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What will be the trajectory of the open source market in 2010?

It will take off

It will grow slightly faster than other software sectors

It will be as difficult as the rest of the industry

Economic Stress Test for the Software Industry: Will Your Company Pass?

By Chris Dowse, Founder & Chief Executive Officer and Ben Galison, Principal, Neochange, Inc.

What does the smart money know? What has the economic meltdown exposed?
On May 22nd the stock market had valued the software industry at a 3.7% discount to the S&P 500, based on the next-12-month price/earnings ratio. This isn’t particularly striking until we consider that for the past five years, the software industry has on average been priced at a 34% premium to the S&P 500.

What could account for this dramatic difference?
While there is definitely widespread uncertainty as to the timing and size of an economic recovery, a swing of this magnitude suggests the market believes something has fundamentally changed the software industry’s future capability to generate earnings. It is an indication that the market believes a structural shift is taking place and that the outlook for the coming year is dire.

The Perils of Swimming Naked: Does the Software Industry Deliver Value?

It's only when the tide goes out that you learn who’s been swimming naked.

Warren Buffet has a saying, “It’s only when the tide goes out that you learn who’s been swimming naked.”2 He goes on to point out that during good times we don’t know how much risk exists within any given company – the degree to which a management team has potentially exceeded sustainable levels of the economic drivers for their industry.

The financial services industry provides a familiar example to illustrate this situation. As the economic crisis dawned, many financial company executives continued with risky business practices despite the warnings that the ‘gravitational relationship’ between housing prices and incomes had been exceeded. In the banking industry, these economic drivers are well established, studied thoroughly and reported regularly. In the software industry, economic drivers of revenue and benefit are somewhat less obvious and more difficult to measure; however, data does exist and it presents a disturbing picture.

Software-driven productivity stalled well before the economic crisis

Figure 1: Comparison of software investment against software driven labor productivity growth

A 2007 Federal Reserve Board report on US labor productivity reveals that the software industry had exceeded the ‘gravitational relationship’ of software investment levels (customer spending) and software-driven productivity (customer value delivered)well before the economic crisis started3. Figure 1 compares the contribution of software to US labor productivity improvement – a macro-level measure of software-driven business benefit – and the relative level of software investment as a percentage of US GDP.

The graph shows that since 2001, software spending moved consistently with the growth of the economy (at a flat rate of around 1.5%), but that over the same period the improvement in growth attributed to software declined nearly 40%. While resolving this value delivery gap will require tackling some complex issues, there are two certainties that will drive and shape the software industry’s future beyond the economic crisis:

  1. Software Cannot Deliver Value if its Adoption Is Ineffective
    Study after study (Butler Group5, Neochange/Sandhill6, CRM Magazine7) evidence the fact that most enterprise software is still poorly adopted, regardless of application type. These studies consistently peg average adoption rates at less than 50%. Neochange’s own research indicates that 2 out of 3 buyers realize less than 50% effective usage6. This is less an issue of shelfware than it is a problem with companies not using software effectively to deliver value. As one IT analyst describes it, companies are ‘oversoftwared.’8
  2. CIOs Are on a Long-Term Mission to Reduce Total Cost of Ownership (TCO) and Prove IT Value
    CIOs are accountable to their organizations for the ROI on technology investments, and they are not happy. CIOs need to see a positive change in ROI: As such, spending will go down until value delivered goes up. Regardless of the causes, customers are not harnessing the value of their software investments and they not only need, but expect help from their software providers.

    Software companies cannot expect to continue earning a consistent share of the economic pie when their contribution to customer success has deteriorated so dramatically.

    Put simply, the customer’s adoption problems are now the software provider’s problem

The economic squeeze has forced IT organizations to cull software investments that do not deliver. These changes in customer behavior and value expectations are fast-paced and represent a significant threat to ISV revenue and earnings. This threat will materially reshape the economics of the industry.

The next 12 months will reveal which software players have been ‘swimming naked.’ Software companies can expect their very viability to be tested.

