The biggest buzz in the software industry is clearly Application Service Providers (ASP's). This comment relates to some of the strategic considerations which affect an individual software company. Subsequent comments will explore the ASP phenomenon in greater detail.
The software industry has long been characterized by the receipt of large upfront payments from users in return for a permanent license. Depending upon the growth rate of a company and other strategic considerations, support and other revenues have constituted anywhere from 10% to 60% of revenues, but the main driver for the companies has almost always been the "sale" of software licenses.
This dependence upon license fees relates to what the CEO of Memorex bemoaned a long time ago - lack of linearity in revenues. Revenues are not evenly spread across four quarters of the year. Worse, they are not spread evenly throughout the quarter and many CEOs and CFO's have lamented the concentration of sales in the last two weeks of the quarter. This lack of visibility has led to high stress rates in public companies who are trying to guide analyst expectations on the results of the quarter. Even worse, as the president of Informix commented, it has led many software companies (and hardware companies before them) into engaging in quarter-end and year-end discounts to pump up sales - and destroy margins.
So what must a software company consider as it moves to the ASP model? There are a number of ASP models and we'll get into that in the next comment, but for the moment let's talk in generalities. In general, a software company gets its cash from a license upfront and most of the time gets its revenues upfront unless it runs afoul of SOP 97-2. Under the ASP model, a software company will receive less cash upfront, generally receiving cash on a monthly basis over time and, equally as important, will recognize its revenues over time as services are performed or as the contract progresses. Moreover, revenue recognition will be delayed even if the cash comes upfront. So the effect is that the balance sheet will show less cash, there may be an increase in receivables and revenues and net income will be less than the traditional model. A public software company may have to educate its analysts (probably not a tough job), but probably will also have to educate its shareholders who may focus more on earnings per share.
Having said this, it appears that the ASP model is here to stay, although in my opinion, it will affect different verticals in different ways and will affect different types of users in different ways. In human resources, accounting or other supposedly non-mission critical software, users maybe more willing to move to the ASP model. However, we think almost all software is mission critical because a user cannot operate without it, but that is another story. Where software gives a company a strategic competitive advantage, it seems it is much less likely that the company would use an ASP or even that such differentiated software would be available from an ASP. Unfortunately, we've already heard reports of turf battles between in-house IT groups and ASPs so that will also affect the business.
The ASP phenomenon magnifies the cash problems that rapidly growing software companies face. They could do so well that they run out of money. If the upfront cash from licensing is substantially reduced because of moving to the ASP model, where does the cash to finance growth come from? LPI has discussed financing the end user contracts, but that also will be covered in a future comment.
For the present, it is clear that a software company moving to the ASP model must consider the effect of such a move on its financial position and position itself so that it can make the move.
© LPI Software Funding Group, Inc.
593 Cricket Lane, Suite 200 Wayne, PA 19087
610.687.4434 610.341.6100 email@example.com
March 7, 2006