"You can't always get what you want.
But if you try sometimes, you just might find, you get what you need."
--Rolling Stones, "You Can't Always Get What You Want" Most executives in Silicon Valley take it for granted that selling software is a better business model than selling hardware.
In their mind, this goes without saying. The self-evident reasons relate to software's remarkably high gross margins. With near-zero variable costs, software businesses offer the ultimate in scalability. Software businesses are simultaneously less-capital-intensive than hardware. This combination of low capital intensity and high gross margins, also leads to better valuations in the marketplace. What's not to like?
Despite these seemingly irrefutable advantages, many start-ups are "choosing" to sell hardware instead of software. "All things being equal," software may indeed be the better model, but therein lies the issue.
There is an old joke where a man is crawling beneath a streetlight looking for his lost keys. Despite that, he readily admits he lost them at a location further away in the dark. When asked why he's searching in that area, he naively replies, "The light's better." While the "light" may be better with a software business model, these models are becoming difficult to execute--particularly for a start-up. With tactical execution and business models highly interdependent, having the "better" business model but an inability to succeed is a futile exercise.There is a silver lining
The industry has changed in ways that improve the "business model" elements of selling hardware. The key driver is the standardization and general availability of hardware components, particularly those used in generic Intel-based 1U servers. As a result, the hardware is not a proprietary design, but rather a type of packaging. (Think of it as an alternative to a cardboard box.) Combine this availability with the proliferation of Ethernet, TCP/IP, and license-free operating systems such as Linux and BSD, and this allows a company whose primary competitive advantage is software to deliver that software in a box--a hardware box.
One might ask why a company would choose a hardware model in such a scenario when 1U servers are available from many reputable vendors. The generally accepted practice of delivering software designed for open platforms to be installed by the customer may be up for review. When you examine the details of what it takes to sell, provision, manage and rely on a piece of software, the customer increasingly prefers closed-end hardware to open-platform software. On top of this, for a start-up, this "software in a box" path is actually more cost-effective and easier to execute.
Consider these issues:
Development complexity and quality assurance: One might assume it is easier for a start-up to attempt an "all software" development plan rather than one that includes hardware. However, when implementing on an open platform, the developer is responsible for ensuring that the code will work properly in every scenario. When you consider the number of hardware vendors, operating system flavors (and versions), peripheral vendors, peripheral driver versions, and so on, you end up with a near-infinite test plan. Choosing a single and static hardware platform dramatically reduces the risk and the costs of software development.
Performance: Any software vendor concerned with performance will intrinsically favor a single hardware implementation, as opposed to running on multiple and potentially unknown configurations. With fewer degrees of freedom, it is possible for the developer to tune the performance of the hardware and the systems software (OS plus drivers) to the task at hand. In addition, the designer can eliminate code or features that are designed to support tasks that are unnecessary in this implementation, freeing more resources for the specific function. This can also help reduce cost.
Security: One of the hottest issues for CIOs today is security, and here again the hardware delivery mechanism has an advantage. A closed-box design is harder to penetrate than an open-platform system. Intentionally designing the system to have limited points of entry minimizes the security holes. Lastly, the security design can be hard-coded into the system, which reduces the chances of a user or intruder removing it.
Provisioning: When a customer receives a 1U server with a single on and off switch and a single I/O port (Ethernet jack), implementation is fairly straightforward: Plug it in and turn it on. But one huge negative result of open-platform software is that IT departments have been burdened with the tasks of installing, provisioning, tuning and troubleshooting software. More freedom leads to more ways to screw up the process. Software delivered in a closed box is inherently simpler and easier to provision.
|When you examine the details of what it takes to sell, provision, manage and rely on a piece of software, the customer increasingly prefers closed-end hardware to open-platform software.|
Reliability, stability and customer service: When open-platform software fails, users can call numerous help desks--all of which will be eager to put the blame on someone else. With software sold as a single, closed server, there is only one point of contact. More important, because of the single static implementation, there are dramatically fewer issues. This is important for applications that live closer to the network layer where system interruption is unacceptable.
Pricing: It is increasingly difficult to establish and defend baseline pricing for software. As before, this is more important if the functionality of the software is closer to the network layer than the application layer. In this space, hardware is typically purchased and software is given away to support the sale. Perhaps it is a perception issue--people are more comfortable paying for something they can touch, see and feel. This is accentuated by the fact that many software applications are available as open source in some shape or form. And while your software may be clearly better than the free alternative, free is tough to compete with.
Distribution: One of the key reasons to consider an open-platform software approach is to potentially leverage the customer base of the hardware vendors that are already in the market. Admittedly, this worked great for Microsoft with IBM, and Veritas with Sun Microsystems. However, this is no easy task. Hardware vendors have learned from their mistakes in the past and are much less likely to sign favorable distribution deals. Hardware vendors are also unlikely to consider distributing a product until it is proven in the marketplace. Since one must first establish early traction with direct sales, there is no reason not to adopt a "software in a box" model from the beginning.
The firewall market is one in which this software-in-a-box phenomenon has begun to play out. Check Point Software pioneered this space with a software-focused, open-platform business model. Later, vendors like NetScreen began taking market share with a hardware-based delivery platform. In a June 2002 Internet Security report, analyst Bob Lam suggests that more than 50 percent of the 2001 firewall market was hardware-based. Moreover, by 2005, Lam predicts the market will be 70 percent hardware-based.
According to Lam, "Check Point appears to be at a disadvantage because of its software-based architecture, which some customers view as more difficult to install and less robust than comparable products on the market." Responding to this threat, Check Point has parted with companies like Nokia to deliver closed-box systems based on their software.
Admittedly, this theory applies much more to functional software, such as firewalls, Web servers, security devices and storage solutions, than it does to high-end applications. You shouldn't expect SAP to ship a hardware device anytime soon. Functional software applications are more task-oriented and require less customization than high-level business applications. Additionally, functional applications are much more likely to be judged on criteria such as performance, throughput, reliability and availability. All of these things favor a static hardware implementation.
Higher margins, reduced capital intensity and higher valuations are three reasons for favoring a software-delivery model. If you are passing through hardware sales, it will be impossible to mimic 90 percent software margins--but 70-plus percent margins are not out of the question. In addition, today's custom manufacturers are more than willing to assemble boxes after the order (a la Dell Computer), and ship them to the customer. This virtually eliminates inventory risk and positively impacts capital intensity. Most important, however, Wall Street appears to understand the value of this new approach. NetScreen currently trades at 6.5 times forward sales--which is more than you can say for most software companies these days.
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Above the Crowd focuses on the evolution and economics of high-technology business and strategy. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice.
J. William Gurley is a general partner at Benchmark Capital, a venture capital firm in Menlo Park, Calif.