Software as a Service (SaaS), Software on Demand, Hosted Solutions...it goes by many names and is a new emerging software business model. The benefits to the buying customer are obvious...rent the software and hosting infrastructure rather than buy it up front. But, what happens to the software company business model? The answers are different for start-ups versus established software companies.
Start-ups need to get to revenue, and then to cash flow break even quickly...before the cash runs out. Any entrepreneur knows that cash is king. Selling up front perpetual licenses brings in the cash, but SaaS subscriptions provide a smooth predictable revenue stream that builds up over time.
Michael Skok of North Bridge Venture Partners says that it takes 70% to 100% more capital to fund a SaaS company to a liquidity event than a traditional perpetual license company. It also takes 2 to 3 times longer to get there. However, NBVP believes the extra time and money is worth it and pays off in higher market cap values.
Mr. Skok is not guessing...he has real numbers. NBVP has 8 funded SaaS companies out of a total of 53 portfolio companies. The estimates are averages for enterprise software applications. Consumer applications can be done less expensively, and get to market faster. The feature requirements, integration and customization requirements are also usually less demanding for consumer applications. NBVP actively invests in both enterprise and consumer SaaS companies.
Michael Skok was a panelist on a Mass Technology Leadership Council session on Software as a Service. He shared the following facts based on his investments in SaaS companies;
- SaaS companies need an average of $35M in VC capital, versus $20M for a similar perpetual license company.
- It takes 6 to 7 years to get to a liquidity event (IPO or acquisition)
- Public equity markets pay a 10% to 20% premium for predictable revenue streams
- SaaS companies move faster than big companies. They can introduce new features instantly versus waiting for the next major release. Think years.
- SaaS requires an architecture that supports end user customization
- Industry standards are critical for interoperability
- Steady state business models require 15-18% for engineering and 30-35% for Sales and Marketing.
Established traditional software companies must deal with "renting" their software for something like $5 per user/ per month versus selling it for $20K. This effects quarterly profitability and sales compensation. Established companies have the advantage of cash flow from their perpetual license business to sustain them while the SaaS business is growing, but the strategy conflicts are pervasive.
If you are a sales person with a $1M quota and you have the choice of selling a $100K perpetual license, or a $2K a month SaaS subscription, which would you do? Some companies are changing their sales compensation models and metrics to level the playing field. They might give quota credit for 24 to 36 months of the subscription and pay commissions as the revenue comes in. Or they might just pay commissions based on 18 to 24 months of subscriptions.
Engineering costs for SaaS software are higher for both start-ups and established companies, and it takes longer to develop. Engineers must design in user customization and remote development capabilities. It takes a unique architecture and extensive User Interface design to allow customers to customize and integrate a hosted SaaS application, especially remotely. Remember, this isn't shrink wrapped desktop software. Most enterprise software is customized in some way for each customers environment. Traditional companies sell consulting services to do this. SaaS companies must build the customization features into the base software.
Hosting is a big deal, and a subject unto itself. I will not get into it here but suffice it to say that it is very expensive and complex to build and manage a 24X7X365 service that is always up. Most companies outsource this, but it is not free. It must be factored into your pricing model and cashflow model.
How do software companies price their SaaS offerings? Jim Geisman president of MarketShare, a software pricing consultancy, said most companies use a 3 year break-even formula for SaaS vs. Perpetual license prices. Jim makes his living consulting on these issues so I will not reveal all his secrets, but he did share this hypothetical example.
A SaaS company prices its product at $65 per user per month for 10 users. A competing company offers to sell you the same software for $17,500 plus the normal 15% annual maintenance. Which is the better deal? It depends on how many users and your time horizon. The break even point is 3 years. After that SaaS actually costs more than the traditional license. But, after three years you would probably upgrade your traditional license to a new release, so the amortization clock starts again.
The panel predicted that SaaS would continue to grow as a percentage of total software contracts, but that both models would persist for a long time. The estimates are that about 10% of software is sold as SaaS now and that over the next 5 to 10 years it will grow to 25%.
If you are considering the SaaS model for your software company make sure you focus on these things;
- Cashflow - VCs must be patient and willing to fund you to break even.
- Sales compensation - Look at metrics, total compensation, and cash flow.
- Engineering - Have an open architecture that supports end user customization
- Hosting - Partner with a solid, well funded, hosting company
- Legal contracts - Automatic renewals, termination clauses, SLA (Service Level Agreements), privacy issues, data loss, data export, and a variety of other issues must be addressed in your subscription license.
Done correctly SaaS is a very compelling and rewarding business model. Salesforce.com is the poster child for SaaS success. The stock market will reward companies that can get "over the hump" and build a predictable revenue stream. Smart VCs are willing to commit the funds necessary to get to liquidity.