In the recent Cloud 20 webcast I hosted, we discussed the topic of the financial business model that SaaS providers will mature into. Right now, we know that SaaS providers that are public do not have business models that are as attractive as the business models of successful license based software companies. In the TSIA Service 50 index, we track the public data of many of the leading established license based software companies. In the graph below, we compare the business models of SaaS companies in the Cloud 20 to the average of business models of software companies in The Service 50:
I have made the above observation in multiple forums over the past two years. There is nothing quite as special as the profitability of a mature license based software company. And to date, SaaS companies have not proven they can be anywhere near that special. But let’s move the conversation one step forward.
The Target SaaS Business Model
Right now, everyone I speak to regarding the SaaS business model believes it is still maturing. “Hey, most of these SaaS providers are in high growth mode as they grab market share. The mature business model will emerge after the land grabs.” OK, I can buy into that assertion. So as SaaS becomes a more and more popular mode for consuming software, how will these SaaS business models mature? We know that a “healthy” enterprise software company generates gross margins north of 80%, spends less than 40% on Sales, Marketing, and G&A, 15% on R&D, and generates a profit north of 20%. What will a “healthy” SaaS business mode look like? The image below shows the actual business models of some of the SaaS companies we track in the Cloud 20 and places them next to a hypothetical target business model for successful, mature SaaS companies.
As the image shows, even large SaaS provides like salesforce have a long way to go before they approach a business model that looks even remotely interesting from a profitability perspective.
The Levers of the SaaS Business Model
In our recent webcast on The Cloud 20, I asked the attendees where the greatest opportunity lies for SaaS providers to improve the performance of their business models. Will they be able to reduce the
percentage they spend on R&D? Will sales and marketing expenses trend smaller as brands become larger? Or perhaps G&A will reduce as a percentage of revenues as these companies grow. The audience was very clear in their response. They believe the greatest opportunity for SaaS providers to improve the SaaS business model is to improve the margin on subscriptions. That makes good sense. Except, a majority of the audience also believed that average subscription prices for SaaS offerings will trend lower, not higher, over time. This means the entire SaaS business model hinges on the volume of incremental subscribers outpacing both the price pressures on subscriptions and the cost to serve more and more diverse customer needs. This may indeed be the scenario that plays out for SaaS. However, that is not how it has played out in other IT markets. Think PCs. As the capability and complexity of each unit went higher, the cost per unit went lower and lower. The result has been a very low margin low profit business model for the PC manufactures, regardless of the market share they command.
What is the target business model for SaaS providers? Based on the rapid adoption of cloud based software models, we will find out shortly enough. I’m just not sure those of us in the IT industry are going to like the answer.