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A Profile of Software Industry Risk

By
Gordon Tucker, Ronan O’Shea and Rob Gould – Protiviti Inc.

Source: Protiviti's KnowledgeLeader
The software business has long been one of the leading and most innovative industries in the United States. What began in the late 1950s as a highly specialized technology business servicing a small number of customers that owned large mainframe computers has proliferated to become an industry where software is embedded in nearly everything, from computers and medical equipment to mobile phones and home appliances. This article will discuss the current state of the software industry and explore the leading risks its industry leaders must recognize and address to better mitigate the risk profile of their business. 

CURRENT STATE OF THE INDUSTRY
The software industry continues to evolve rapidly, expanding due to innovative new product and service applications (apps), hardware platforms, delivery mechanisms and growing global markets. Four key trends dominate the industry today:

1. Innovation and Product Development
The first trend is the fast pace of innovation and product development that is creating many new applications, services and platforms on which software is used. The most visible of these is the rise of SaaS (Software as a Service), which started off with standardized off-the-shelf, packaged applications but has moved into customized apps built to the specific requirements of a company. SaaS applications for the business market have been rapidly expanding because many companies perceive them as offering a lower total cost of ownership, potentially reducing the need for in-house IT staff to manage the applications. A variant of SaaS is PaaS (Platform as a Service), whereby customers or third party software companies add their own applications to an associated SaaS platform (e.g., Salesforce Appxchange and NetSuite SuiteFlex).

2. Mobile Applications
The second trend is the burgeoning field of mobile applications, whose growth is being driven by the flurry of new platforms and readily available low-cost devices like smart phones and tablet computers. Businesses and consumers are turning to mobile apps because of their ease of use and constant availability. Even large IT organizations are integrating mobile apps to increase the productivity within their company.

3. Mergers and Acquisitions (M&As)
The third trend in the industry is an uptick in mergers and acquisitions (M&As). A distinguishing factor of today’s M&As, however, is that many of them are oriented towards vertical integration between hardware and software companies. In some cases, it is a hardware firm acquiring a software firm, such as HP’s recent announcement of its purchase of Autonomy. In other cases, it is the opposite, such as Oracle’s purchase of Sun. Such M&As are driving change in the software industry as companies re-architect themselves to become not just software developers, but “providers of full solutions” for their clients.
 
4. New and Expanding Markets
The final trend is the meteoric rise of new software developers who appear in the market and rapidly define a brand new playing field. As in the dot-com era, several upstart companies have managed to achieve enormous success by initially hitting it big with a single application, such as game developer Zynga with its popular Farmville game, and then building on that initial success. Social media companies have gone down this path as well. These developers often drive established companies to compete with them as well as inspire other new upstarts to enter the market, creating a virtual cycle of growth and innovation. 

LEADING RISKS OF THE SOFTWARE INDUSTRY

Given the current state of the software industry, the following key risks emerge:

1. Competition from SaaS Competitors
The movement to on-demand software is a top risk for traditional software developers. Arising out of the shift to online (cloud) applications and data storage, SaaS companies are taking on many tasks formerly fulfilled by off-the-shelf software. What remains to be seen is how quickly they will penetrate the market. At this time, SaaS apps have heavily penetrated the customer relationship management (CRM) and human capital management (HCM) functions and less so the order fulfillment, supply chain, manufacturing and core financial functions.  They also have higher levels of penetration in smaller and medium-sized organizations or smaller divisions or distributed locations of larger organizations.
In the future, SaaS developers will clearly target more industries and improve their applications to handle more complex functions; this will push the leading traditional developers to compete or lose their own market dominance. While SaaS apps are not yet a silver bullet, companies and people are eagerly adopting them because they are perceived to be less complicated, more intuitive and built on platforms that people use every day, such as iPads and smart phones.

2. Product Obsolescence
In today’s world, every industry is subject to technological innovation and radical disruption. New hardware devices, platforms and software approaches can result in profitable opportunities for nimble and savvy software companies. However, they can also bring on rapid product obsolescence for a software company that lets its prior successes blind it to change. To mitigate this risk, companies need to monitor trends and anticipate where the market is going. They need to invest in significant R&D efforts to enhance their own technologies and better understand their customers’ needs. Given the length of the development lifecycle for cutting-edge technology, however, this is often not protection enough.  Ariba, a leading provider of sourcing solutions, is an example of a company that anticipated the SaaS movement and now offers only SaaS solutions.

3. Privacy and Security Risks
The software industry has always been at risk for security and privacy breaches. Despite their best efforts, developers have been unable to prevent hackers from penetrating their code to gain unauthorized access to data that their applications maintain for users. In today’s SaaS environment, protecting against privacy and security breaches becomes even more complicated. Even with assurances of security protection, SaaS apps are highly vulnerable to intrusion and the theft of personal or financial records of a company’s employees and customers.

In an effort to regulate this threat, the U.S. and most governments throughout Europe have enacted strict rules about the privacy rights of individuals as well as penalties for breaches of confidential personal information, identity theft and financial data such as credit card numbers. To mitigate this risk, SaaS and other software developers must continuously develop stronger methods of security to stay one step ahead of those who would seek to gain unwarranted access to applications.

4. Intellectual Property (IP) Protection
The IP value of an innovative application has risen sharply in a world that is now more global, competitive and prone to piracy. Not only do software developers need to protect the investment they made in engineering, programming and design costs of their applications, but they also need to be sure they can maximize the financial value from licensing any inventions, patents and service marks affiliated with them. As a result, developers must take many steps to ensure the value they put into a project is not lost to illegal sharing, product imitation, patent infringement or counterfeit production and distribution of their software.

5. Pricing Models
As little as two decades ago, no one would imagine that pricing models would be a risk in the software industry. But today, pricing models are increasingly complex as companies transform themselves from being just developers of software to providers of solutions. One result is that many developers are moving from a license model to a subscription model. Another is that we see more companies bundling software, services and maintenance into a package for customers, or entirely customizing a solution for each client. These trends complicate the rules for revenue recognition, forcing the adoption of new accounting standards and, in some cases, damaging the financial reputation of companies that have stretched GAAP rules too far.
Furthermore, the economic downturn has created significant foreign currency fluctuations, especially between the dollar and euro, that have impacted the stability of pricing models. This has demonstrated that the software industry is sensitive to global economic conditions, a risk that will need further analysis and new solutions for companies that are increasingly selling software products and services on a global basis.

A BULLISH FUTURE
The software industry appears to be climbing a wave of growth and profitability. Trends indicate that it will continue to be an industry in high demand as new technologies, platforms and innovative solutions are created. For every function or task for which software has already been applied, there is the never-ending pursuit of more “elegant” solutions that work faster, smarter and better. Meanwhile, delivery models and new generations of smart phones and tablet computers are rapidly improving the speed at which content is delivered and the quality it is displayed in. Although there is still a need for traditional off-the-shelf software, improvements like these will continue to drive the growth of SaaS solutions, mobile apps, the video gaming industry, 3-D entertainment and as-of-yet undiscovered software applications.
 If there is anything clear about the future, it is that the leading risks in this industry – especially security and privacy, competition from SaaS apps, and product obsolescence – will increasingly challenge software companies to manage and mitigate. These risks will require extensive resources invested in continuous R&D efforts and keen management oversight.   

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