Unless you are a software vendor yourself, and even if you are working for a software vendor, it is likely that you do not understand how a software company works. A software company has a life, a beginning, middle-age, and old. This is true for all businesses of course, but software vendors have a unique life-cycle that allows for massive corporations like Microsoft to totally eclipse hardware companies like Intel and have almost no parallel in traditional consumer-based companies.

There are three primary revenue streams in all software companies:

1. License sales
2. Maintenance & support
3. Professional Services

When a software company is young, new, and small then all of it's focus is on the software itself. The company must sell the software, find new licenses for it and survive doing so. Every customer is important, every customer helps to refine the software and virtually every dollar of each sale (and usually a lot more on top of it) is put into research and development of that software. The sale of the software, or more correctly, the licensing of the software is the primary revenue of the company. The problem with license revenue is that it is typically seen as a one-time sale, though it might be a large sale it happens once per software solution and so each sale is expensive. In fact, it can often cost more for a sale than the sale itself provides in revenue. But why would a company choose to do that?

The answer comes from understanding that the second revenue stream is recurring revenue, it is guaranteed revenue that is accounted for every month often locked in for three or more years. At the beginning of the company's life when there are virtually nothing but new users, this is a very small and unimportant part of the overall company revenue and somewhat unimportant as an indicator of the underlying strength of the company. But eventually things change, if the software is successful then eventually you have a lot of happy customers gladly paying year after year to "maintain and support" their software and that revenue stream becomes the dominant stream.

The important thing to understand is that unlike License revenue, which requires that new consumers be found and is a one-time expense, the maintenance revenue continues for years even after the original software has become unsellable. I've modeled a software company that has a very successful software solution that grows by an incredible 25% year over year for 10 years and then starts to decline in growth by 50% over the next 10 years. Before that decline starts to happen, however, the maintenance revenue stream has already surpassed the license revenue stream, it has already become the most important revenue stream to the company.

At this point in a software vendor's life, the focus of the company has to change from exciting new customers to keeping old customers.

But it isn't just that the vendor now has a significant, near-guaranteed revenue stream, the margin (or profit) on this revenue stream is very much larger than license revenue. Recall I said that some license sales actually lose money. By that I mean that the R&D required to make a sale ("yes, we'll make it do that if you buy it") can easily swamp the actual license sale. Contrast that to maintenance revenue, while feature requests are accepted there is little incentive to meet any particular one (though of course the software cannot be static) ... most of the money coming through maintenance and support revenue streams is profit with a margin of 90% or more being seen in real life scenarios.

Professional Services -- The Third Revenue Stream

Astute readers will have realized that I predict a multi-year period in where the cost of sales is greater than the revenue though I don't model it within the charts. Much of this revenue shortfall will come from investment capital but a viable company needs to start to show if not a return on investment by year 3, certainly a story that supports a likely positive ROI within another two years. The missing revenue is often made up from Professional Services, consultants and experts paid usually on an hourly basis to design, build, install, configure, test, maintain, customize, secure, and upgrade the solution. And this can be quite a large revenue stream as well but for a public software company it is a double-edged sword.

Public companies are beholden to their shareholders to perform in ways that are going to improve the share price. The share price determines the total capitalization of the company, in other words, the share price X number of shares == total company worth, and it is often expressed as a "multiple of revenue" or just "the multiple". Because of the highly profitable recurring revenue associated with a maintenance stream, the greater the percentage of the total revenue of the company coming from that stream the greater the expected valuation for the company. A desired target for a software company is approximately 30:1, so that a company with $1billion / year in revenue could expect to be sold for approximately $30billion.

One way to look at that split is to recognize that the actual cost of production for software tends toward zero as the sales tend to infinity ... you get to reuse your work product over and over again. Professional services is different, however, it does not generally get many economies of scale. The multiple on a pure-play professional services company is in the low single digits and so the greater the proportion of revenue coming from professional services, the lower the multiple.

Business Model Details

The two charts below show the monthly revenue stream and the total cumulative monthly revenue respectively. The revenue model starts with $1000 of license sold in month one with a smooth 25% increase of sales year over year for the first 10 years so that month two sees $1,020.83 in new revenue and $2,020.83 for total license revenue. Starting with year 11 the company saw a relatively smooth decline in new license sales such that sales are nearly zero by year 20.

Maintenance / support costs are calculated as 20% of the previous month's cummulative license revenue.

Professional Services revenue are not modeled.