Selling software on a cloud-based subscription model has become so commonplace these days that new software startups must have a pretty compelling reason if they intend to pursue the traditional approach of perpetual license sales.
The cloud model is recurring in nature and thus provides a more predictable revenue stream. In the traditional perpetual license model, software firms would sell a piece of software for indefinite use by the customer. The only recurring revenue component came from an annual maintenance contract (typically 14~17% in enterprise software) until the next big release came out and was (hopefully) adopted. Another advantage of the SaaS model is that it allows for frequent minor upgrades to the product, entailing minimal disruption to the customer. It also enables segmenting the market more finely and offering custom packages to segments that deliver more value.
Investors favor SaaS businesses for all of these reasons. One look at the revenue or Ebitda multiples of Salesforce.com (pure SaaS) vs. Oracle (which is perpetual-license heavy) will demonstrate this.
The dilemma for established firms
Established software companies, however, are confronted with the challenge of whether, when, and to what extent they should shift toward a software-as-a-service revenue model. The choice resembles a classic innovator’s dilemma.
Over the long-term, if well-executed the recurring SaaS model provides a concave-upward growth curve for the business. However, the initial investment to develop a cloud solution (certainly a true multi-threaded, multi-tenant product) is disproportionately high relative to its long payback period. For example, an enterprise software firm might sell a perpetual software license for $200,000 in one shot, whereas SaaS pricing might be something like only $25 per month per user, with a ramp up period.
These economics place a tremendous burden on the cash flow of a traditional software company aspiring to make the conversion. I’ve been fortunate to witness from the comfort of the investor chair the challenge of transforming into a SaaS model. In every case, we underestimated the time and financial resources necessary, not to mention the organizational shift required. Excruciating details like turning upside down the sales force compensation model are crucial (no salesperson in their right mind would promote the SaaS product if they earn a thousand-x commission on the perpetual license product), to cite just one example.
Lessons from Adobe
This is where Adobe’s bold and categorical move into the cloud can offer some interesting teachings to aspiring SaaS converts.
First, Adobe stacked its cloud offerings with products that had joined the portfolio via acquisition and still remained somewhat fresh in culture and operation, such as the firm’s Marketing Cloud business, which includes marketing automation and CRM tools like Neolane, a French startup Adobe acquired last year for $600m.
Secondly, Adobe was not afraid to “kick away the ladder” in its climb toward becoming pure-SaaS, such as refusing to back down when the Marketing Cloud business unit provoked dismay when it discontinued its shrink-wrapped version of Creative Suite in May 2013.
When Adobe began its business model shift, it tested the appeal of software subscriptions in smaller markets like Australia before a global rollout.
The company also masterfully managed its sales organization’s transformation too, by restructuring compensation packages to reward recurring revenue and penalize the old.
Finally, Adobe communicated extensively on its shift, both internally to all personnel and to the market, openly explaining its rationale.
Last week, Adobe annonced its first half 2014 results, 67% lower than the same period two years earlier, which is consistent with the profile of a firm that jumped into SaaS with both feet. Fortunately, the stock market seems to be rewarding Adobe’s audaciousness; the stock price has more than doubled since then.