AI shifts the apps space – time for a new Apps Leader Board?

The software industry has undergone a major shift several times in the last 50 years.  Each time this has happened, the vendors on the leader board often get changed.  All-new leaders emerge and older, stalwart vendors may struggle to retain market share and market relevance.

When these shifts occur, vendors in the old technology paradigm often find themselves backed into a defensive corner. They can choose to reinvent their products and company to align with the new market realities or, more often, they tend to fight the change while causing the customers and employees to suffer.

We’re seeing one of those change cycles today. Older, cloud-based application software vendors are realizing that AI-enabled/AI-first solutions are coming soon. The stock market has also noticed this and has been punishing the stock price of many traditional software vendors. The question therefore is which current vendors will survive and prosper in a new AI powered application software world?

When a new category of software emerges

Software buyers are often a very practical, realistic and pragmatic lot. When they sense a major shift is occurring in the software market, they begin to scale back any future expenditures around the old technology. In doing so, they put a very sharp focus on the costs around their old tech. They will pull back economically wherever they can. And it makes sense. Spending more money on top of the incredible amounts they’ve already spent with this vendor in the past will not get them anything terribly new, current or of value. These customers will drop maintenance or the number of subscriptions/seats/licenses they use. They will actively investigate any avenue to reduce further expenditures along these product lines as they’d like to spend their capital on new tech instead.

In contrast, the affected (old) software vendors will try and milk every last dollar they can out of their customers for the foreseeable future. These vendors know that their revenues will get constrained and, as a result, will resort to a number of non-customer-friendly tactics to blunt the economic impact of these new customer economic market responses.

In effect, customers and software vendors at this stage of their relationship can sometimes be in an acrimonious, expensive and frustrating mutual existence.

Looking at the revenue side of the software-customer relationship, the vendor is expecting overall revenues to begin to go flat or trend downward while still promising revenue gains to their Wall Street or private equity overlords. These vendors will try to push through a number of very unpopular and customer unfriendly price increases to offset this loss of revenue and growth retraction. They will resort to all manner of “wallet fracking” activities on the current customers while actually gaining little if any net-new customers. Cynics call this wallet fracking activity “harvesting”.

Wallet fracking triggers an acceleration of customer defections. To prevent defections, clever software vendors will slip in new contract terms that make it harder and harder for customers to break free of this relationship. Vendors are trying to lock in customers while customers are trying to escape by any means possible.

Vendor lock-in strategies try to force an artificial customer loyalty to the vendor and product. While short term investors (e.g., private equity firms and activist shareholders) might applaud the use of these techniques, they only serve to infuriate the remaining customers and accelerate customer defections in time.

In short, customers know that the relationship is coming to an end. They see the vendor spend a great amount of research and development effort in the design of ever larger and more opaque contracts replete with indecipherable renewal pricing. All of this is done at the expense of, not for the benefit of, the customer.

On the cost side, vendors often try to right-size headcount in light of the new fiscal, technical and economic realities about to impact the company. It’s not uncommon to see significant layoffs of personnel in research and development, marketing and product development roles. A number of development projects in some of the software vendor’s product lines may get indefinitely deferred if not canceled altogether. Some products are moved to a life support only mode to save costs. Vendors, cynically, spin this as a way to create value for customers when all they are really committing to is to supply basic security, tax and regulatory patches.

The preceding paragraphs paint a dark view of software technologies that are moving ever closer to end of life (EOL) but these are common scenarios. Readers should not be surprised of this as we all know firsthand how rapidly technology evolves and changes. Application software is no different. Companies that use commercial software often want to toss out the old technology to make way for the new.

Not that many vendors are able to gracefully and timely shift from one old technology paradigm to another.  Virtually none of the mainframe vendors of the 1980s and early 1990s made the transition to client server well. Ditto for the client server solutions moving to the cloud. And, if history is a guide, many of today’s cloud solutions will fail to be big leaders in the AI apps age.  Wall Street understands this phenomenon and this may be one of the factors underlying their bearish view of this space.

Survivors 

So, which vendors will make the transition to the AI Apps Age?

That may be a simple question to ask but it takes a fair bit of explanation to answer. The key to understanding the future of application software is to understand “margin compression “.

Margin compression occurs when software customers no longer are willing to pay the monies they previously did. Software customers may find that the value proposition around a given software vendor or its solutions no longer warrants a pricey premium. As a consequence, the software vendor is getting squeezed from shareholder demands, investors, bankers, and customers while bringing in less and less revenue.

When revenues are down or flat and customers are not accepting price increases, then the net margin is getting squeezed.

Software vendors need wide margins (and lots of it) to fund R&D efforts and to delight investors. This is the money they plow back into product development, geographic market expansion and technical enhancements. When margins are being compressed, large scale development efforts often get cancelled, deferred and/or extended into the future.