A Stress Test for ISVs: Will Headcount Reductions be Enough?
As a measure to stabilize the financial system, the US government created a ‘stress test’ for banks. ‘What-if’ scenarios were designed to determine whether banks could survive the possibility of worsening economic conditions and to enable them to take corrective actions if it appeared they could not. Current economic conditions have already had a material impact on revenues in the software industry. Recognizing that economic conditions will worsen, how can ISVs gauge their risk?

Below are three scenarios that ISVs could face within the coming year, which individually and collectively would test the limits of many vendors.

Figure 2 describes the revenue impact of these scenarios. Figure 3 documents industry events and trends to substantiate these scenarios and the magnitude of their risk

Figure 2 Company Revenue Impact under ISV Stress Test Scenarios

Scenario 1:
20% Reduction in

Scenario 2:
50% Reduction in
Professional Services

Scenario 3:
25% Reduction in
New License / Upgrade

  • Maintenance renewals continue trend of 5% quarterly reductions
  • Heavy discounting on 2008 deals drives down average maintenance contract values for years
  • Customer pressure for price reductions increases to meet internal IT budget cuts set beyond 2009.
  • Customer discretionary IT spending cuts target the price points of implementation/integration services
  • Powerful user groups introduce KPIs for reducing total cost of ownership (TCO) and optimizing business processes as conditions for maintenance fees, thereby
    cannibalizing existing services10
  • Sales cycles continue to draw out as customer purchases require additional levels of approval and ROI is further scrutinized
  • Sales cycles continue to draw out as customer purchases require additional levels of approval and ROI is further scrutinized
  • Advances in software utilization tracking provide usage visibility to justify delaying upgrades until returns on prior purchases are realized


Figure 3: Economic Stress Test for ISVs: ‘What-if’ Scenarios with Associated Drivers

Could These Scenarios Become a Reality for Your Company?
Executive teams are not standing still – many have announced and implemented cost reduction activities to protect earnings in the short-term. Reducing headcount will help software companies weather a short-term earnings dip, but for long-term viability, ISVs will need to create strategic blueprints for helping customers succeed with effective product adoption and value realization. Software leaders should take the following actions to strengthen their companies.

No Bailout Is Coming: Software Executives Need to Act Now

  1. Align the Leadership Team to a Customer Value Mindset
    The biggest barrier to the software industry’s future success is the outdated mindset that software companies are in the product/feature business. In actuality, services have for years dominated the customer’s total spend to reach software-driven value. Buyers do not want software per se; rather, they are after the value that software delivers: increased sales, operational efficiencies, and product innovation. This does not mean ISVs should not strive to be world-class product providers. But product innovation is ultimately pointless if customers are unable to derive value.

    The first step to move a company forward is refocusing the leadership team on customer value. Executives need to adopt as a guidepost a shared vision of customer value realization linked directly to their company’s products, services, operations, and partners. Getting the CEO on board is paramount. The CEO must be convinced that the current earnings shake-up requires a longer-term investment in customer success, ahead of the sole pursuit of product innovation. Unless the CEO is willing to shift business priorities and redirect company efforts and investments to address the adoption problem, other actions will have little impact.

    As the software marketplace has evolved, the bar has been raised for ISVs across the industry. Customers expect their vendors to be complete solution providers, delivering innovative products with high levels of operational excellence and customer intimacy. At this stage of the industry’s maturity, providing services that enable customer success with products is a necessity for ISVs, not a nicety. It can also be economically attractive. TPSA member research has shown that customer accounts with professional services investments produce almost triple total revenue and achieve higher renewal rates11.
  2. Institutionalize Customer Success across Company Silos
    Once leadership is committed the vision of customer success should be put into operation across the company. Nominating a Chief Adoption Officer (CAO) is a powerful step and visible sign of commitment. Some forward-thinking ISVs have already created this new, cross-functional role reporting directly to the CEO.

    A cross-functional perspective is essential. In many ISVs customer knowledge is fragmented, trapped in silos. Leaders must work across these silos – particularly the services, support and sales functions – to ensure that key customer information is brought back into the organization, shared among employees and put to use enabling to customers to succeed.

