SEPTEMBER 2009

In this issue

Deconstructing the Demand for
On-Demand (SaaS)

Deals Fall Apart:
How Private Company Sellers can avoid Busted Deals in Today’s Market

 

We welcome the opportunity to have a more detailed discussion of the Commercial Technology market.

For more information contact:

Gretchen F. Guandolo
Director
KippsDeSanto
(703) 442-1413

Erin C. Lucien
Vice President
KippsDeSanto
(703) 442-1414

Jon Yim
Vice President
KippsDeSanto
(703) 442-1404

Deconstructing the Demand for On-Demand (SaaS)

By Jon Yim, Vice President, KippsDeSanto & Co.

SaaS Defined

What is SaaS (Software-as-a-Service), and why is it having such an impact on the software industry? Is SaaS just the latest technology acronym that can be pronounced as a word or is there truly inherent value in the SaaS model, particularly in today’s challenging market environment?

SaaS is a method of delivering software applications as a service over the Internet rather than implementing and maintaining the software on-site. The rent vs. own real estate analogy is simple yet accurate; on-demand software is rented for a period of time while on-premise software is owned and maintained by the customer. Another cornerstone of the SaaS model is its multi-tenant architecture, whereby all users share a common code base and infrastructure that is centrally maintained by the vendor. As a result, a SaaS customer typically enjoys the benefits of lower up-front investment costs, less capital and operating IT budget requirements, faster time to deployment and more frequent upgrades and bugfixes. Furthermore, SaaS players have successfully attracted both large and small customers. Historically, larger enterprises have been the technology trendsetters, but with the aforementioned benefits, customers of all sizes are able to adopt the SaaS model. To date, the four software application markets with the greatest penetration of SaaS are CRM, human capital management, enterprise resource planning, content management & collaboration. According to recent estimates from The 451 Group, these four application sectors represented a worldwide SaaS market of $6.2 billion in 2008, with 27% and 25% growth expected in 2009 and 2010, respectively. Additionally, Gartner forecasts the global enterprise market for software-as-a service will grow to $16 billion by 2013. These growth estimates are staggering when compared to the single digit growth expectations for the software market as a whole.

SaaS vs. Traditional Software Companies—De-mystifying the Differences

The rapid and widespread adoption of SaaS is having an undeniable impact on the broader software market. Not only are early stage companies choosing to take advantage of the SaaS trend, traditional on-premise software companies are aggressively evaluating ways to participate in the SaaS movement. One of reasons is the many “assumed benefits” of SaaS over traditional on-premise software models. But how true are these assumptions?

To better understand some of the differences between SaaS and on-premise software companies and the impact the different models have on a vendor’s financial profile, KippsDeSanto & Co. (“KDC”) independently analyzed 20 publicly-traded SaaS companies and over 110 publicly-traded on-premise software companies¹. In addition, we have reviewed Wall Street research reports and various industry publications as well as interviewed SaaS vendors to conduct a thorough analysis on the characteristics of SaaS companies in today’s market and assess the most commonly referenced assumptions to provide our independent take on their accuracy. While we found that not all of the market assumptions hold true, our research supports the thesis that the SaaS model presents numerous benefits and competitive advantages compared to the traditional on-premise software model. We have summarized our findings in the KDC Scorecard below.

KDC SaaS Scorecard

	Presumption		KDC's Finding	KDC's Scorecard
Higher Growth	Given the agility provided by the SaaS model, SaaS companies garner higher top-line growth.		Based on our analysis, SaaS companies continue to exhibit above-market growth.	+
Higher GM%	Unlike the on-premise model, SaaS firms tend to have lower costs of goods sold as a percentage of revenue.		As evidenced in our analysis below, we did not find this presumption to hold true. Conversely, SaaS gross margins are in-line with on-premise companies.	+⁄–
Lower OpEx	Given the unique subscription model and multi-tenant system, SaaS companies should have lower operating expenses, particularly as it relates to S&M and R&D costs.		Given the infancy of SaaS companies, we were not able to evaluate normalized operating expenses. However, even at this stage, the scalability of R&D expenses is evident.	+
Lower TCO	Total cost of ownership is lower than on-premise software.		We have reviewed a number of publications and select empirical evidence, but given the limited information, this presumption remains to be seen.	+⁄–
Higher Visibility	As revenue is recognized ratably over the length of the contract, SaaS companies enjoy the benefits of higher revenue visibility.		Inherent in the subscription nature of the contracts, SaaS companies enjoy higher revenue visibility, as well as growing market power over the terms of the contract.	+

