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Hallmarks of Success for Software Companies
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In addition to a wide economic moat, there are five hallmarks of success that "we look for in successful software companies: increasing sales, long track records, expanding profit margins, large installed customer bases, and great management. If you can find companies that possess all five characteristics, you've probably identified the creme de la creme of the software industry.

Increasing Sales

Unlike mature Industries such as consumer goods, software is relatively new and should grow faster than the economy. Successful software companies should increase revenue at least 10 percent annually in stable economic conditions. Steady growth indicates a company has either a growing demand for its software, loyal customers, or the ability to raise prices "without losing business. In addition, successful companies typically have large amounts of recur­ring service revenue locked in.

Long Track Record

The low barriers to entry of the software industry contrast with high barriers to success—it's easy to start up a software firm, but it's much more difficult to create one that's still around after several years. Thus, look for software companies that have thrived during multiple business cycles and have solid results during both the peaks and valleys of IT spending. Sticking with firms with at least five years' worth of historical financial data will keep you from getting burned by the flashes in the pan.

Expanding Profit Margins

Successful software companies should be able to expand margins over time through economies of scale. Once software is developed, the marginal cost of producing additional copies is virtually nil, which means that each new dollar of sales should fall straight to the bottom line. Also, look for companies with high-margin license revenue increasing as a percentage of total sales.

Large Installed Customer Bases

Successful software companies typically have large customer bases that remain loyal to their products and services. Because technology buyers are inherently conservative and loath to buy products from a vendor that might go out of business, they are more prone to continue buying software from companies they trust. In the lousy IT spending conditions of the past few years, many established firms have performed well by relying on their large customer bases.

Great Management

The saying "buy the jockey, not the horse" has even more relevance in the software industry because a company's most important assets are the people (i.e., the programmers, salesforce, and management) who come to work every day. One negative characteristic of management in the software industry, however, is the egregious use of stock options. Because there's a shortage of top-notch programmers, it's not uncommon for management to give away big chunks of the company at the expense of shareholders to lure talented employees. If you can find a management team in the software industry that has resisted the temptation to give out huge option grants every year, you've definitely found a team that's willing to go against the grain.

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