Software Industry Shows Signs of Middle Age

It's getting harder for small software companies to survive in a maturing industry where the biggest companies are sucking up the lion's share of the available IT dollars, according to a top investment banker.

SAN FRANCISCO—The software industry is steadily maturing and will soon start to act closer to its age by using debt to fund future expansion and development, rather than equity, which has long been the standard industry practice.

This is the view of David Roux, co-founder and managing director of corporate investment firm Silver Lake Partners of Menlo Park, Calif., who spoke here Wednesday at the Red Herring fall conference on small capitalization technology companies.

Roux said his view is that small startup companies have to rapidly grow beyond $100 million if they are going to have a good chance of making money. Most companies that earn $100 million or less tend to lose money, he said.

Furthermore, the days when the software industry as a whole grew at 20 to 30 percent per year ended with the 2000 tech industry crash and will never return, Roux said.

Instead, industry growth will be in the middle to high single digits, he said, which is more in line with other mature segments of the computer industry such as storage and semiconductors.

The reason for this is a "dirty little secret of the software business" and that is that the average selling price of software products has declined every year since 2005, he said, adding that software companies dont report their total units sold because if they did it would show "pervasive price declines" all across the industry.

/zimages/2/28571.gifRead more here about why venture capitalists are paying attention to security and data integration technology.

At the same time, there has been a return to profit growth since the 2000 crash. In fact, the great irony is that while the technology sector "experienced a depression much worse" than the nation as a whole experienced during the Great Depression of the 1930s, "software industry profits never went negative," he said.

The software industry has returned to growth and profitability because of strong cost-saving measures, which has occurred because of a return to scalable business models due to "economies of scope," Roux said. Software companies are being much more realistic about what their business models can achieve, he said.

While profit margins have recovered, only the largest companies, ones that generate more than $5 billion in annual revenue, sustain profit margins greater than 30 percent.

/zimages/2/28571.gifAriba follows the on-demand trend. Read more here.

Companies that generate annual revenue of $1 billion to $5 billion in annual revenue drop down to profit margins of around 17 percent. Midsize companies that are producing revenue of $100 million to $1 billion can sustain 9 percent margins. But companies that cant quickly grow beyond the $100 million level are generally losing money.

The conclusion is that "bigger is wildly better" for anybody trying to compete in the software business, he said. The question for any CEO of a small to midsize software company that wants to survive and prosper is "how am I going to get to be a $5 billion business or bigger."

These factors are behind the consolidation that is going on in the software industry, Roux said. He said the market share of the top three software vendors, Microsoft Corp., Oracle Corp. and SAP AG, has increased from 24 to 30 percent just in the past five years.

Next Page: Salesforce.coms dissenting voice.

John Pallatto

John Pallatto

John Pallatto has been editor in chief of QuinStreet Inc.'s since October 2012. He has more than 40 years of experience as a professional journalist working at a daily newspaper and...