 

Assumption #1: Higher Growth from SaaS Model

Broadly speaking, SaaS vendors have enjoyed significantly higher growth in recent years than traditional software companies. As the chart at the right illustrates, public SaaS companies have outpaced traditional software companies by approximately two to three times over the past two years. This trend is expected to continue into 2010, even under a bleak economic landscape. We believe that this higher growth is fueled by a combination of factors. First, demand is strong as SaaS vendors can deploy solutions quickly with lower initial investment to overcome budget barriers that thwart traditional license sales. Second, the subscription model itself provides a stable, recurring revenue stream to the vendor over the duration of the contract term with new sales layered on top versus the constant need to “hunt elephants” and win large new license sales to drive growth. Last, but not least, the subscription model and economic benefits offered by SaaS vendors enables them to market to businesses of all sizes, small or large.

In our analysis, we also considered the lifecycle of SaaS companies whereby the majority of them are smaller than the more mature on-premise software companies. However, in our research, the median latest twelve months revenues for SaaS and on-premise software companies were approximately $180 million and $230 million, respectively, dispelling the notion that SaaS companies are nascent. Furthermore, the poster child of the SaaS market, Salesforce.com, exceeded the $1.0 billion revenue mark in 10 years through predominantly organic growth, compared to traditional software companies that reached the same size over 17 years with the help of much larger acquisitions. Although the sectors and time period measured in this comparison are not aligned perfectly, we believe SaaS has clearly demonstrated its ability to garner market share in the software industry and would anticipate this strong momentum to continue in the future.

Assumption #2: Higher Gross Margins Median Gross Margins

Another assumption is that gross margins for SaaS companies should be higher than on-premise companies. Many presume as SaaS companies reach certain economies of scale, they will benefit from widely distributed hosting network and delivery costs. However, this scalability of direct expense is commonly achieved upon reaching a critical mass. Also, SaaS companies can offer much more developed plans for technical support and user training than on-premise companies. Consequently, as the chart depicts, SaaS companies tend to have similar gross margins compared to the traditional software companies.

Assumption #3: Lower Operating Expenses

Given the unique subscription model and multi-tenant architecture, SaaS companies are assumed to have lower operating expenses, particularly as it relates to sales and marketing (“S&M”) and research and development (“R&D”) costs. For software companies, S&M and R&D are traditionally the largest operating expense categories. On the S&M side, SaaS applications have a lower initial commitment, which allow a company’s sales team to close new deals more quickly using web-based communications with subsequent follow-on sales driving additional leverage. On the R&D side, the multi-tenant architecture provides a competitive advantage over the on-premise software companies that need to support multiple platforms and multiple versions of these applications. Based on our research, we were able to confirm the R&D scalability, but we did not see the similar trend for the S&M cost, we believe due in part to where SaaS companies are in their lifecycle. However, we believe as the SaaS companies continue to grow market share and acquire economies of scale, overall operating expenses should be more scalable than those of traditional software companies, primarily given its multi-tenant architecture.

Assumption #4: Lower Total Cost of Ownership (“TCO”)

One of the attractive attributes of the SaaS model is its lower initial capital requirement. Thus, many estimate the TCO to be lower for SaaS applications than the on-premise software model. There are a number of different publications that attempt to illustrate this assertion, but very few analyses have been able to compare TCO on an apples-to-apples basis. Most studies only address the initial capital costs comparison and do not take into account the full lifecycle of software dependency from set-up costs and deployments to recurring and upgrade expenses. In theory, the SaaS companies seem to offer lower TCO as vendors can provide solutions to customers without requiring the purchase of additional infrastructure software, services or hardware. However, given the early adaptation of the SaaS model, we believe a full TCO assessment remains to be seen.

