SmoothSpan Blog

The economics of SaaS are magical.  SaaS combines two powerhouse ideas for generating revenue and growth: radically reducing friction in the sales process and recurring revenues.  The first means SaaS companies can close deals with a fraction of the effort needed for a normal transaction.  As SaaS CEO Chris Cabrera said when I interviewed him, there is no need for a try before you buy because buying is so cheap and easy customers just want to get started after the first demo.  I’ve talked about recurring revenues as well.  Recurring revenue gives SaaS companies the power of compound interest.  This recurring revenue cushions the down times and compounds the good times so long as they keep customers happy to minimize churn.

The people I talk to in SaaS companies are loving life and are convinced the world is going SaaS quickly.  There are many signs that the old barriers and objections are steadily coming down.  Cabrera commented that security, that big nasty totem SaaS detractors love to wave, was a factor in 2 out of 10 sales calls 3 years ago, and now he only hears about it in 2 out of 100 calls!  Cabrera goes on to suggest that in 10 years, SaaS will have completely taken over.  I don’t think he means there will be no other businesses, just that SaaS will dominate the marketplace.  Singh, for his part, also feels that the SaaS players will move rapidly upwards in scale, and his own company is efficiently pursuing an acquisition strategy to compound that growth further.  SaaS companies have proven they can sell up-market too–Sing has customers with 180,000 seats and Cabrera is selling 200-300 seats per customer which is a far cry from the low teens of seats that Salesforce sold to each customer when it started.

The other magic of SaaS is that it’s a completely disruptive business model.  It forces companies with an established business to take their usual model where license revenues are recognized in their entirety in the quarter they were sold and start spreading that revenue out on a monthly basis.  Many of these companies are barely making their numbers as it stands, and any move to SaaS is going to create a short term apparent slow down in business that they can ill afford.  Because both men have lived the non-SaaS life as well as SaaS and know full well what’s on both sides of the curtain, both Steve Singh of Concur and Chris Cabrera predict it will be very hard to impossible for companies to switch.

Let’s assume all of this is true:  the economics of SaaS are magical, SaaS will inherit the world within 10 years, big software can’t move up market because the big companies will buy SaaS too, and the business model change almost requires living through self-immolation.

What are the established players going to do?

They’re going to try to eat the elephant in bites.  They’re establishing what I’ve called “protected game preserves“.  Phil Wainewright calls it the “See No Evil”, “Hear No Evil”, and “Speak No Evil” strategy for SAP, Adobe, and Microsoft.  Oracle is apparently going to ignore SaaS for as long as it can.  Their strategy is based on capturing recurring revenue too, but they do it buy buying the companies that succumb along the way and milking their maintenance and professional services recurring streams.  Perhaps they assume there will be big enough SaaS companies in a few years that they can acquire those too.

Here’s how the protected game preserves work for these companies:

• Adobe is entering the new market of word processors with their BuzzWord acquisition.  It doesn’t compete with anything they sell today, so it’s a safe bet and a protected game preserve.
• SAP is trying to confine their ByDesign product to the mid-market, where they don’t sell much anyway.  Peter Zencke is already talking about how this product is a lot slower than their regular product because of its layered architecture.  Probably true, but its a nice way to tell a big customer “no” that pushes them for SaaS.  It’s interesting that the “factor of 4” slowdown is almost exactly what they need to keep it away from their large customers.  This is the pat answer to Phil Wainewright’s concern that if the product is great it will cannibalize.  SAP will tell you it’s great, but doesn’t yet scale outside the market they want to restrict it to.
• Microsoft is featuring add-on services to their existing perpetual license products.   Same old markets, but you have to buy their regular product for the services to be of any use.

How well are these strategies likely to work?  I like SAP’s the best and Adobe’s the least. 

Adobe is venturing very little, and has minimal risk, but they have a lot of ground to cover to shake loose an interesting audience.  They’re building a market there, which is potentially time consuming even helped along by SaaS compounding.  It’s also a market that offers them no leverage to speak of for transitioning the rest of the business.

SAP, on the other hand, seems pretty clever.  They built their entire span of products into ByDesign, so they have a ton of leverage to achieve a great product/market fit.  At the same time, the 4x poorer performance is a poison pill that starts to keep it from being too threatening with the big customers.  They can go into that middle market and butt heads with other SaaS players hard.

Microsoft, as usual, is in the middle, scratching their heads about the web.  They know they need to do something, they’re just not sure what.

The real issue all of these players have is that SaaS is a hobby for them.  SAP has made a pretty big development commitment, but it remains to be seen how much effort they can afford to invest.  Remember, even if SaaS isn’t cannibalizing, these companies all have to invest in growing their SaaS businesses while still keeping enough investment on the core that they don’t tank their numbers.  Even a protected game preserve strategy can’t help with that because the budgets are a zero sum game. 

Here are my predictions on how this plays out:

None of these companies will take huge pain, Steve Singh is right about that.  Of the three, the Germans at SAP have historically had a greater pain tolerance when they’re doing what they think is right, and I also feel they have a pretty clever strategy to make a really big game preserve.  I give them the best chance of keeping head above water as the SaaS transition unfolds, but I don’t look to them to build a commanding presence because they can’t invest enough without maiming their core.  The rest of these companies are going to have to look for acquisitions in the SaaS world.  It’s the only way to seize SaaS market share quickly.  By acquiring, they don’t pay the advance cost of the compounding, they get compounding handed to them as a going concern that is hopefully growing rapidly and profitable. 

The difficulty with a SaaS M&A strategy is that if the SaaS pundits are right, the fundamentals for these companies can deteriorate while SaaS valuations go up.  That’s a nasty M&A whipsaw if your acquisition currency is devalued while your targets increase in value.  Adobe has something of a hedge because their business is highly correlated with activity on the Web.  SaaS and Web 2.0 are both web-based, so Adobe can benefit.  Microsoft I wonder about.