It’s no secret Software as a Service (SaaS) has generated tremendous excitement among many customers for its apparently transformational adoption model and ownership experience. Unlike client-server applications, SaaS delivers faster time to value often via a viral buying cycle as well as lower risk deployment. The early adopter focus has been on small and midsize businesses (SMBs) because SaaS makes it economical to reach them with broad penetration for the first time. Where SaaS has carved out successes in large enterprises, it has largely been in more independent, non-mission critical departmental functions who have no capex budgets such as HR, CRM, or marketing, not end to end suites. Despite the undoubted progress that SaaS is making, we believe the adoption of core, mission critical processes (Financials, order management, industry-specific processes such as manufacturing or securities processing) in large enterprises is still many years out for a variety of technical and business challenges.
SMBs have been the early SaaS suite adopters because traditional vendors couldn”t reach them
SMBs have been the low hanging fruit for early SaaS adoption because they’ve historically been underserved by application vendors. Small deal sizes and bare bones cost of ownership requirements typically were critical stumbling blocks. The small deal sizes mean vendors have to reach them with a much lower cost channel than direct sales.
So far there are two emerging channels. The first is online, customer-initiated self-service complemented by inside sales that often becomes the viral “discover, learn, try, buy, recommend” process best articulated by Ray Ozzie in his 2005 Services Disruption Memo. The second is further out because it requires a greater transformation among existing VARs. Today they make a modest commission on the sale of traditional perpetual licenses or SaaS-based subscriptions. Configuration or customization and integration is where they make their margin. It’s a time and materials business. Expanding the market requires that in the future they deliver the same services to SMBs at a fraction of the cost. The most likely way is to become mini ISVs by transforming their industry-specific expertise into an application hosted on and extending their SaaS provider, and use those higher margins to support much lower margin services. That way the VAR should be able to squeeze down the subscription/service mix for their highly price-sensitive customers.
On the product side, SaaS flips the implementation risk from the customer to the vendor; the cost of ownership (TCO) experience is claimed by some to be as much as an order of magnitude lower.
Will suite emerging suite vendors such as Workday and Netsuite join SAP and Oracle in the enterprise?
Perhaps. But there are still some obstacles in their path.
Why suites from at least some vendors are ultimately likely to emerge center stage in the enterprise
The TCO value of end to end process integration offered by suites is likely to emerge in the enterprise in the SaaS generation for the same reason best of breed collapsed in the client-server generation. At first, the besat of breed products seem to offer better functionality, faster deployment, and more departmental autonomy. But building and maintaining point to point integrations over time turns out to be a crushing expense. For example, it’s not clear that CODA’s widely cited development of a Financials product on SalesForce.com’s platform means they can jointly deliver a reconfigurable order to cash process. They appear more likely to share just the development and deployment platform, Force.com, not the end to end processes. In the client-server generation, that would be the equivalent of running both on BEA Weblogic and assuming that means they’re integrated. As in the client-server generation, however, the slow maturation of suites means the best of breed vendors will have a long time in the sun.
So what’s the hold-up with suites?
Why SaaS suites need time to prove their TCO advantage over best of breed SaaS applications
The favorable TCO economics for SaaS suites is nothing more than a hypothesis at this point based on the experience of the client-server generation. Nor does that necessarily translate into an overwhelming advantage for SaaS suites over client-server suites. After looking at the following numbers, you would think it would. My friend Vinnie Mirchandani posted some provocative thoughts on traditional client-server TCO expenses, claiming it reached from $500 per user per month to as high as an astonishing $1,000 per user per month (cited in a presentation at Software 2007). Quoting in full:
“Here are some numbers. If you spend $ 1 on a software license, over the next decade you will spend between $ 2 and 3 in annual maintenance contracts. You will spend 50c to $ 1 in project team training (vendor classroom training, travel costs, additional licensing of a training tool like RWD that SAP recommends), You will spend between $ 1 and $ 5 with the systems integrator and software vendor consultants (in some cases the services may even be $ 10+ if you have a complex roll out). You will spend between $ 1 and $ 2 for every major upgrade – likely one every 3 years. So, even without factoring in costs of your own staff or incremental hardware you are looking at $7.50 at the low end and $ 21 (or more) at the high end for every $ 1 dollar of software license costs.”
For Business By Design, SAP’s new, purpose-built SaaS product, the company is claiming pricing in the range of $150 per user month. But even if that’s a proxy for similar suite products such as Netsuite and Workday, that doesn’t mean the TCO is that low. For example, just looking at Vinnie’s list above, there are still upfront costs such as project team and user training, business process reengineering, configuration, and integration and data migration from vendor and SI consultants. Finally, nobody knows how difficult or expensive it will be to maintain the admittedly fewer interfaces to legacy or specialized systems across upgrades than it will be for best of breed SaaS applications. Interfaces do change, even for SaaS suites, especially as the functionality evolves. One issue no one disputes is that SaaS makes an enormous difference in the crushing cost of supporting older versions on an extended compatibility matrix of possible customer infrastructure configurations. In client-server systems, that could chew up as much as 80% of the vendor’s R&D budget and untold amounts of customer operations expense. With SaaS, that all goes into innovation that gets delivered to the customer as soon as it’s ready.
