3. 1. 2  Development companies: to create products or to provide services?

As we said earlier, a company that hopes to focus on development will have two main options to choose from: it could generate standard products, packaged to sell to the mass market (shrink-wrapped, as they are called), or it could generate custom developments, tailored to the needs of individual clients.

The first option has the potential of generating large profit margins but they will be difficult to maintain over time, and it has barriers to entry that could prove unsurmountable. The latter is a far more labour-intensive option with much lower profit margins, but it offers more possibilities of generating constant sources of income over time and of being less sensitive to changes in the macroeconomic environment.

We will now describe the differentiating features of these two options in detail.

Economies of scale and the possibility of large profit margins

Required reading

M. Cusumano (2004). The Business of Software (Chapter 1, "The Business of Software, a Personal View").

The economic process of software creation has special features not seen in other industries, affording it huge positive returns to scale.

On the one hand, commercial companies need to invest large sums of money in development before they can create a commercial version of a product to release, and they must often invest again every two or three years to maintain a constant flow of income. Since the aim of this development is to generate a standard product, it is very risky because there is no certainty that the investment will be recovered later through sales. However, once they have a finished product, the marginal cost of each additional copy sold is next to nothing. The first copy of the software created is very expensive, but the rest costs virtually nothing.

This leads to huge economies of scale on the supply side, which combine with significant economies of scale on the demand side: both due to the time invested in acquiring the skills to use an application and the possible incompatibility of formats, switching from one product to another is a difficult and expensive task. As a result, the bigger the user base of a product, the easier it is for this base to grow and survive over time. In the software market, then, we can come across "winner takes it all situations", where huge profits are generated and the entry of new companies to these markets is simultaneously blocked.

The companies that have exploited these large economies of scale include some of the giants of the software industry, such as Microsoft, which tops the desktop operating systems market, and Oracle, with its purchase of PeopleSoft in 2005. However, there are small companies too, known as independent software vendors (ISV), that produce feasible businesses by exploiting specific niches. Examples include Pretty Good Solitaire, developed by the two-staff micro-enterprise Goodsol Development Inc. (one of the most popular solitaire games), and HomeSite, a HTML editor developed by the Bradbury Software micro-enterprise in 1995, which was purchased by Allaire Corp. (Allaire was later purchased by Macromedia, which, in turn, was absorbed in 2005 by Adobe).

In contrast, a company that engages in custom development will not have access to the economies of scale of standard software. Every new customer will require a specific development, making it a costly investment in time and effort, although this type of company does tend to reuse its developments where possible.

3. 1. 2. 1  Need for initial investment

When we set up a company based on the traditional product idea, we come across an important problem: the need for initial investment. During the early stages of the company, dedicated to development, there will be no income flow, but there will be expenses until the first versions of the software are ready for release. Besides the expenses deriving directly from development, we need to take into account the necessary expenses of marketing and sales. There are two solutions to this problem: obtain external investment, or start another type of business activity that generates sufficient income to allow for simultaneous development of the product.

Custom development companies entail much less risk and can start their activity with a much smaller investment (development only begins once a contract is signed), thus avoiding the need to search for outside investors.

The financial literature tends to focus on the discussion of companies that finance their development from venture capital investments since they are more attractive. This type of financing allows for faster growth, which is an important factor in success according to Cusumano. (Michael Cusumano, The Business of Software)

At this point, we can consider the following: what parameters do we use to judge the success of a business initiative? Investors and financial publications consider a successful company to be one that manages to make a profit every year, and probably those that display growth too. A company that remains the same size with an income statement showing no profit will not attract the attention of investors or the financial literature. However, a company of this nature may have been very successful in creating quality jobs and maintaining them over time. For many entrepreneurs, this can be the main aim.

Obtaining sufficient outside investment can be an insurmountable obstacle and, even when it is possible, it has certain disadvantages that we need to take into account. The presence of investors will put pressure on the management decisions of the company, as it will have to generate sufficient profits to repay the investment and make gains. This situation will limit the autonomy and decision-making capacity of its founders.

The other option is not straightforward either. The company would have to redirect its business to services in an attempt to generate sufficient revenue from them to allow for the simultaneous development of the product. As we shall see later, it is difficult to be successful in this through the provision of services because the profit margin is smaller. Moreover, the lack of economies of scale and the presence of competition restrict the possibility of keeping prices high enough.

In this context, free software emerges with new features to alter the scenario. The possibility of cutting costs through the collaboration of volunteers, together with the new schemas of distribution and marketing offered by this collaboration constitute a relevant disruption of these scenarios and have the potential to significantly reduce the initial investment required.

