Software Business Models Explained
The software industry is known for its innovative drive and constantly evolving nature. Nowhere is that more apparent than in the rapid development of software business models.
Trying to navigate the huge variety of business models can seem like a daunting task. Software companies have to take many different factors into consideration before choosing the business model most suited to them.
This article offers a guide to the major software business models currently available to help business leaders decide which option is most fitting for their companies. We will discuss the key features of each business model, the main differences between them, and how software companies can adopt the right model while keeping their business protected.
What is a Business Model?
Having a clear understanding of the purpose of a business model is the first major step in deciding what kind of model your software company needs.
A business model outlines a company’s plan for making money by generating revenue, achieving profits, and delivering value to its customers. The business model includes all the various procedures and rules developed by a company’s leadership to help them run the business.
A business model should address the following issues:
Who the company’s target consumers will be
The company’s particular niche
The products and services the company will offer
How those products and services will be marketed and sold
The potential expenses and liabilities the company might face
How much revenue the company expects to generate
The company’s plan for turning and maintaining a profit
Every business model has a different structure and therefore a different way of addressing these issues and achieving the company’s goals. That’s why it’s important to consider the benefits and potential downsides of each business model to determine which is best suited for your software company.
Choosing Between Different Types of Business Models
Choosing a business model affects all other aspects of running a software business. What business model you decide on will determine the direction that your business will take, impacting everything from what products and services you offer to how you will market and distribute your software.
Choosing the right software business model should therefore be done very carefully, with full knowledge of all the options available. There is no ideal business model that suits all software companies. Instead, business leaders have to consider all options before them and determine which specific model or combination of models best aligns with their business goals and value propositions.
There are several major types of software business models, each with its own unique characteristics:
Distribution business models, which are the most important software business models and include three types: on-premise, cloud, and hybrid. Distribution models depend on how a software company wants to distribute its products and services to its customers.
Software licensing business models, which involve the licensing of the source code a company creates. The two main types of source code licensing models are proprietary and open-source.
Target audience business models, which depend on whether a software business wants to target other businesses (B2B) or consumers (B2C) in selling its products and services.
Software revenue business models, which include a wide variety of models depending on a software company’s preferred revenue stream(s). Revenue models include such familiar revenue generators as subscriptions and app purchases.
While there is no single industry-wide way of classifying all the software business models, this outline provides a comprehensive overview of the main types of models available to software companies. Let us now look at each of these business models in detail.
On-Premise Business Models
The on-premise business model is based on a distribution approach where software products are installed and run by the customer in-house, on their premises. Usually, that means either the customer’s computer or a local server. The on-premise model is the most traditional type of software business model, and has been in use for decades by companies such as Microsoft and Oracle.
The advantage of an on-premise approach is that it allows companies to customize their product to meet the specific needs of their customers and clients. The software can be integrated with the customers’ other systems and services. And importantly, the customer is responsible for all the expenses associated with the infrastructure. The on-premise approach is also preferred by customers who handle highly sensitive data such as the health records of patients. It is also the most viable option for businesses that may not have a reliable network connection.
In terms of potential disadvantages, an on-premise distribution approach requires an implementation process that can be very time-consuming. The customer will be required to have their own support team and in-house server hardware, especially for software that is corporate-level. As well, the more customized the software is, the riskier and more difficult it may be to upgrade on-premise software.
Cloud Software Business Models
Cloud-based software has been among the most transformative parts of the software industry in recent years. The cloud is defined by several of its main features. It is based on the remote hosting of software platforms and applications and is Internet-based, allowing it to be accessed through any device.
Cloud computing also allows for the automation of services and the pooling of resources. With the increase in remote work and our collective dependence on smartphones and mobile computing, all these features of cloud computing have grown in popularity.
In terms of cloud computing infrastructure, there are several options. Public cloud computing provides openly shared and run cloud storage and sources. A private cloud is reserved for individual organizations or companies, can operate on or off-site, and is more secure than a public cloud. A community cloud is a cloud that is shared by several organizations or companies that have similar needs. A hybrid cloud combines two or more of the previously mentioned clouds.
There are three main types of cloud services: software as a service (SaaS), infrastructure as a service (IaaS), and platform as a service (PaaS).
