The software business model is changing

Spoiler: What’s going on with software companies? And why is Wall Street reacting so strongly? The answer is pricing. There is a real shift happening in the software industry, and the market is trying to figure out what that means. But it’s a reminder that we are not investing in “software” as a category. We are investing in specific businesses. And over time, the quality of those businesses matters far more than the market’s initial reaction, even when it feels like a bumpy ride. 

Artificial Intelligence is changing the business models for software companies–resulting in a meaningful shift in how these companies price their products. Many are embracing a hybrid pricing strategy of consumption-based pricing, alongside their typical subscription-based pricing. This is a significant shift since subscription pricing has been highly successful for software companies. The market has had a multiyear love affair with subscription-based pricing, so any change or uncertainty around this is being viewed as a negative. 

We’ve been anticipating a shake-up in software for over a year now—we sold out of FactSet and Adobe in the second half of 2024 on the premise that their pricing power was receding. But recent innovations like Claude Code and OpenAI Codex have brought these changes into greater focus. 

The old days of buying software were like the old days of buying music or movies. You would buy Microsoft Office 2003 for $400, and then own it forever. If you wanted new features, you would buy the next version several years later–or not. The downside for software producers was that if they made a great product, they might only make money every 5 years or so. Meanwhile, they were still paying software engineers to keep building new versions with new features, regardless of whether customers were interested in buying. This is sometimes called the “Waterfall” model of pricing—one big purchase after a long period of no purchases. 

For more than a decade software companies have embraced subscription-based pricing to make their revenues more predictable and to smooth out the timing of their costs with the timing of their revenues. Instead of buying Microsoft Office once every several years for $400, you would essentially rent it for $10 per month like you do with Netflix or Spotify. Now the customer could receive new features and continual updates, always having access to the latest and greatest version.  The market has rewarded the companies that made this transition with higher valuations, due to the more predictable revenues. 

Consumption-based pricing is a major change, particularly when it comes to who has pricing power. Consumption-based pricing (also called usage-based pricing) means customers pay for software based on how much they actually use it, rather than a flat monthly or annual fee. This means that the price software companies get to charge is directly proportional to the value they deliver to the customer. This is good for the customer, and good for the great software producer who delivers a lot of value. But it’s bad for the mediocre software producer who has been resting on the laurels of fat profit margins and subscription pricing predictability. 

The key for software companies to survive and thrive in this era is to deliver a lot of value. The customer has to see that they’re much better off paying for the software than not, and they need to see that value on a consistent basis. This is different from selling once, or getting an automatic subscription every month. The onus is on the software producer to keep justifying their existence. That’s an existential threat for the companies who are not poised to deliver enduring value. But it’s an opportunity for the companies who can.  

Palantir’s CEO Alex Karp called out this change several months ago when he said, “It’s hard to move from: ‘I get paid because you can’t get rid of me’ to ‘I get paid because you could get rid of me but you don’t want to because you’re creating so much value’ — but that’s where the future’s going.”

We think certain companies that saw this wave coming, like Palantir, ServiceNow and Cadence Design Systems, are delivering extraordinary value to their customers and are pricing relative to the value they produce. This may or may not be rare. The point is, it isn’t a given. 

We won’t get to full usage-based pricing overnight. Customers also like the predictability of the subscription-based model. And if they don’t fully understand what they’re getting into with usage-based pricing, budgets could blow out unexpectedly. Customers definitely don’t want that. 

Here’s Cadence Design Systems CFO John Wall (Cadence CFO) on hybrid pricing:

“We don’t see AI forcing a wholesale change from subscriptions to consumption. Our customers still want predictable access to trusted signoff engines and certified flows. So, multiyear subscription remains the core of our business. What AI does is it changes how much customers run the tools and where value is created. There’s more automation, there’s more iterations, there’s more compute. So, we’ll attach more usage-based pricing for incremental capacity and AI-driven optimization.”

For now, expect a hybrid model where usage-based pricing is an additional lever for software businesses to pull. But it’s reasonable to expect that as more of the work gets done in an automated way, more software revenue will be tied to usage-based pricing from AI agents doing the work. And as a corollary, the subscription pricing power would recede and become a shrinking part of the mix. At this point, it’s unclear exactly what the balance between the two will be. 

The software business model is changing. The customer must see continual value for the continual price they pay. Some software companies will be doing better than ever, many will not.

Here’s John Wall again, making exactly this case, “AI is not replacing our products. It’s amplifying demand and accelerating adoption.”

Treating all software companies as an undifferentiated block is mistaken. There will be winners and losers. We intend to own the winners.

 

Best regards,

Evan McGoff

 

Disclosure: Dock Street Asset Management, Inc. and/or our clients may own Palantir (PLTR), ServiceNow (NOW), and Cadence Design Systems (CDNS). This article is not intended to be used as investment advice.