Hard evidence of the customer TCO advantage for SaaS suites in the enterprise won’t emerge for a period of at least another 5-7 years we would guess. Even if the products were mature today, which is far from the truth for reasons we explain below, it would still take considerable time before they could fully penetrate IT operations at some major companies. Only then, when they can measurably affect the IT cost structure of these customers over time compared to their peers running on different platforms, will all CIOs feel the pressure to meet the new, lower cost benchmarks.
Why SaaS suites need time to develop their go to market approach
Others have written about how for SMBs suite vendors can’t use the more viral adoption model aided by inside sales typical of departmental approaches. While suites need to reach C-level decision makers, Netsuite, for example, claims that in order to scale more rapidly it needs VAR/SI’s who can make a business out of a first year subscription payment of $25K (vs $75K for Great Plains) and business process reengineering, training, and data migration services of $25-50K (vs $75-225K for Great Plains). Relative to premise-based software, the service mix has to be lighter. The only way they believe that model can work is if the VAR/SI’s can create reusable, vertical extensions that Netsuite hosts for which partners can charge another $25K in high margin subscriptions in order to subsidize a $50-$100K implementation project with minimal margins.
The challenge of selling direct with a richer services mix without viral adoption and while trying to build a channel has created entirely different economics for Netsuite vs. SalesForce.com. Both are roughly 10 years old but Netsuite’s estimated revenues for 2008 are $160m vs SalesForce.com’s $1080m. Netsuite lives on -0.05% operating margins compared to SalesForce.com’s 15%. Both stagger under sales & marketing expenses that approximate 50% of revenue because of the slower reported revenue growth coming from subscriptions. But Netsuite’s gross margin is roughly 10% lower than SalesForce.com’s, coming in at 71%, because of the richer service mix currently required to deploy suites.
Two other potential partner models include resellers who can reach a higher volume of customers in order to live on the lower margin commissions, or IT outsourcers who take over a customer’s entire IT shop, including SaaS applications, and become a managed service provider (MSP) for the whole infrastructure.
At the enterprise level, despite being able to charge customers for upfront commitments of one or two years given enough of a discount, the recognized revenue still gets pushed out, depressing growth and margins. Bookings growth isn’t a substitute. The only way to make this work is to gradually migrate revenues over to the new model over time. Plus, vendors will have to overcome additional partner resistance. The rich time & materials billings generated by custom implementations has to give way to a new generation of highly configurable software.
Why SaaS suites need time to mature as products
While this topic is worth a whole blog post on its own, several issues pop out. First, there is the issue of the trade-offs between multi-tenancy and configurability. Vendors such as SalesForce.com appear to tackle the problem of configurability and multi-tenant scalability purely in shared tables within one database schema instance. They appear to have cracked the code on scaling out with commodity boxes rather than scaling up with expensive big iron while keeping the marginal cost of administration down.
It’s still unclear if they are disadvantaged in configurability.
SAP and Oracle, whether by virtue of having to drag along legacy technology or some other reason, appear to offer customers more isolation. SAP gives each customer their own database instance and Oracle’s On Demand product appears to give each customer an entire application instance. Keeping marginal administration costs low falls to the maturing management layer, the same type of technology that VMware claims will enable applications to meet service level agreements autonomously (e.g. without administrator intervention). Like SalesForce.com on a different dimension, it’s still unclear if they are disadvantaged on the ultimate TCO front by virtue of high internal administration costs. Giving each customer their own instance, however, has the added benefit of reassuring them that their data won’t be commingled with anyone else’s.
The other issue holding up suite maturity is simply the Mythical Man Month. Suites take time to reach functional maturity no matter how many developers are working on them. There have been reports in the blogosphere of complaints in the Netsuite customer base about product maturity 10 years after they started. And SAP co-founder Hasso Plattner told a questioner at a Churchill Club event this spring that he would have to wait another 5 years for an enterprise-ready SaaS product from SAP, despite having started 4-5 years ago.
SaaS relevant for a class of processes today, but not all
For suites to reach both SMB’s and the enterprise, there needs to be both business model and product innovation. Given the customer popularity and VC attention, many startups appear to believe that subscription pricing and hosting means they are SaaS vendors. That just qualifies them as warmed over application service providers (ASPs). This transition seems to be shaping up as a classic Innovator’s Dilemma. Oracle says SaaS isn’t attractive because it’s a lower margin business that requires a new product and a new go to market model. SAP seems to have reached the same conclusion but is plowing ahead gradually on both fronts. While SaaS clearly appears to be working for departmental applications, the jury will be out on enterprise-class suites for several years at least. Everyone agrees you can’t take an existing enterprise-class client-server suite and squeeze enough complexity out of it to reach SMB’s. Nor, on the go to market side, can enterprise vendors immediately substitute a subscription pricing model for their traditional perpetual license one. Netsuite seems unlikely to reach the enterprise by virtue of its design center and channel. Meanwhile, Workday appears to be following the same steady strategy into the enterprise as its predecessor, PeopleSoft, without taking on SAP and Oracle in manufacturing this time. In the end we believe the Innovator’s Solution in the enterprise is going to take some years more both on the product and go to market side.