While executing a turnaround in any industry can be a difficult task, digging a software business out of trouble is a Herculean one. Certain product, financial, and labor market forces unique to the sector reinforce one another when a software company is performing well—and also when things start to go wrong. With the right formula, companies can ride a wave to fantastic success. When the environment changes, they must battle mightily to avoid being sucked into the abyss.

The odds against turning a software company around are thus extremely high. A McKinsey study showed that out of 492 companies defined as struggling, only 13 percent were subsequently able to revive themselves (see sidebar, "About the research")—an unusually low proportion. Yet turnarounds are possible, and the rewards make the effort worthwhile.

Why is it so difficult?

Software turnarounds are tough because, at the first signs of trouble, forces specific to the industry can combine to create a deadly downward spiral.

Take product market forces. Software is a winner-takes-all business in which three factors—the need for compatible technology in networked environments, high switching costs, and increasing returns to scale—unite to ensure that only a small number of players...