While this book is relatively old for internet standards, it illuminates the early transition to SaaS (Software as a Service) from traditional software license and maintenance models. Timothy Chou, current Head of IoT at the Alchemist Accelerator, former Head of On Demand Applications at Oracle, and a lecturer at Stanford, details seven different business models for selling software and the pros/cons of each.
The rise of SaaS. Software-as-a-Service (SaaS) is an application that can be accessed through a web browser and is managed and hosted by a third-party (likely a public cloud - Google, Microsoft, or AWS). Let’s flash back to the 90’s, a time when software was sold in shrink-wrapped boxes as perpetual licenses. What this meant was you owned whatever version of the software you purchased, in perpetuity. Most of the time you would pay a maintenance cost (normally 20% of the overall license value) to receive basic upkeep services to the software and get minor bugs fixed. However, when the new version 2.0 came out, you would have to pay another big license fee, re-install the software and go through the hassle of upgrading all existing systems. On the backs of increased internet adoption, SaaS allowed companies to deliver a standard product, over the internet, typically at lower price point to end users. This meant smaller companies like salesforce (at the time) could compete with giants like Siebel Systems (acquired by Oracle for $5.85Bn in 2005) because companies could now purchase the software in an on-demand, by-user fashion without going to the store, at a much lower price point.
How cloud empowers SaaS. As an extension, standardization of product means you can aptly define the necessary computing resources - thereby also standardizing your costs. At the same time that SaaS was gaining momentum, the three mega public cloud players emerged, starting with Amazon (in 2006), then Google and eventually Microsoft. This allowed companies to host software in the cloud and not on their own servers (infrastructure that was hard to manage internally). So instead of racking (pun intended) up costs with an internal infrastructure team managing complex hardware - you could offload your workloads to the cloud. Infrastructure as a service (IaaS) was born. Because SaaS is delivered over the internet at lower prices, the cloud became an integral part of scaling SaaS businesses. As the number of users grew on your SaaS platform, you simply purchased more computing space on the cloud to handle those additional users. Instead of spending big amounts of money on complex infrastructural costs/decisions, a company could now focus entirely on its product and go-to-market strategy, enabling it to reach scale much more quickly.
The titans of enterprise software. Software has absolutely changed in the last 20 years and will likely continue to evolve as more specialized products and services become available. That being said, the perennial software acquirers will continue to be perennial software acquirers. At the beginning of his book, Chou highlights fifteen companies that had gone public since 1999: Concur (IPO: 1999, acquired by SAP for $8.3B in 2014), Webex (IPO: 2002, acquired by Cisco in for $3.2B in 2007), Kintera (IPO: 2003, acquired by Blackbaud for $46M in 2008), Salesforce.com (IPO: 2004), RightNow Technologies (IPO: 2004, acquired by Oracle for $1.5B in 2011), Websidestory (IPO: 2004, acquired by Omniture in 2008 for $394M), Kenexa (IPO: 2005, acquired by IBM for $1.3B in 2012), Taleo (IPO: 2005, acquired for $1.9B by Oracle in 2012), DealerTrack (IPO 2005, acquired by Cox Automotive in 2015 for $4.0B), Vocus (IPO: 2005, acquired by GTCR in 2014 for $446M), Omniture (IPO: 2006, acquired by Adobe for $1.8B in 2009), Constant Contact (IPO: 2007, acquired by Endurance International for $1B in 2015), SuccessFactors (IPO: 2007, acquired by SAP for $3.4B in 2011), NetSuite (IPO 2007: acquired by Oracle for $9.3B in 2016) and Opentable (IPO: 2009, acquired by Priceline for $2.6B in 2015). Oracle, IBM, Cisco and SAP have been some of the most active serial acquirers in tech history and this trend is only continuing. Interestingly enough, Salesforce.com is now in a similar position. What it shows is that if you can come to dominate a horizontal application - CRM (salesforce), ERP (SAP/Oracle), or Infrastructure (Google/Amazon/Microsoft) you can build a massive moat that allows you to become the serial acquirer in that space. You then have first and highest dibs at every target in your industry because you can underwrite an acquisition to the highest strategic multiple. Look for these acquirers to continue to make big deals when it can further lock in their market dominant position especially when you see their core business slow.
The misaligned incentives of traditional license/maintenance model. Software was traditionally sold as perpetual licenses, where a user could access that version of the software forever. Because users were paying to use something forever, the typical price point was very high for any given enterprise software license. This meant that large software upgrades were made at the the most senior levels of management and were large investments from a dollars and time perspective. On top of that initial license came the 20% support costs paid annually to receive patch updates. At the software vendor, this structure created interesting incentives. First, product updates were usually focused on break-fix and not new, “game-changing” upgrades because supporting multiple, separate versions of the software (especially, pre-IaaS) was incredibly costly. This slowed the pace of innovation at those large software providers (turning them into serial acquirers). Second, the sales team became focused on selling customers on new releases directly after they signed the initial deal. This happened because once you made that initial purchase, you owned that version forever; what better way to get more money off of you than introduce a new feature and re-sell you the whole system again. Salespeople were also incredibly focused on closing deals in a certain quarter because any single deal could make or break not only their quarterly sales quota, but also the Company’s revenue targets. If one big deal slipped from Q4 to Q1 the following year, a Company may have to report lower growth numbers to the stock market driving the stock price down. Third, once you made the initial purchase, the software vendor would direct all problems and product inquiries to customer support who were typically overburdened by requests. Additionally, the maintenance/support costs were built into the initial contract so you may end up contractually obligated to pay for support for a product that you don’t like and cannot change. The Company viewed it as: “You’ve already purchased the software, so why should I waste time ensuring you have a great experience with it - unless you are looking to buy the next version, I’m going to spend my time selling to new leads.” These incentives limited product changes/upgrades, focused salespeople completely on new leads, and hurt customer experience, all at the benefit of the Company over the user.
What are CAC and LTV? CAC or customer acquisition costs are key to understand for any type of software business. As HubSpot and distinguished SaaS investor, David Skok notes, its typically measured as, “the entire cost of sales and marketing over a given period, including salaries and other headcount related expenses, and divide it by the number of customers that you acquired in that period.” Once the software sales model shifted from license/maintenance to SaaS, instead of hard-to-predict, big new license sales, companies started to receive monthly recurring payments. Enterprise software contracts are typically year-long, which means that once a customer signs the Company will know exactly how much revenue it should plan to receive over the coming year. Furthermore, with recurring subscriptions, as long as the customer was happy, the Company could be reasonably assured that customer would renew. This idea led to the concept of Lifetime Value of a customer or LTV. LTV is the total amount of revenue a customer will pay the Company until it churns or cancels the subscription. The logic followed that if you could acquire a customer (CAC) for less than the lifetime value of the customer (LTV), over time you would make money on that individual customer. Typically, investors view a 3:1 LTV to CAC ratio as viable for a healthy SaaS company.