We will look at these aspects in more detail in the following modules.

3. 1. 2. 2  Maintaining the revenue stream

One of the basic questions that any company needs to ask is not only how to raise revenue at a given moment, but also how to maintain it over time. While continuity will be the norm for companies that focus on providing services (generally, if clients are satisfied, they will continue to need the services), in companies that focus on the production of standard solutions, the maintenance of a steady stream of income will be fraught by a range of problems.

Cusumano, in The Business of Software, compares the process of writing a successful software product to writing a best-seller. Doing so will generate huge profits but it is also very difficult and only occasionally generates the latter. The natural life cycle of a commercial software product will eventually cause it to lose the ability to generate income.

Initially, early versions will have several flaws and their functionality will not be finely tuned to the needs of users. This will allow the company that created it to maintain its income over time with the launch of new versions that gradually incorporate improvements into the product, both through debugging and by obtaining much more information on requirements from user and customer feedback.

Predictably, if new versions of the product contain sufficient improvements and are more attractive than the previous ones, they will continue to generate revenue. However, once users decide that the application is good enough, their motivation to pay for a new version will wane. Similarly, trying to maintain the income obtained from a best-seller with sequels has only limited effectiveness.

There are strategies to combat these trends and maintain a stream of revenue through the licensing of successive versions, typically at the expense of consumers. The total or partial incompatibility between successive versions of the product, coupled with intensive campaigns to publicise it, will lead to a new situation of economies of scale on the demand side in favour of the latest version, which will force many users to change even though the previous product met their needs.

However, due to the nature of some software products, constant updating is necessary due to changing user needs.

Tax and labour legislation changes often, which means that users need to update their application every time this occurs. As a result, revenue can be kept constant over time because of cyclical adjustments in the financial system and legislative framework.

In addition, once the initial idea has been exploited and studied, it will pave the way for other companies to start producing similar software without having to spend time on R&D or requirements analysis. If they can make the product more quickly, perhaps streamlining it and maintaining only the basic features, they will be able to compete for the same market at a better price. Once enough companies enter this market, generating products that can be interchanged with one another ("commoditisation"), we reach a unique situation: in the absence of other differentiating factors, consumers will buy the cheaper product, which will generate a highly competitive situation.

This phenomenon is common to any type of product and should also be possible with software. However, certain factors protect the dominant companies in this process, which would ideally lead to greater technological diffusion and bring benefits to users (albeit making it more difficult for companies to obtain large profit margins). As explained above, there are some strong economies of scale on the demand side so it will not be as easy for users to consider competing products as true replacements. Moreover, the use of proprietary formats creates an important captive situation that is difficult to escape from.

Hence, free software emerges as a driving force for a situation in which free goods are perfectly interchangeable: the appearance of a similar product that is distributed freely or even free of charge makes it more difficult to maintain high revenues from licensing and may be one of the few ways to break the captive inertia generated by proprietary software.

Free software as disruptive technology

The term disruptive technology, coined in 1999 by Clayton M. Christensen, refers to innovations that, for their low price and features or due to their focus on a new type of customer, manage to displace the previous market solutions. Free software could thus constitute a disruptive technology, given the possibility of obtaining it for free and its ability to contribute to the widespread use of software through existing technology gaps.

Though it would considerably limit the possibility of maintaining high profits from licensing, the transformation of the software industry into a scenario of interchangeable goods (commoditisation) could open up new markets, generating an ecosystem of needs around the new interchangeable and widely adopted product.

Traditional software companies with their product focus can generate huge profits but also suffer major losses during unfavourable economic cycles. Despite being consolidated businesses with established products, between 2000 to 2002, many software companies lost 80 to 90% of their value; even Microsoft lost two thirds of its value (Michael Cusumano, The Business of Software).

During adverse economic periods, consumption falls and software products are the first to feel the effects. Users simply stop buying software, which can have a serious effect on the product companies that depend entirely on this source of income. Consequently, it is difficult to find a product company solely of this nature, as the guarantee of its income would be too precarious and unpredictable, and would inevitably suffer in harsh times.

Although any business activity will be affected in such scenarios, companies focusing on services are more capable of maintaining their income due to their long-term contracts and clients – who are mainly other companies and, albeit to a lesser extent, will still need to maintain their infrastructure. In many cases, these infrastructures allow the client company to operate more efficiently, thus increasing its chances of survival in difficult times. As a result, it continues to spend on new technology services.