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Transforming from a Hardware Manufacturer to a Software and Services Provider

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Hardware commoditization, the Internet of Things, the machine-to-machine (M2M) evolution, and the dramatic growth in intelligent device adoption are forcing many traditional device manufacturers to go through a huge transformation. Many hardware and device manufacturers have realized that it is the software or firmware embedded on the device, or the software that controls the device capabilities and capacity, that has become the strategic differentiator and the key to driving monetization and profitability.

Until recently, hardware and device manufacturers placed all the value in the physical appliance or device; but with the recent shift to software, manufacturers are able to dramatically increase their software and device revenues, reduce device manufacturing costs and extend the life of the device with software.

To survive, many hardware manufacturers have and are becoming more software centric. Manufacturers are realizing they must run their businesses more like software vendors, make the move to virtual appliance offerings and take the concrete steps necessary to reap the substantial monetization benefits that arise from becoming a more software-centric business.

The problematic present

Many device manufacturers — especially those in the telecom/networking, computer peripheral, industrial/building automation, medical device, and electronic test and measurement markets — business models have been structured around the sale of a physical device. Any software on the device has been viewed as just an incremental piece of a larger device sale — and often may have been steeply discounted or given away (especially at the end of the quarter) in order to move more boxes. Salespeople also have been incented by their commission structure to sell boxes and not to worry about software too much.

Economic pressures, however, have revealed the weaknesses of these types of business models. These weaknesses include:

  • Low margins. With hardware/devices, commoditized components represent a high percentage of unit cost. In some cases, customers may even buy these components in higher volume and at a lower price than the vendor. So margins are very limited.
  • Large inventories. Device manufacturers have to stock some reasonable supply of units configured according to their various model-specific parameters. This ties up capital unproductively.
  • Slow time to market. The binding of new capabilities to manufactured units creates a lag between innovative development and the delivery of business benefit to the customer. In addition to slowing the monetization of development investments, this lag can also result in the loss of market share to faster competitors.
  • Dependency on refresh cycles. Device manufacturers don’t make a lot of money on happy customers unless and until those customers hit a technology refresh cycle. This can be a real problem if you sell really good products with long useful lives. It also places salespeople into less-than-ideal relationships with the installed base because they have to keep hunting for fresh meat.

For these and other reasons, hardware-centric business models have become less appealing. Fortunately, for companies with market-worthy IP, there’s a compelling alternative: software — offering customers solutions where software is the key enabler of creating differentiation and market-ready solutions.

The fortuitous future

There are many reasons for device manufacturers to make this transition to software centricity including:

  • Higher margins. When you cut the manufacturing, supply-chain management, distribution and inventory carrying costs associated with hardware/devices out of your business, profits go way up. These profits satisfy stakeholders and can be invested back into the business.
  • Faster time to value. With software, you can start delivering your IP as soon as you create it. And you can recognize revenue as soon as the customer places an order and gets a license key.
  • Greater lifetime customer revenue. A software-centric business model allows you to create recurring revenue streams through subscription licensing, maintenance/upgrade fees, usage metering, capacity and capability provisioning, bursts of use, disaster recovery and/or other appropriate mechanisms. So instead of being limited to the occasional hardware refresh, you can build multiple, predictable sources of ongoing annuity-like income.
  • Better alignment of features/costs with target customer requirements. Software entitlements give you much more granular control over how you package and sell functionality. So you can create low-end, mid-market and premium products with the same basic code. And when you implement postponement strategies, all you change with each different product is which software capabilities you license to the customer, which enables you to carry lower physical inventories of devices.
  • Less sales friction. Using software entitlements, you can shorten sales cycles and ease customer acceptance with techniques such as “try before you buy” — allowing prospects a trial period while ensuring that they will not be able to continue using your product if they don’t purchase the necessary licenses.
  • Streamlined self-service distribution. If you continue to offer commoditized hardware, you can quickly and easily drop-ship devices. Or if you make the move to virtual appliances, customers can retrieve the software they need, when they need it, via a self-service electronic software distribution (ESD) portal. This cuts your costs and improves customer satisfaction.
  • Play in the cloud. Software that runs on standard computing platforms can be readily deployed on customers’ virtual machines in a private cloud environment — or delivered under SaaS, PaaS and/or IaaS models. So you can jump right into the growing cloud marketspace.

Device manufacturers can become more software companies by separating their value-added IP from physical components and monetize the software or by offering virtual appliances. These virtual appliances run as value-added software on commodity hardware, thereby transforming the company’s core business model.

