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Why Software Business Models of the Future Probably Won't Come In a Box

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Why Software Business Models of the Future Probably Won't Come in a Box

Published: February 07, 2007 in Knowledge@Wharton

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Microsoft's Vista operating system should give the company a revenue stream that will run for years, but that doesn't mean the company can rest on its laurels. Experts at Wharton say the January 30 launch of the consumer versions of Microsoft's flagship software may be among the last of its kind -- a product sold for a flat fee in a shrink-wrapped box. Indeed, many wonder if the software business model that has made Microsoft so dominant for the last 20 years may begin to fade in the decade to come as new software business models -- from open source to advertising supported -- gain increasing traction.

Traditionally, Microsoft and most other software companies deliver software primarily by licensing "shrink-wrapped" products sold through retail channels or arrangements with hardware vendors. While a number of different pricing schemes for software licensing exist, customers typically pay a flat fee for perpetual use.

But new models of software pricing and distribution are becoming increasingly popular. "Open source" software relies on voluntary programmers to build applications that can be distributed freely. Ad supported software includes web-based applications that are free as well, but they generate revenue through advertisements. Also on the increase: "on-demand" software where customers rent software applications when they need them and pay only for what they use.

All of these models pose unique threats to Microsoft, although that is hardly news to CEO Steve Ballmer, who clearly sees the challenges ahead. At a Wharton Leadership Lecture this past December, Ballmer noted that the two biggest competitive threats to Microsoft are open source software and advertising supported applications. "Right now, the emblem of the first one is Linux and the emblem of the second one is Google. But it's not the companies, it's the phenomena" that present the greatest challenge to Microsoft, said Ballmer.

Wharton legal studies and business ethics professor Kevin Werbach says Microsoft is right to be concerned. "Ten years from now, Microsoft must be weaned from ... license revenue. But it's a long process, because they justifiably don't want to cannibalize a revenue stream that remains phenomenally lucrative."

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Meanwhile, it's not immediately clear what the software model of the future will be. Kendall Whitehouse, a senior director of information technology at Wharton, notes that "there probably isn't one model that will win out. Instead, you will have a blend of business models." Kartik Hosanagar, an operations and information management professor at Wharton, agrees that a hybrid business model -- consisting of parts of traditional licensing, on-demand, ad supported and even open source -- will emerge in the software industry. "The winning model of the future is a hybrid," he says. "The only certainty is that the Internet will have a big impact" on whatever that winning model is.

The pressure to find new models, however, rests with Microsoft. "Microsoft has the weight of incumbency and will struggle to switch to an Internet-only model," Hosanagar adds. "And even if Microsoft did move toward Internet delivery, it's not clear that customers will buy it."

If It Ain't Broke...

Don Huesman, a senior director of information technology at Wharton, suggests that Microsoft's traditional licensing model won't fade quickly, and Microsoft's financial results back him up. The revenue streams from the introduction of Vista and Office are just beginning. For the second fiscal quarter ending December 31, 2006, Microsoft reported record revenues of $12.54 billion and net income of $2.63 billion. It announced on January 25 that it is projecting revenues of $13.7 billion to $14 billion for the March quarter, with much of the sales gains coming from Vista and Office.

Microsoft's results show the upside of conventional software licensing, Werbach says. "Licensing has the benefit of stability and predictability: It's a lucrative annuity if you manage it the way Microsoft has with Windows and Office. On the other hand, everything depends on convincing the customer to buy and then upgrade the product. In between those events, you get little or no revenue." According to Huesman, the game for Microsoft is more about experimenting with new models than making sweeping changes. "For Microsoft, licensing isn't slowing down. It also has a diversified revenue stream."

Yet Microsoft's licensing and distribution model typically means that it rolls up features into one all-you-can-eat software product, while online rivals and open source applications can evolve more quickly. Another challenge facing Microsoft is that it may become increasingly difficult to convince customers to upgrade, especially if its new features don't leapfrog advances provided by its competitors. For example, Microsoft included a new desktop search feature in Vista, but Google beat it to the punch with its freely-downloadable Google Desktop Search. "That move clearly gave Google a lead," says Hosanagar.

Software licensing, however, is likely to evolve. Huesman notes that subscription services are likely to converge with traditional licensing schemes -- an arrangement that is already common in the corporate world. "In a corporate setting, you don't own the software as much as you pay for access to it," he says. "You subscribe for routine updates," blurring the line between perpetual

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