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The High Cost of Selling Software

04.07.2010

The cost of getting software into the hands of customers is typically 2 to 4 times more than the cost of developing the software…

During the current economic downturn, governments have looked to stimulate the economy, and have shown particular emphasis on the small businesses that are seen as the engine for creating jobs.  One common stimulus has been to promote new software and other technology R&D efforts that create Intellectual Property (IP).  From my way of thinking, they have it wrong in their stimulus target.  Many small businesses are able to create software IP through “sweat equity”, that is, labor that not directly compensated.  The cost of licenses and hardware need to create the software is usually very small and the typical small business entrepreneurs invest their time while remaining in their home offices close to family and friends.

Unfortunately, after making the sacrifice required to create the product, many of these entrepreneurs then face the very sad fact that this software development effort is usually only a quarter of the total cost of getting the product to the final consumer.  (Don’t believe me?  Look at annual reports of software companies and software divisions of publicly traded companies to see where their costs are: R&D is typically 15-35% of total revenue.)  Our entrepreneurial software developers (many now encouraged with government money) need a substantial amount of additional funding to get their products to market.  Event booths, airlines, hotels and meals, agents, publicity, sales brochures, and advertising are not sweat equity expenditures.  These essential expenditures must be paid for with real money.  Governments are giving money to the only part of the IP product life cycle that can be done without money and creating a glut of companies ill prepared to to benefit from their work or government money.

There are two business models that have changed this reality a bit, but both are dynamic and have some risks.  The first is called Freemium (Free + Premium).  Today I was listening to a CNET interview with Phil Libon, Evernote CEO.  Their offering is an on-line service that stores your lifetime of personal data.  Their basic service is free; their income comes from their premium product.  Phil had an interesting comment about their conversion rate (percentage of free customers who choose to upgrade to the premium paid status).  “I want our conversion rate to stay within a very narrow range of 2-6%”. “… If it is too low, then they don’t make any profit, and if it is too high, then there is not enough value in the free product and they will not spread the word to enlarge the pool for conversion.  Freemium (Free+Premium) seems to be a credible and viable business model, but notice that it still has a high upfront cost as it builds its free customer base.  In this model, the free product hopefully goes viral and at that point you can release your premium product for income and eventually profits.

The second model is truly revolutionary: the app stores, with iTunes being the most well known.  Developers get 70% of the price paid for each app sold (remember that with the traditional approach to the market, only about 25% goes back to the development team’s budget).

The very low license price and defined Terms and Conditions for both customers and sellers results in a situation where impulsive purchases and viral marketing is possible.  The low cost means discovery is also not as big a challenge since customers can now easily try many things at relatively low cost.

App stores appear to be the only true place where developers can sell without large sales and marketing budgets; however, it is unclear if any other app stores will ever follow the success of iTunes or if more complex niche software (i.e. the more expensive single license) will still work in this model.  When eBay started being successful, many others created their own auction sites.  However, it turned out that the market would adopt only one auction site.  Is it possible that iTunes is the eBay of today?  Will the copy-cat sites not gain critical mass and might iTunes reach its limits as eBay has?  I really don’t know, but today it is clear that iTunes Apps are a real place for teams of developers to succeed with virtually no sales and marketing budget.

Both the successful app store model and the successful Freemium example have one thing in common: individual users are the target market.  They are not selling to IT directors, business unit managers or chief financial officers.  The products for the corporate or government world must meet defined user requirements, not conflict with any rules in their workplace (i.e. ports of SAP data would never be allowed without IT and Legal review), and the price must be within their individual authority limits.  The individual user world has no such restrictions.  This means that a large categories of traditional software is simply not appropriate for these new route-to-market strategies.

Lastly, I would think that the two models can be combined.  App stores can have free and premium versions simultaneously; however, as I write this, I can’t think of a successful example of the combined model.  My instincts tell me that either approach is complex enough alone.

To summarize, if you develop the perfect product but have limited financial resources, your best marketing approaches are to sell it directly to the customers you already know or to sell it through an app store to individual user customers.  Otherwise, you must assume that sales and marketing expenditures will be at least twice the cost of engineering and development in the first two years.  If you don’t have the money, don’t start the software.  If you have the budget, then remember that although Sales offices are expensive, labor intensive, and slow to show results, they are adjustable.  The Fremium approach to viral selling is faster and scales better, but it is not easy to assess marketing progress or fix what is not working.  For me, I love the possibilities of Freemium and I like the romance of programmer-only companies working with app stores. However, I know that conventional sales and marketing works.

The number of technology companies with great products but insufficient money to successfully market their software is huge.  Governments of the world would do much better by their entrepreneurial software developers if they stopped encouraging them to create even more orphan technology and instead stimulated means for helping them find customers for the products they are already developing on their own time.

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