Today’s cloud-based application software vendors may already be feeling some measure of margin compression from their own customer base. Vendors in this situation face a difficult choice. They can try to raise margins via price increases to customers while cutting costs. Or they can seek new R&D funding and try and build next generation solutions. The latter strategy can be especially difficult as existing investors may not fund the effort and the company may not have the time to bring such new offerings to market.

In fact, many pre-existing software companies may simply be too late and too undercapitalized to participate fully in the AI application party. Similarly, some pre-existing vendors may have an entirely inappropriate cost structure to succeed in this new era.

Today’s apps vendors

Many of today’s application software vendors were caught flat footed by the rapid advance of AI in the last three years. By the time management teams realized the speed with which AI innovations were occurring, few of these vendors had the infrastructure, software, and other components needed to field robust, competent solutions in the AI apps market.

Worse, the vision and/or strategy was not present. It’s interesting to note that with only one or two exceptions, almost no application software vendors had built any Large Language Models (LLMs) or if they had, they were small vertical specific ones. Likewise, with only a couple of exceptions, most software vendors had not built the appropriate AI hyperscaler technology to power these new solutions. Now, many of these vendors have been forced into alliances with 3^rd party companies.

The most significant shortcoming with today’s application vendors maybe their abject lack of vision on ideating new headless, composable agentic driven workflows. Software vendors have forgotten how to do large scale primary research and/or how to even reimagine or reinvent the nature of work itself. Most application software companies have built solutions around transaction processing workflows that haven’t fundamentally changed much in three-to-five decades. They’ve gotten fat and happy reanimating the same thing over and over and over again. We may see few real successes in the AI applications age from the old vendors of yore.

So which application software vendors will be the most vulnerable? Possibly the most vulnerable group are old school vendors with high cost of sales, high customer acquisition costs and high cost of goods sold. These companies demand premium high-end pricing while delivering a commodity product. In the future, they cannot justify these prices and other economic components as the software market will reward vendors who have low cost of sales, low customer acquisition costs, low cost of goods sold, etc. Old vendors can’t use their old economic models in trying to win in the AI age.

The economics today are quite different and compelling. When AI tools can generate significant amounts of code and do so relatively error free, a native AI applications vendor should be able to ideate, create, test and release very low cost, high value applications quickly. The best of these firms will choose software delivery, sales and channel partner models that are low cost and possess little friction.

Those new competitors may be troublesome for old school vendors as old vendors will likely struggle to take their high cost, high margin, and people intensive operations into a more fluid, dynamic and rapidly obsolescing AI-based apps market. New AI apps, whether they be agents or full-blown applications, will be/have to be built extremely low cost, deployed and distributed on a low-cost basis as they could possibly be rendered obsolete in a matter of days or months not decades. This observation is counter to the traditional application software marketplace where apps took years to build and were expected to remain market relevant for decades.

Rapid obsolescence, low-cost software development, a more fluid business environment and the opportunity to create apps that do more than process transactions are just some of the change factors impacting the application software market today.

So, the losers will be old vendors still trying to shoehorn a bit of AI into their old product lines without rethinking, entirely, how they will sell, deliver, enhance and price software. “Low cost” are two words that could get a person fired at a traditional software firm. Yet, those two words will define one of the most important characteristics of a future software market leader.

Who could transition, if any firm?

Software vendors that could successfully transition to an AI-based apps world would need to:

• Already have a low-cost structure in place. A firm with a high cost, high price business model might not be able to transition quickly enough before competitors have a cost structure more in alignment with new AI economics. Think about it. How can a high-cost vendor suddenly pivot to being a low-cost provider? How do they explain all those prior expensive sales, complex pricing models, obtuse contracts, etc.  in the past? Tigers don’t change their stripes overnight.
• Have a way to create, market, monetize and reinvent their new AI software solutions in a very short time.
• Be prepared to see their AI solutions undergo rapid and frequent obsolescence and replacement
• Find ways to repurpose some of their core processing assets (e.g., the payroll gross-to-net calculations, key production scheduling algorithms, invoice fraud detection rules, etc.) into AI agents

Alternatively, some vendors might not want to play the apps game like before. Instead, they may want to find better ways to monetize the data inputs and outputs of current systems as data is the feedstock of AI tools. Unfortunately for many vendors, the ownership of transaction data mostly remains with the customer not the vendor. Getting around this data ownership issue may require some creative technical and contractual thinking.

The AI Apps Leader Board contenders

Application software vendor Zoho might be one vendor that makes the transition to the AI Apps world. In a recent presentation, Zoho’s Chief Strategist, Vijay Sundaram, shared his observations on this shift with a group of industry analysts. Several of his slides really resonated on this transition from cloud to AI application software company.

