Why Good Ideas Fail, Part II

In recent times the software industry has come under a lot of pressure from open source developers. Open source software (OSS) has the tendency to persevere and continue attacking a market in spite of failure. This characteristic is precisely the prerequisite for success in the software business. Consequently, OSS is the most unsettling competition to the software industry.

The success of Linux has emboldened open source developers, and people are now openly questioning the viability of the whole software business. Is the commercial software industry really necessary or will majority of software development become open source?

One would expect the software industry to innovate in the face of competition from OSS, but this has not happened so far. Microsoft is the most vulnerable company, but Microsoft has only wasted money on research; Microsoft research is focused on producing papers and not products. Moreover, the company has more than 50 billion dollars sitting idle in the bank; this is money which should have been used for product development, but Microsoft simply hasn’t figured out what it wants to develop.

Software is important to users and this importance is increasing with time; users care about software because it directly contributes towards productivity. Inspite of this utility, the average computer user is spending more on junk food than on software. If things continue the way they are going, soon investors will be convinced that all the money the software industry was capable of making has been made, and it is time to move on.

Software industry has to innovate as growth of the lucrative industrialized world PC market has slowed, and software companies can no longer rely on new PC sales for growth. Innovating in the software industry is not easy as existing software users tend to play it safe by sticking with products that have demonstrated clear productivity benefits. New and innovative products do sell, but in order to be successful they require patience and persistence on the part of software companies. This necessarily implies bigger investments, more risk, and a longer wait on returns.

New startups are always poorly funded, and can not be expected to try breaking into mature software markets. However, well funded companies capable of introducing innovative products are also taking a relaxed attitude. Instead of going the tough route of selling new software products, these companies want to make easy money by releasing endless upgrades.

Software companies believe they can out-innovate OSS products. This is wistful thinking; once an open source software project takes roots, it starts improving at a pace similar to those of commercial offerings. Moreover, software upgrades suffer from diminishing returns: users care about the first few updates, but after a while additional functionality stops being of interest to them. This behavior is not acknowledged by software companies as they have managed to sell upgrades in the past. However, past experience is not a good guide in an immature industry. Products that entered the market at the inception of the software industry are only now starting to experience diminishing returns; continued dependence on upgrades will ultimately lead to disaster.

The software industry has to address two problems in order to avert the crisis situation which is developing: the industry needs to justify long term investments in innovative products, and it needs to keep OSS at bay.

If the software industry manages to address the first problem it will automatically address the second problem. OSS has become a threat precisely because the software industry has not been innovating for the last 10 years. Currently, the software industry is making most of its money from a few well understood products that are not too hard to clone. This situation has given open source developers well defined targets that are easy to attain.

The bigger problem facing the software industry is that of justifying long term investments. A sophisticated software product such as an operating system can require a long time to develop and gain acceptance in the marketplace. Such projects are inherently high risk, and can fail even at the implementation stage. Because of the long time to profitability, opportunity costs become a big issue, and the total cost of the project can run into hundreds of millions of dollars.

There does not seem to be an easy way out; OSS is not going to go away and long term investments in new products are inherently risky. Fortunately, other industries have faced the same problems and successfully risen to the challenges; there is no reason the software industry can’t do the same.

The pharmaceutical drugs industry faces problems that are similar to those of the software industry but an order of magnitude worse. On average a new pharmaceutical drug requires $800 million to develop, and the development process can last 15 years. Once a drug is on the market it has a limited window of opportunity to make money. This window of opportunity is the period during which the drug has patent protection. After the patents for the drug expire, generic drug manufacturers start producing the drug and the product stops being a big money maker.

In both the software and the pharmaceutical industries, the primary threat to profitability comes from the eventual easy replicability of the ideas behind a product. Non-generic competition can be a threat at times, but does not alter the pricing structure of a market catastrophically.

Pharmaceutical companies understand the threat of generic competition very well. Pharmaceutical companies make highly risky long term investments in innovative products to counteract the effects of their big money makers becoming generic; failure to do so typically results in a massive loss of profitability. This is precisely what the software industry has to do to stay ahead of OSS (no advocation of software patents implied here).