Assumption #5: Higher Visibility

Unlike traditional software companies that recognize revenue when software is shipped and accepted by the customer, SaaS revenue is recognized ratably over the length of the contract, therefore avoiding the typically lumpy nature of the large license sale model. However, the terms of the SaaS contracts themselves are pivotal in determining the true level of revenue visibility. Earlier in the lifecycle of the SaaS model, contracts were more customer friendly with trial-based, month-to-month cancellation terms as vendors tried to entice customers who were still unsure about moving to a SaaS solution. As demand for SaaS solutions has eclipsed the growth rate of the overall software market, we are observing a changing tide in customer contract terms whereby customers are signing contracts with longer durations and tighter cancellation clauses, thus increasing revenue visibility for the vendor.

So where do we stand?

After a thorough analysis of various financial and operational attributes of publicly traded SaaS companies, compared to their on-premise software peers, we believe that most of the assumptions tested held true or could not be adequately contested with an exception of the gross margin theory. Also, while theoretically the TCO of SaaS solutions may be less, the jury is still out until the market matures further and the entire lifecycle of costs can be considered. One thing is clear, the SaaS evolution has had a disruptive effect on the broader software market, and both traditional on-premise and SaaS players continue to scramble for a larger slice of the SaaS market. The recent flurry of SaaS M&A activity underscores this trend.

SaaS M&A Activity

Given the attractive attributes of SaaS companies from a financial perspective (i.e. strong growth, revenue visibility), it is not surprising that M&A activity for SaaS vendors has been strong. In 2007, M&A activity for SaaS companies increased considerably followed by a downturn in 2008, reflecting the movement of the broader market. Similarly, revenue multiples contracted in 2008, which again we believe is at least in part a reflection of the movement of overall technology market valuations. However, in 2009, we witnessed first billion dollar SaaS transaction with Adobe’s announcement to acquire Omniture for approximately $1.6 billion. This is the ninth-largest deal so far this year. On the valuation side, SaaS revenue transaction multiples increased from 2.05x in 2008 to 2.81x through September 15, 2009 and remain significantly higher than the on-premise application software counterparts at 1.45x over the same time period.

Who is interested in acquiring SaaS companies? According to our research, both SaaS and the traditional on-premise software companies have broadened their SaaS offerings. While traditional software companies are looking to SaaS acquisitions as a means to augment growth and obtain/retain market share, the ability to successfully offer both on-premise software and a SaaS solution is not a simple task given the inherent differences in the models from both a technical and operational perspective.

SaaS consolidation appears heavier in the human capital and content management application segments than in other enterprise application markets; however, we predict more vertically-focused SaaS solutions to experience increased consolidation. We believe that as SaaS adoption continues to accelerate and demand by customers grows, SaaS applications will gain traction across most of the enterprise application markets segment.

Conclusion

In the past, customers only had one software purchasing option: buy, customize and maintain applications, and in many cases, this option was not viable for small to medium size businesses with limited capital and IT resources. With the introduction of the SaaS model, customers have an alternative that offers faster deployment at lower initial acquisition costs for businesses of all sizes and types. Moreover, with shrinking IT budgets in today’s economy, SaaS is becoming an attractive alternative for new software investments, particularly in certain sectors of the enterprise application market. The benefits of SaaS to both the software vendor and customer are fueling the burgeoning supply and demand of SaaS applications and giving SaaS a growing role in the dynamic software industry.

¹ These companies include publicly-traded on-premise software companies headquartered in North America that are traded on the major stock exchanges and have latest twelve months revenues over $25 million.

Acknowledgments

A special thanks to contributors to the DeConstructing the Demand for On-Demand article: Gretchen Guandolo, Erin Lucien, Brian Tunney and Marty O’Brien.

Disclaimer

The information and opinions in this report were prepared by KippsDeSanto & Co. and the information herein is believed to be reliable and has been obtained from and based upon public sources believed to be reliable. KippsDeSanto & Co. makes no representation as to the accuracy or completeness of such information. Opinions, estimates and analyses in this report constitute the current judgment of the author as of the date of this report. They do not necessarily reflect the opinions of KippsDeSanto & Co. and are subject to change without notice.