Software as a Service (SaaS) Business Model
Software as a service (SaaS) is a distribution model whereby a cloud provider hosts applications that are then made available to various end users across the Internet. SaaS services can be accessed through both desktops and mobile applications.
The SaaS market is huge, with end-user spending estimated to reach $176.62 billion in 2022 and $208.1 billion in 2023. The popularity of SaaS model is due to its many advantages, which include the ease of use and access thanks to cloud-based hosting. This has allowed SaaS providers to have high customer retention rates. SaaS pricing is based on recurring payments, enabling customers to subscribe to services over an extended period.
SaaS is useful even for companies that already have on-premise services, enabling customers to build on their existing software infrastructure by gaining access to the cloud. Companies such as Microsoft and Adobe provide both on-premise and cloud products for that reason.
SaaS business models are either horizontal or vertical. The horizontal SaaS business model, as used by companies such as Salesforce and Hubspot, is designed for a wide variety of customers and offers services applicable to their various needs across industries. The vertical SaaS model targets specific industries and customers, providing cloud services that meet their unique needs.
IaaS and PaaS Models
Infrastructure as a service (IaaS) is a service through which software companies help their customers to build and develop their own applications on-demand. IaaS companies provide essential services such as servers, storage, networking, firewalls, and IT infrastructure to help businesses.
The advantage of using IaaS is that it saves businesses the cost of having on-premise infrastructure. As well, IaaS allows companies to scale up or down as needed. Microsoft Azure is a famous and popular example of IaaS.
The platform as a service (PaaS) model offers customers the ability to develop and run an application in the cloud. Building on IaaS, PaaS supports the application development cycle in full, and includes services such as development tools and graphic user interface.
The popularity of the cloud is a clear sign of how successful the cloud software business model has become. The quick implementation process and ease of access make the cloud ideal for many businesses.
Downtimes, however, are inevitable and should be anticipated with contingency plans. All businesses that use cloud services should have a solid data backup plan and recovery strategy in place to ensure smooth running operations during periods of downtime.
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Hybrid Software Business Models
The hybrid software model, as the name implies, is a distribution approach that combines on-premise software applications with the use of cloud-based solutions. Such popular products as Adobe Creative Cloud, for example, combine on-premise products with a vast range of cloud-based services that supplement those on-premise products.
The advantage of the hybrid software distribution model is that it gives customers greater flexibility. Customers are able to move information and data between their on-premise centers and cloud services hosted by third parties, without having to rely exclusively on their infrastructure or that of any third party. As well, sensitive information such as health records can remain on-premise, while less sensitive data can be stored in the cloud.
The hybrid software business model however requires a larger team of front-end developers who can handle interface tasks and update software to ensure the interaction between on-premise and cloud-based services is as integrated and seamless as possible.
Software Licensing Business Models
Software licensing business models are based on how software licenses are used. Software licenses dictate the terms of use that customers and clients of software companies have to use when signing up to buy the software. Such licenses determine who is allowed to edit the source code, what the conditions of usage are, and whether the code can be shared and/or modified.
While there are several such business models, the two main source code licensing models are proprietary and open-source licensing.
Proprietary Software Business Model
Propriety software licensing is used by software companies to protect their copyrighted software, so that the source code cannot be accessed, changed, or reused by third parties.
The advantage of having proprietary software is that it provides customers and users with the guarantee that the product will function properly, since it has reliable support, security and bug fixes, and regular updates as needed. Since the software is copyrighted, it can also be monetized.
On the other hand, making software proprietary means that you are responsible for how it works, and any updates or security fixes it might need. This requires that software companies have the necessary engineering capacity to handle such services. Proprietary software can also be more vulnerable to cyber-attacks and more expensive as compared to open source software.
Open Source Software Business Models
With the open source software business model, users have access to both the software and the source code. Anyone can access, modify, and enhance the source code. The software, depending on the license, is fully customizable.
Open source software has the advantage of having community-wide support, so that it can often be safer to use than proprietary software. As well, software companies can use open source software to boost their brand and expand their customer base.
Software companies can use open source as a business model by taking several approaches, such as by providing customization, support (through training or debugging services for example), hosting (by selling access to infrastructure), and offering premium features.
