. This is a hard business to stay put in. Sybase tries to go after certain niches. To guard against becoming obsolete, you have to have a corner on the market. We focus on doing just that at all times.

Small companies are a little more focused, a little more versatile, and very nimble. In our business, where things happen so fast, those are distinct advantages. The disadvantage is that you typically have little muscle in the market or the channels.

When the economy is in a downturn, the ability to generate cash and make money is of paramount importance. If you don't have that, you can't invest in new technology or new generation. Size matters: You want to be small when the market is good and large when the market is bad.

Building the Customer Base

The consumer space is basically a volume game. You have to sell a lot or make a thin margin. The enterprise space, however, is very different. Enterprise is based on reliability and serviceability, and once you are in the door, unless there is a good reason to remove you, typically you don't get displaced very easily. We tend to stick there, providing good service and solid future road maps.

In this business, there is no economic value to your customers to move from your products to somebody else's products. As a vendor or provider, all you need is one interruption, and you are in trouble. Your ability to back up your customer, recover his system losses, and fix his problems quickly, professionally, and accurately are key cornerstones to your customer support.

Software has a lot of bugs, principally because there is so much code generated every day. My software needs to interact with the software of many other companies, including the software being generated by my customers themselves. You often don't know what is connected to you. When your customer has a problem, you have to dive in and figure out what is wrong and fix it because your customer's business could be at risk. It's critical that you're able to do that. If the use of your software shuts down anyone's business, your reputation is at stake. A loss of reputation is very tough to recover.

It is not impossible, however, to move your system up, especially if a newer idea comes along. The customer is always confronted with keeping the platform stable with good support or moving to something else that is a little more innovative and less expensive.

Typically the inertia of an incumbent is the best account protection. If my customers buy my software, use it day-to-day, have their people trained on it, are happy with my responsiveness, and they understand my road map, and if I've kept up my research and development with my competitors, then even if I am a little late, they will still wait for me. They like doing business with me, and that whole chain ties to robust customer support. Not only is that the most lucrative part of the business if your platforms are stable and your products are good, but it is also the strongest connection bonding you to your customer.

Software is a people business. People buy from people in this industry. It's extremely rare that you have such an innovative idea that you are the only one who can provide it and customers will buy from you even if they don't see you.

We are definitely not in the mail-order business. Our products are complicated, and it takes time and energy to explain them, to help put them to work, and to map into our customers' needs. That is where much of the margin and the "stickiness" come from. You have to be there for your customer and look them in the eye. They have to know you are trustworthy, that you have a good plan for the future, and that you won't come and go on them. Trust and loyalty take time to grow. Personal contact is the key in this business.

It follows, then, that the most profit-rich area of software is customer support - the service and maintenance part. It reflects the degree of stability of your product. Customers continue to pay you to make sure you are responsive, and because you are a more stable platform, you don't need to spend much money to fix the same problem many times. That makes service usually the most lucrative piece.

Making and Marketing Good Ideas for Software Products

In creating a new software product, your aim most of the time is to offer a more efficient way of getting something done. If your customer has ten people managing three systems, your product should provide a better way to run the business. The product you offer can collapse your customer's three systems to two, reduce the ten people to six, run the business faster, and improve your customer's interaction with his customers. That is a more efficient new software product.

Coming up with a way to replace, condense, or simplify some of the things being done today by other IT systems and processes gives you a winning product. That is evolution. Every so often our industry comes up with some revolutionary ideas, the Internet being one of them, and commercializes it. Those revolutionary products have a longer shelf life.

The product cycles in our business run 12 to 18 months at the longest. If you come up with something truly new, very exciting, and evolutionary, you will probably be able to sell it in a reasonably profitable way within 12 to 18 months. If you miss that cycle, it is best to move on because nobody buys older technology. Occasionally, we have truly innovative ideas that have a little longer shelf life - maybe three to five years.

When you have an idea for a product, you try to sell it, and if you don't already have a base business, you try to sell it through partners. When you reach a certain number of partners, you make next-generation upgrades and try to sell it yourself.