    Company metrics must also be aligned to adoption and customer value objectives. Reorienting goals and rewards at both the executive level and throughout the ranks is necessary to accomplish the wholesale shift in behaviors and mindsets. For a company to transform, its metrics must change.
  3. Lead the Customer through Value-Centric Sales and Service
    As the ISV reorients toward customer success, the organization fundamentally moves from being in the product business to being in the productivity business. Value assurance becomes the focus throughout the entire customer lifecycle, including sales. Adopting a ‘value-delivered’ approach to sales and initiating value/ROI discussions early in the sales cycle puts the customer relationship in the proper frame right from the start. Arming the sales force with a ‘value path’ that maps product capabilities to customer value drivers enables ROI to be transparent, convincing and measurable. In addition to reshaping the sales cycle, this evolution brings a greater importance to services that drive adoption and effective usage of the product.

    The Neochange/Sandhill Group software survey found that 95% of buyers want their vendors to take a leadership role in driving adoption and the achievement of value. The same survey also showed that 80% of buyers are willing to pay for value assurance services to enable effective usage6.
    The question for ISVs is which value assurance services to offer?

    Which services do your customers most need?

    Which will differentiate you from your competitors?

    Large enterprise ISVs are already succeeding through wise choices on this front. Oracle’s Advanced Customer Service group, for example, delivers services aimed at reducing customer costs and optimizing customer business processes. Other value assurance services may include ROI acceleration offerings, business domain maturity assessments, or change leadership assistance.

    Whatever the scope of the service portfolio, it is unlikely that any one company can deliver everything with quality. As such ISVs also need to strengthen and effectively lead partner ecosystems in the delivery of a solution-centric approach. ISVs can no longer end customer services at the implementation/integration stage and expect to drive sustainable growth.

Software Executives Face a Once-in-a-Lifetime Challenge.
Ironically, it is customer adoption, the bottleneck to sustainable growth, that will be the path forward and out of the revenue trough that software companies are experiencing. The current economic adversity impacting customers will permanently raise the threshold for software companies to become more customer-centric and value driven. Although this trend existed before the meltdown, the pressure to reduce costs has accelerated changes, bringing new levels of ROI scrutiny and accountability.

Thankfully, the arc of technology history is strewn with stories of innovation in which companies rise through adversity and drive future growth. The survivors of the next twelve months will be those companies that recognize the permanent shift in customer behavior and expectations that has occurred and create their own internal “stimulus package” focused on efforts to drive customer success.


  1. Credit Suisse, Software Source, May 22, 2009.
  2. Warren Buffett, Annual Letter to Berkshire Hathaway Shareholders, February 29, 2008.
  3. Stephen D. Oliner, Daniel E. Sichel, and Kevin J. Stroh, “Explaining a Productive Decade,” Federal Reserve Board, August 2007.
  4. Credit Suisse, Software Decoded, July 2008.
  5. Butler Group, “Exploiting Enterprise Applications,” March 2006.
  6. Neochange, Inc. and SandhillGroup, “Achieving Enterprise Software Success,” January 2008.
  7. CRM Magazine, CSO Insights 2006 Sales Performance Optimization Study, July 2006.
  8. http://advice.cio.com/thomas_wailgum/why_erp_is_underused_companies_are_oversoftwared
  9. ServiceSource, Service Performance Management Industry Report, Q4 2008.
  10. http://blog.softwareinsider.org/2009/04/29/news-analysis-details-on-the-sugen-kpis-for-sap-enterprise-support/
  11. Thomas Lah, “Services Economic Impact Analysis”, May 2009.

Chris Dowse is CEO and Founder of Neochange, Inc. Ben Galison is a Principal with Neochange. It is the leading management consulting firm focused exclusively on the complex challenge of Effective IT Adoption. Neochange’s innovative AdoptITTM methodology mitigates adoption risk and accelerates corporate earnings improvement. For article feedback, contact Chris and Ben at inquiries@neochange.com

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