Generic drugs constitute a majority of the drugs available to patients, but this has not stopped pharmaceutical companies from growing and staying extremely profitable. Pharmaceutical companies make their money by targeting lucrative market segments; thus, they are able to charge fat margins. Trends in the software industry suggest the same thing will eventually happen with software. Most of the software in popular use now will eventually become open source, and software companies will need to target market segments to make money.

In the pharmaceutical industry generic and non-generic drugs are complementary. Generic drugs play an important role, they ensure cheap availability of drugs to patients and force pharmaceutical companies to innovate. OSS seems to be assuming an analogous role in the software industry. Generic drugs are cheap but not free; generic drug manufacturers charge nominal profits on top of the manufacturing costs. Linux OSS distributions are starting to exhibit the same trend.

The profit making window of opportunity for a product varies vastly in the pharmaceutical industry, and depends on patent expirations. Software sales behave somewhat similarly but for entirely different reasons. Software products do not stop yielding fat margins abruptly, but they do stop making money eventually. In the software industry the profit making window of opportunity is a function of the popularity and implementation complexity of a product. This is a consequence of the limited resources available for OSS development.

OSS developers cannot afford to waste development effort on everything that comes along; they have to wait and watch to discover the successful products, and then develop implementations. Depending on the complexity of the product, this whole process can easily take more than 10 years. Also, a good open source implementation does not immediately kill commercial products; software migration is a very slow process and commercial products can continue to make money for quite a long while.

The pharmaceutical industry uses a lot of tricks to maintain consistent profitability. The industry uses diversification to guard against risk, it uses pipelining to guarantee a steady flow of new products, and it uses market research to direct development funds. All of these concepts are totally alien to the software industry.

Most software companies are one product companies, and have nothing in the pipeline apart from upgrades. As OSS developers get better organized, one product software companies will find it tough to survive. Only companies with diversified product portfolios, big R&D; budgets, and large pipelines will manage to deliver consistent results. Companies unable to restructure themselves will become roadkill.

Microsoft is a classic case of a company in dire need of restructuring. All of Microsoft’s products are high volume products; consequently, they are high priority targets for OSS developers. The OS functionality is already generic and MS Office is quickly headed that way. Microsoft has absolutely nothing in the pipeline to make up for the loss of revenue that is imminent. The company has so little confidence in the growth of its software business that it is diversifying out of software and into products like XBox.

Microsoft can only avoid the confrontation with OSS developers by segmenting the high volume markets. This is not too hard to do in case of MS Office. For instance, the $50 spreadsheet is being used for everything from financial analysis, and statistical analysis to Monte-Carlo simulations; this is akin to selling cheap Aspirin as a cure-all. Microsoft can easily create specialized products for the bigger segments, and make good money doing so. People will gladly pay a lot more than $50 for the productivity benefits such specialization will bring. OSS will try to match Microsoft, but if Microsoft continuously pipelines new products, the company can keep growing and stay profitable.

Microsoft’s big problem is the OS market. The OS market can be segmented as well, but the company does not have the expertise to do so. Currently, the OS design expertise of Microsoft is no greater than that of OSS developers. Microsoft immediately needs to start four-five OS projects with different design goals, and pipeline more of them in the future. A good chunk of these projects will fail, but Microsoft will eventually have some successful products, and the expertise to combat open source operating systems.

Microsoft might be a slow learner but it has adapted to changing market conditions in the past, and can be reasonably expected to do the same this time as well. Other big software companies will likely follow suit. This restructuring will be good for innovation in the software industry, and it will also be good for the ‘failed good ideas’ of the past.

Innovation is something the software industry simply cannot do without. The competitive nature of the industry ensures that good ideas cannot permanently die in this industry. Good ideas of the past are always waiting for smart and enterprising entrepreneurs to resurrect them.

by Usman Latif  [Mar 14, 2004]

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