The Coming Service Revolution

OPINION from SandHill.com - is Ray right? post your own opinion.
Ray Lane, Kleiner Perkins
More than a change in pricing or business model, software as a service is an inevitable, fundamental shift in enterprise software culture.
Jan 31, 05
Software as a service is transforming our industry. It’s more than a new way of pricing or a business model change, it will drive a whole new mindset for enterprise software suppliers and customers. First, let me be clear about what I mean by software as a service. I’m not referring to ASPs – although they are a big part of it. I define software as a service as tying supplier revenue to a business outcome: the supplier sees the client’s end result, measures its success, and receives revenue based on the results achieved. This doesn’t necessarily mean success-based pricing, however. It can be subscription, or even license based. In some cases, a company offers to sell a service. Negotiations can take place around buying the intellectual property, but the company can buy a software license and pay the supplier to operate it. You can find a lot of examples of companies that are offering a service with very complex software behind it (Amazon, EBay, iTunes, SalesForce) - even if the customer owns a license (Elance, Oracle Online, Siebel On-Demand). These suppliers focus on selling knowledge – not bits. A Customer-Driven MovementThe concept of selling software as a service is not new. It has been on the table for more than 10 years. But it hasn’t been very meaningful or relevant until now. The recession forced a discussion between customers and the industry. In the past, this discussion was about prices, not “pricing”, but prices: They’re just too high. Now it’s a different conversation: Do we have a pricing model problem? Do we have a business model problem? Do we have an impedance mismatch between price and value? Would there be a competitive advantage to having a subscription-style pricing model?The nation has emerged from recession. But the software industry is only recently starting to recover after four hard years. Customers are in control. They’re forcing suppliers to compete with each other; they’re demanding lower prices and more accountability for results. But most of the large suppliers are not ready for change. And the only way they will change their models is if their customers demand it. But how do customers alter the behavior of a 40 year-old industry that still believes it is a ten year-old? When will customers learn that the benefit of a model change will be painful on them too, but the payoff might be worth it in results? It’s like stopping smoking: You’d go cold turkey. “I’m not going to pay up front. I’ll pay you ratably over the life of the project and you’ll profit when my project starts delivering business value.” If that happened, we’d see a lot more software delivered as a service and much happier customers.On the other hand, if the economy picks up much more, it’s possible that the balance of power will shift back to the software companies. I.T. organizations will start to scramble to meet growing demand from the business and lose their current focus on maximizing R.O.I. Further, the technology industry has always had the ability to reinvent itself which further shifts influence to the suppliers. These dynamics will only allow us to perpetuate the broken model we’ve always had: Selling licenses up front. But if customers can maintain control of pricing (through competition), they will force the industry more to sell software as a service, and price it accordingly.Making the TransitionIt will be many more years before we see the majority of the industry shift to this model. ASPs will emerge first, followed by today’s startups that don’t have to meet public expectations. It’s certain that large companies won’t lead this move, except where they are starting new businesses outside their traditional markets. But many established software companies will see the benefits and figure out how to make the transition: A service delivery and pricing model gets software vendors out of the “hockey stick” sales dynamic at the end of the quarter. It gets the customer out of having to buy something before they can use it. Even the largest, most entrenched suppliers can start by offering software online, especially to under-served markets and incremental offerings to existing customers. Companies can also use the down market and its lower expectations to begin offering more remedial commercial arrangements, such as term licenses or leases, for example. And then, vendors must learn to say “no” to big discounts to get deals done in the quarter. Every deal done for quarterly gratification by a sales team or analyst expectations erodes long term value. Customers already know this and drive supplier to highly discounted deals, which many times turn to shelf ware. But even the staunchest customers can be tempted. It’s like buying drugs: who do you blame, the buyer or the seller? Often, if the seller presents an attractive deal for short term benefit, then the buyer can’t resist. Say a supplier is offering 80 percent off the regular price, the buyer knows he’s buying a lot of pain and trading away the future value of having a supplier engaged with his outcome. At the same time, the supplier could make five times more over the life of the customer/project if he waits and negotiates a more ratable arrangement. Of course there’s a catch. The supplier must be more accountable for the claims made in the sales cycle: If the supplier thinks this is a bad idea, then a more serious problem exists.A Better ReputationA move to a service model means the reputation of the software industry improves. If the transition occurs gracefully, customer satisfaction will grow, profits will grow and become more predictable and, ultimately, the industry will grow from real demand by customers when the technology is actually needed and consumed. Although the industry’s past youth and cowboy culture was fun, the products of our industry are far too important to deliver over the transom with an 800 number for service. Ask yourself the question about the relative reputations of software service companies vs. software products companies (amongst their respective customers). It’s not even close, and that’s because service companies are in the business of pleasing their customers every day, not just when they need the next deal. How does a large supplier avoid a share price haircut when converting to a service model? First, this doesn’t happen overnight. Second, it requires education of public market analysts about the development of long term profits and cash flows. Analysts recognize that if you’re a software company that can grow 10 to 15 percent a year and increase profits and free cash flow, that you’re a good investment. There are way too many people in our business and on Wall Street thinking that this is still a get-rich-quick industry. Those days are gone. But the software industry is still a better investment than most any other industry, and will be for a long time.The Startup AdvantageSmall private companies starting up have an advantage. They can develop a service model from scratch and use it as a competitive advantage. Salesforce.com doesn’t offer more, they offer more service. Elance delivers a result through its intellectual capital, not bits. It boils down to simple economics. With a large customer, you can discount very large product sales up front and erode the value of a relationship or develop a long term relationship that is a win-win in terms of price/value that builds a more sustainable and predictable business. Any economic analysis will show that the service model will offer a better opportunity long-term for profits and cash flow, despite more required investment in the short term. As a startup, if you’ve got the right funding, start off as a service business, using subscription pricing. You won’t have to defend your history. No problems of changing business models. You will need to invest up front before you see the benefits, but once you do, it’s beneficial to customers, investors and management. It’s a much more predictable model. And it’s the way we’ll all be doing business in the future. Ray Lane is a general partner at venture capital firm, Kleiner Perkins Caufield & Byers. Before joining KPCB, Lane was president and COO of Oracle Corporation.