Other Software Licensing Business Models
While proprietary and open source licensing are the two most popular models, software businesses have many other models to choose from.
Those licensing business models include:
Perpetual licensing
Floating licensing
Subscription-based licensing
Feature-based licensing
Cloud-based licensing
These models are supplemented by many others, such as trial-based licensing and account-based licensing. As the names of these licensing models suggest, the key differences have to do with how long you wish to allow your software to be accessed and from where. Perpetual licensing models, for example, provide users with permanent access, while subscription-based licensing models depend on a continued subscription for access.
Deciding on what kind of software license to use depends on what kind of business strategy you wish to implement for your software business. It should also be noted that you can always use multiple licenses at the same time, if that suits your strategy better.
Target Audience Business Models (B2B & B2C)
Target audience models depend on what kind of strategy a software business wishes to implement in terms of its customer and client base. The business model will be different based on whether a software company wants to target other businesses (B2B) or consumers (B2C).
In the case of B2B, the target audience includes other businesses that purchase and make use of the company’s software products and services. Targeting other businesses as customers can enable you to provide additional services tied to your software products, such as by integrating your products with their in-house or on-premise products.
The target audience in the B2C model consists of individual customers and clients. With B2C, support services can be more general rather than specialized, to meet the needs of individual users. As with the B2B model, the B2C model applies to all distribution models, whether on-premise, cloud-based, or hybrid, since individual users are increasingly using cloud-based services in addition to acquiring on-premise software.
Software Revenue Business Models
Software revenue models focus on how software businesses can generate revenue with their products and services. Most software companies use a variety of revenue models through a mix of revenue streams to meet different market and user needs.
The following are some of the major business models and revenue streams:
Paid Apps & License: In the case of paid apps and license-based revenue streams, customers are charged for installing a product. With regards to the on-premise distribution approach, that usually means that customers pay a one-time, upfront fee to use the software.
In-App Advertising: With in-app advertising, the application is free, but software companies can make money by selling advertising space on the application. The most famous examples of this business model are Facebook and Twitter. In-app advertising can also take the form of sponsorship.
In-App Purchases: In the in-app purchase model, the application remains free, but the company sells products and services via the app or site. This is a particularly effective revenue strategy for eCommerce sites.
Subscriptions: In the subscription model, users pay an annual or monthly fee to access the app, products, and affiliated services. The software is leased rather than bought. Subscription models often offer free trial and standard subscription options. Freemium is another subscription option, which combines free versions with premium paid versions that have additional features.
Usage-based Model: In this revenue model, customers only pay for services and products that they use. Usage-based licensing is often used in B2B products.
Transaction Fee: In this revenue model, companies charge a commission based on the volume of transactions that they enable and/or execute. Companies such as eBay and Uber make use of this revenue model.
Charges for Support and Consulting: These revenue streams involve providing services to special corporate clients or customers, such as in the form of customized software products.
Combining Business Models
Software businesses can use two types of business model interactions: the one-to-many business model interaction or the many-to-many business model interaction.
The one-to-many business model interaction is one where a company creates certain products and services and sells them to customers. The many-to-many business model interaction enables producers to create products and content on a platform such as YouTube for fellow users, who are the consumers.
Beyond these business model interactions, it’s important to keep in mind that businesses can often find ways to combine two or more of the business models discussed above. Ultimately, it will depend on what kind of combination is most suitable to your business needs and can help you achieve your business objectives.
Finding the Right Business Model and Staying Protected
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The wide variety of software business models can make the choice of the right model seem daunting. You should take your time to consider the various types of business models and think strategically about how each of them can help you meet your goals and targets.
As you grow your business, you will have the opportunity to change your business strategy to meet new challenges and take advantage of new opportunities. That means being open to adapting new software business models as needed. The key is to start with a model that suits your current needs and be open to making changes as needed down the road.
It’s also important to remember that each business model comes with its own challenges. The success of cloud computing, along with the increasing popularity of remote work, has increased the likelihood of cyber threats and ransomware attacks, for example.
For all software businesses, meeting the challenges in the current business environment means having the right insurance coverage in place to stay protected. Business owners in particular need to ensure that they have the right policies to protect themselves and their business as they grow and innovate. With the right coverage, software businesses can stay protected while implementing the right business model to help them achieve their goals.