This is a gradual process. It gets you closer to the customer so you can get a lot more market research. After you have done that for a while, the next step is to grow by pushing your business overseas. Then you battle against your competitors in the new space.

In product marketing, you have to speak to the needs of the market and follow its trends. Establishing yourself as an innovator, providing products and services to help customers do something more efficiently than they could before by reducing the number of systems, staff, or other resources, is normally how software is marketed.

The industry moved off mainframe to prepackaged applications to get through the year 2000. Now the needs are for integration solutions to enable all those packages to talk to each other and use the Internet to best advantage. The next step will be having wireless, the Internet, and broadband collide, followed by a move toward intelligence.

Software Business Financials

Normally if you are in the mature part of the curve for the business, your pricing is dictated by the market - supply and demand and how other people price. If you have an innovative idea and you are a market leader, you can dictate the price. You won't stay market leader for long, though, because the market is very turbulent, and you always face challenges by new startups. Then the prices start shifting. After a while the product matures, and you price as everyone else prices. This is the early lead cycle. You are the first one there, and you can actually take a lot of the margin off the table.

In a mature, non-Internet-based cycle, you price on number of users. If it is Internet-based, you price on number of systems because with the Internet, you can't count users. Early entry always gets the lead in the price war.

Depending on the company, expenses run typically as follows:

• Research and development costs between 15 and 20 cents on a dollar of revenue.

• The Q&A cost is between 8 and 10 cents.

• The sales and support infrastructure are between 25 and 35 cents on the dollar, depending on the kind of company that they channel. If they sell through partners, it will be lower; if they sell direct, it will be higher.

• Your marketing costs are 10 cents on a dollar.

• Your costs of goods is typically between 5 and 10 cents, depending on whether you make all or some of the components.

If you add this all together, you have 20 to 30 cents per dollar left, and that is your profit. Your predominant cost is for people. Our business is very people-intensive, or brain intensive. We typically have a high percentage of people supporting and people selling - and a very high percentage of people doing engineering work.

The costs of our products are not high. If you develop your own software and don't resell other people's components, you don't have to pay royalties, so you can run a margin business in excess of 80 percent. On the other hand, we spend a lot of money on R&D for innovations - very big numbers.

It is easy to see how most of the well run software companies make 20 to 30 cents net on the dollar before taxes, depending on how pervasive they are in a certain market. It is a highly lucrative business and that is why so many people jumped in.

Skills in Highest Demand

The most important skills in the software industry go back to the product side, the engineering and innovations. Today, a lot of people can program, but whether they can program reliably and turn those programs into a product is the big question. They must be able to have a great idea, to develop it, and - most important - to develop it in a commercially viable way, linking it back to customer support. That skill is paramount.

The secondary skills are in the people who can actually take such complex equations and map them into something customers not only understand but see that they need. Those are the two most important roles: creating a product and creating a demand.

The software industry will continue to evolve to a higher level of intelligence. In the past, software was used for programming, for mimicking certain processes and parallel orders of things, how factories are run and how certain businesses are run.

In the future, a number of high-potential software applications will be based on intelligent systems - software that can actually learn and adapt and heal itself if it runs into trouble. It will self-diagnose, recover, and alert people. The wireless phenomena will drive software intelligence and will be ubiquitous.

Approaches to Risk Taking

There are two components of risk. One is risk management. The other is risk taking.

Risk taking depends on the time. Ten years ago, when the market was searching for new direction, it was best to be a little more of a risk taker. If you fit only on the old paradigm, you may have missed the entire wave. The penalty for missing a wave is very high. It could almost cost the company.

You have to take a certain amount of risk. That is what a good management team does. You take the risk, and you monitor the progress of new ideas and new components. You know you will win some and lose some, but you're confident that you are knowledgeable enough, with fast enough reactions and reflexes, that you can pull back from potential loss and continue to be a winner.