For these reasons and others, device manufacturers should think long and hard about making the transition to more software-centric business models.

How to make it happen

There are a lot of things a company has to do to make the transformation from a hardware-centric model to a more software-oriented one. And many companies are actively engaged in this transformation. While it is certainly beyond the scope of an article like this to fully explain how such a transformation is accomplished, some core requirements to consider include:

1. Socializing and building consensus for the transformation. The move to software sales requires collaboration and alignment from all areas of the company. So it is important to get everyone on board before undertaking this kind of initiative. Everyone should be educated about the advantages your company is pursuing so they have a clear sense of why the effort involved is worthwhile. This will likely require bringing in new people with a software background and changing metrics and incentives to drive the proper behavior necessary to make such a change.

2. Understanding software licensing methodology. With hard goods, customers own something that they can pretty much do with as they like. With software, on the other hand, customers don’t actually own anything. Instead, they purchase the right to use the software based on the terms and conditions of their licensing agreement. The parameters of these agreements include license terms (the time period for which entitlements such as use, maintenance and support are conferred), license metrics (the restriction of use by device, by number of named users, by number of concurrent users, by location and/or by some capacity metric), and licensed features.

3. Determining appropriate compliance policies and enforcement mechanisms. Software compliance policies can range from simply trusting customers to monitor their own usage to closely monitoring that usage with a zero tolerance for license violations. Most companies take an approach somewhere between these extremes and may have different policies for different customers based on factors such as size and geography.

4. Mapping the software value lifecycle. With hardware, the exchange of value is largely completed in a single transaction when the physical goods are shipped. With software, the exchange of value tends to be more continuously extended over a multi-event lifecycle. The events in a software lifecycle may include:

  • Conversion from a “try-before-you-buy” license to a full-production license
  • Software upgrades, updates and/or bug fixes
  • Migrations from a competitor’s product
  • Renewals of existing license and/or maintenance agreements
  • Up-sells to versions with richer functionality
  • Transfers of existing licenses to different machines, platforms or locations
  • Returns due to administrative or technical errors

Device manufacturers need to map out this software value lifecycle in order to tool their business processes appropriately.

5. Defining and executing product management and go-to-market strategy. There are many commonalities between hardware and software product management. In both cases, a vendor has to determine how to structure and brand multiple products lines and package and price different sets of functionality. But software gives vendors much more flexibility in feature packaging. It also raises new issues regarding backward compatibility, integration with third-party products and the pace of upgrades. Nowadays, software vendors also have to think about how SaaS, the managed service provider (MSP) channel and cloud computing are going to impact their solution engineering.

When device manufacturers move to software, they also have to consider a variety of go-to-market issues such as:

  • How will we announce and promote our new software business and branding?
  • What kind of discounting and/or entitlement incentives will we use to promote sales?
  • What distribution channels will we use for our various products and target markets? What discounting and aggregation programs will we implement to incent our channel partners?
  • How will we position our solutions and their respective value propositions against those of our competitors? Will we make special offers to customers who want to replace our competitors’ software with ours?
  • How will we tier and structure our technical support entitlements?

6. Implementing appropriate sales training and compensation policies. Traditional intelligent device manufacturing companies typically require sales training that aggressively addresses the entrenched hardware sales culture. Key points of this training will include an understanding of software entitlements and the software value lifecycle. Salespeople also need to be educated about how customers make software buying decisions, how to leverage “try-before-you-buy” licensing and other aspects of the software sales cycle that are materially different from that of hardware.

Sales compensation must also be modified to appropriately incentivize salespeople to build future software revenue streams. It may be particularly worthwhile to weight compensation in favor of software licenses and license renewals — rather than on a single bookings target — given the fact that renewals represent a high-margin sale with a low cost of sales.

These points highlight the fact that a transition from hardware to software is not an easy or simple one. But given the potential rewards — and given current pressures to improve business performance — it can be highly profitable and worthwhile.

Mark Bishof is president and CEO of Flexera Software. Most recently, he served as general manager and executive vice president of Macrovision’s (now Rovi) Software Business Unit. Prior to that, he led worldwide sales, services, channels and alliances for Macrovision. Prior to joining Macrovision, Mark held executive positions at IBM, including vice president of worldwide industry solutions sales and vice president of worldwide sales for WebSphere Business Integration. Mark was brought into IBM as part of the company’s acquisition of CrossWorlds Software, where he was senior vice president of global sales and services. Prior to CrossWorlds, Mark was a partner at Deloitte Consulting in the Global Telecommunications & Media practice.

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