Many years ago I found myself talking to venture capitalists about the differences between SaaS, outsourcing, ASPs, MSPs, online applications; etc. Also I noticed that my Stanford students had little understanding of the economics of software, so I developed the idea of seven business models to cover everything in the software business, and remove the buzzwords and replace them with economic models.

In my previous blog post we discussed the first four models, this post will cover Models Five through Seven.

Seven Software Business Models

We ended the last blog talking about Model Four being able to provide management of the security, availability, performance and change of the software at nearly 10x less cost.

The question we left with was “how”?

How is it possible to decrease the cost of management without just paying people a fraction of what they made previously?

Standardization, Specialization, Repetition

This will not seem related to software, but bear with me.  For those of you who’ve never read it, the book “Guns, Germs and Steel” was written many years ago by a cultural anthropologist named Jared Diamond who teaches at UCLA. The book is actually the answer to a question his friend, a New Guinea aborigine, had. He asked, “Jared, how come you guys have all the stuff?”

In other words: Why did civilization start and prosper in Europe and in Asia but never in New Guinea?

His answer begins with his observation that civilization took an enormous leap when we moved from being hunter-gatherers to being farmers.

The reason is that once we could farm, we could stop moving, and once we could stop moving, we could specialize. We could have a group of people who farm, a group of people who make weapons, a group of people who make homes and clothing, and so where this was possible, human civilization advanced.

Next question: How do you become an Olympic-class swimmer?

Well unless you’re Michael Phelps, you certainly don’t swim the butterfly, breaststroke, and do freestyle. Instead, you specialize and choose one.  In addition, if you want to be an Olympic-class swimmer, do you swim a couple of laps per day? The answer is no, you swim hundreds and hundreds of laps day after day. And, by the way, you swim in a standard sized pool.

Finally: What is the number one question you should ask a surgeon before he or she performs surgery on you?

If you take nothing else from this blog, hopefully this is what sticks. The number one question you should ask a doctor prior to surgery is, “How many times before have you done this surgery, successfully?” If you’ve done something successfully many times over, the chances for you being able to repeat that success keep going up.

So How Does this Relate to Cloud Computing?

In the early days of the Oracle OnDemand business, I met Fred Magner, CIO for Unocal, one of the largest oil and gas companies. They had heard we at Oracle were managing Oracle Apps, so they decided to make a trip up to visit, largely as a courtesy.

During the post lunch meeting, Fred looked at me and said, “My guys manage Oracle Apps, your guys manage Oracle Apps, what’s the big difference?”

I said, “Well I understand why you would ask that question, but let me ask you just one question: “How many times have your guys done an upgrade from Release 11.5.2 to 11.5.4?” He said, “Well maybe once or twice.” I said, “Well can I introduce you to the team who’ve done this 265 times?”  And by the way if humans can do it 265 times computers can do it faster, and at a lower cost.

So fundamentally, if I can standardize the hardware and software stack, and furthermore standardize the management of security, availability and performance then I can have computers manage the software, increasing reliability and decreasing costs dramatically.

Now back to describing business Models Five through Seven.


Model Five: Hybrid+

The Model Five business models takes the Model Four fees and packages them into an entirely different monthly, per user subscription model. For instance, instead of paying an upfront license fee, you pay $300 per user, per month.

Model Six: Software as a Service (SaaS)

Some people will call Model Six the SaaS model. Pretty much every new application software company that has gone public since 2000 has delivered software in this model. In other words, they are delivering their software only as a cloud service. In our example you’ll notice the choice of at home or at customer no longer exists. Furthermore you the customer have no choice about when the upgrades occur.

But in exchange for increased degrees of standardization, you get dramatically lower cost structures, which are in order of magnitude different than what we’ve seen in Model Four and Model Five.

Model Seven: Internet

Model Seven is the model in which all consumer application cloud services live. The economic model here is sometimes referred to as an asymmetric business model. In other words, I don’t charge you directly for the usage of Facebook, eBay or Twitter. Instead I monetize with ads, which is obviously the case with Google, or I can monetize with transactions like eBay and PayPal. Or if you think about it, every time you buy a book at Amazon, a small percentage of your book fee is going to pay for the use of the Amazon.com software.

Just so you can think about how much the cost structures can go down when you do the heavy degrees of standardization and automation, I did a back of the envelope calculation a couple of months ago to try to calculate what Google would charge each and every one of us if they were to charge us for the usage of search every month. The math came to be about 70 cents per user, per month. If I were to go to Salesforce.com and try to calculate how much they cost to deliver, it’s about seven dollars per user, per month. If I were to take traditional applications, like big Oracle CRM applications, you can probably get the cost to be about $70 per user, per month.

As you look through this, you’re seeing increasing degrees of standardization, specialization and automation resulting in significantly different cost structures as you walk through each of these business models.


In fact, every software vendor needs to choose to operate in one or more of these models. Each model can have certain advantages and certain cost structures buried inside, all of which need to be considered. For instance, a software vendor shouldn’t get confused trying to build a Model Six business on top of a Model Three outsourcing cost structure; it’s never going to be successful.

In summary, be a student of economics, because every major technology transition has been fueled by economics.

And For More Information

For more information, and many more examples of how businesses moved to the cloud:

  • Find my book on Cloud Computing: Fundamentals. In fact, Seven Business Models is discussed in more detail in a TED-sized chapter in this book.
  • Read my prior blog on Seven Software Business Models -part 1.
  • Watch out for my next blog on State of the Cloud – a case study of one company’s journey utilizing the cloud. Coming out Monday, March 9.




Timothy Chou

Lecturer at Stanford University