The other component is risk containment, or risk management, which is extremely important to our business. So much of our business is people-based, wrapped up in the building of intellectual properties. Managing that risk and making sure we can restart with maybe the same set of talents somewhere else are concerns to which every software company pays a lot of attention.

Risk in terms of managing for business continuity on such a high intellectual property-based business and people-oriented basis is a little more challenging. Because of the turbulence of our market, we do need to take risks and manage them to continue to be innovative.

Ensuring the Longevity of Your Company

Diversification is a good way to think about a successful company. I have a very stable, mature business that makes money. I have various stages of incubated business, and I continue to have that pipeline of businesses and markets on which we've focused and built some technology know-how and technology innovation and barrier of entry.

Right now, I have four major businesses. My database business is very defendable but is not a high-growth business. It is a good cash generator because customers like us and stay with us. However, I have an integration business that has been growing 30 percent to 40 percent a year.

You have to pipeline your future opportunities and always look ahead. What are people buying? Who are they buying from? Why should they buy from you? You can't focus on one business and bet everything. Pipelining different stages of opportunities into the market ensures longevity and success.

Staying on Top of Technology

There are three ways to stay on top of new technology.

One way is staying close to your customers. Customers are constantly being pitched to about new ways of doing things and new technologies. You know their demands and what they are thinking about, and you can make sure you move along with them.

Another way is through standard bodies in the industry. The industry has many standard bodies in various stages of maturity. You need to be in the industry making sure you listen to what other people are doing and what industry standards are driving toward, and you stay there.

The final way to stay on top of technology is to be associated with universities to capture some early potentials. You need to keep an eye on what they are doing and figure out how you can apply it later in your business. You have to filter the ideas.

Biggest Upcoming Changes in the Industry

A fundamental shift coming soon in the business involves how people pay for software. There will be a divergence of methods - people renting some software, paying as they go, which is different from the way it's done today. There is a lot of discussion of software as utility. What it all boils down to is a different form of pay-for-it-as-you-go software. All the software companies have to pay attention to that because it will have a profound impact on the business.

The economic aspects of your business can change dramatically, depending on who you are and at which point in the food chain you enter. In the next five years, that will change. Today, because of the choices and the economy, customers have the ultimate power. Five years ago vendors had the power because if the customer did not buy their software, they could not keep up. Now the pendulum has swung the other way, and we have to listen to how they decide to spend money. That will be the biggest change in the industry.

I could help buffer myself by continuously trying to reduce my cost base. That is why you see a lot of outsourcing activities. People try to do things a little less expensively. It has a profound impact on your primary strategy and your acquisition strategy. Because of the turbulence in the software industry, there have been many combinations, some of which were for technology reasons and some of which were for survival reasons.

The only competitors in software for U.S. companies are in some niche areas in Israel, Canada, and Europe. The top ten list today is dominated by U.S. companies. But if you want to stay in the software game, you need to be highly adaptive. Our society and our industry are very fluid and dynamic and are certainly used to changes. This flexibility has made the United States a leader in the industry. The key long-term issue as the industry matures is to maintain that competitive edge and also have enough talent to fuel the growth engine.

A principal reason the software industry does well is that they essentially have no government regulations, other than the same regulations of accounting and so on that all businesses are subject to - but not in terms of how the industry works. Much of the software industry was built on the enthusiastic encouragement of R&D tax credits the government issued some 15 or 20 years ago. These are important logs for keeping the fire going. That is why you find a long line of software companies very close to and interested in public policy. Such a big part of our growth and a big part of our business is overseas. Typically you will find software companies who are mature having at least half of their business coming from overseas.

No Rest for the Leaders

Once you understand the turbulent nature of the business and you compare the lists of top ten companies of yesterday and today, you know you can't sit on any lead. There is no comfort zone. You have to be in constant paranoia. That piece of advice comes from a lot of well known people in the industry. You have to keep moving.

I also try to point out to people that there is no perfect way of doing things. The industry moves too fast for perfection to develop. You have to challenge the status quo. That is how the margin of business is built.