Sundaram identified five impacts that AI will have on SaaS vendors (see image above). I agreed with all of these. Unfortunately, vendor executives at other firms seem to be in denial about several of these. For some vendors, they believe they’ll have years to transition their business model, products, pricing, etc. to an AI-first world. Sure, some regulatory intensive and/or transaction processing modules make take a while to become AI-Agent based but wishing that the AI Age will take a long time to emerge is not a solid business strategy – it’s denial.

Even if you don’t agree with all of Sundaram's five impacts, enough of these are painfully obvious and will likely upend a number of today’s application software leaders. Now, before you start complaining that I’m arguing for the 'SaaSpocalypse', I’m not. I’m simply stating that the software leaderboard will change. Businesses will still need application software. But, software may come in headless, composable apps that are part of long strings of agents. The form, cost, content, protections and more about software will be changing. And with those changes may come new entrants to the space.

There’s also another angle to consider here. Some of Zoho’s top executives have maintained for years that software is becoming commoditized. They’re correct. Now, AI technologies are driving downward the cost of software development to extremely low levels. The impact of this alone has profound consequences on how existing software companies sell, service, market, price, etc. their offerings.

So, will any of today’s software leaders make this transition? Off hand, I can only think of two existing vendors that could possibly make this transition well. Let’s focus on one them for now: Zoho.

Zoho and the new Apps Leader Board

Zoho just turned 30 years old. It is an India-based firm and have, since the beginning, focused on delivering a very low-cost, low friction solution to customers. That low-cost focus has served them well and has helped them become a major software vendor. According to a recent press release, Zoho now has over 1 million customers, around 150 million users and customers in over 150 countries.

Zoho’s privately held status has shielded it from the short-term pressures of activist shareholders, private equity investors, Wall Street and other influences. They build for the long-term.  It’s that long-term focus that differentiates them from most every other competitor of theirs – particularly their larger competitors.

I’ve covered Zoho for more than a decade and have documented their low-cost business model throughout that time.  In 2016, I noted how the company’s low-cost/low-friction solutions were not just foundational but also effective in helping it win deals when competitors can’t match the pricing.  I also pointed out that customers would get more out of a vendor that delivered significant value at low-cost than from a vendor whose core competency was in raising ever larger amounts of capital.  Colleague Jon Reed would have noted that this was a trenchant observation then. It may be more relevant than ever now.

Another item to consider is that many software firms have yet to achieve Rule of 40 compliance. In short, a vendor is compliant if you add their profit margin figure to their annual growth rate. If these two values don’t at least add to 40, then it is spending a lot to capture new business and requiring ever greater quantities of capital to do so. Readers should wonder about the long-term viability of any application software vendor that still hasn’t achieved Rule of 40 compliance by now especially since the cloud era of apps is giving way to a newer AI age of apps. At some point, investors in the prior generation of apps will no longer provide capital to these older firms. They’ll want to pare back expenses and milk their cash cow.

According to a recent Zoho press release:

'Being bootstrapped, private, and built entirely in-house makes Zoho an outlier among competitors,' says Sridhar Vembu, Co-founder and Chief Scientist, Zoho Corporation. "But vendors don't need our help, businesses do, which is why delivering customer value has, for 30 years, been Zoho Corporation's North Star. Before any innovation, strategy, or guiding principle becomes a product, pivot, or policy, it must first affirm the question, 'Will this help businesses?'

My take

Existing application software firms are busily trying to make their current offerings appear relevant in the AI age. They want to re-gift last year’s software in this year’s wrapping paper. These established vendors are sprinkling, incrementally, some agentic, algorithmic and generative AI capabilities in parts of their current solutions. They may be even be adding additional AI platform components to their stack.

But what’s really telling is their lack of radical re-invention of what a business or business user actually wants or could get value from. The vision isn’t there or the existing apps are in the way. Vendors will try to tinker with their existing apps but won’t consider cannibalizing them to make way for a headless process instead. Their quest to preserve much of their old apps comes at the cost of delaying their future and reducing the value you should expect from them.

Readers should note that:

• Just because a software vendor is on the leaderboard today is no guarantee they will be for the next generation of software. In software, as in mutual funds, past performance is no guarantee of future returns.
• Vendors that can’t articulate how they’ll restructure their firm, pricing, etc. to be cost competitive in an AI-driven apps space will face an agonizing future. Instead of sharing these plans with you, they are instead trying to extract more from your firm in toll charges, connection fees, etc.
• Traditional vendors that can’t meaningfully discuss how they will wind down their legacy cloud apps business and launch a radically reinvented AI-age apps firm may already be too late to become a next age market leader.
• Cloud apps vendors should produce for customers and prospects their internal roadmap that shows how they’ll reimagine the nature and content of work, how this will be reflected in headless, agentic workflows and when the vendor can deliver these complete with all necessary guardrails, controls, etc.

That’s a lot of work for vendors to complete and some vendors are not going to move quickly, decisively and thoroughly enough to remain market relevant.

Pick your next vendor well…