Servicing the Software Industry (SaaS)—7 New Rules for the Software Business

Kyle Murphy August 1, 2008 0 Business, Entrepreneurship, Innovation SaaS

Originally published in the Graziadio Business Review

There is something abuzz in the software industry and this time it is not coming from a new hotshot start-up or being propagated by a massive marketing campaign. The buzz is coming from customers and developers alike and it is called Software as a Service, or SaaS for short.

A report by global market intelligence firm IDC projected that ten percent of the market for enterprise software will migrate to pure SaaS by 2009.[1] Information technology (IT) research firm Gartner is projecting a compound annual growth rate for the SaaS industry of 22.1 percent to $11.5 billion by 2011.[2]

This marks a significant change in the software industry landscape and dwarfs the economic impact that social networking (e.g., MySpace and Friendster) and media delivery (e.g., YouTube) innovations are causing, even though they receive much greater media coverage. This monumental shift in the software industry is much more than a technology-driven evolution; it is a completely new game that will require software companies to reinvent themselves.

What is SaaS?

SaaS has been defined in several ways but most simply, it is the development, hosting, and delivery of software via the Internet. A more definitive definition is that SaaS is a completely new business model for the software industry that encompasses a new delivery mode (i.e., web browser), pricing/revenue strategy (i.e., subscription versus license), and value proposition (i.e., service versus functionality). SaaS has also been included in the larger realm of Web 2.0 innovation. SaaS promises lower costs, less IT infrastructure, flexibility, and scalability for businesses. The potential of SaaS has not been lost on the large software companies; Microsoft, Oracle, and SAP, the three largest software companies, have all announced SaaS initiatives.

The concept behind hosted software applications is not that new; during the dot.com boom, application service providers (ASPs) were heralded as the next coming, but fell well short of expectations. Like many early-stage technological innovations, both the technology and the customers were not quite ready. This time, customers are driving the revolution and Web 2.0 technology is making it possible to bring enterprise-level applications to the Internet.

Current Limitations

The SaaS revolution is indeed under way, with vendors and customers actively adopting the new model. But there is a challenge facing the industry beyond the traditional issues of customer adoption and technology limitations. The problem is the software industry itself and, in particular, the management of software companies.

An informal examination of the current SaaS industry reveals a cross-section of software industry veterans starting and running many of the new SaaS divisions and firms (e.g., NetSuite and Salesforce.com). While most management teams take the “Software” part of SaaS very seriously, many seem to relegate the “Service” part to secondary status, merely a function of a web-based application or an application hosted in a shared environment. This philosophical gap will ensure that plenty of SaaS firms and initiatives fail, regardless of how good the software itself may be. SaaS is a completely new business model, not just a new way of delivering software it requires new rules.

For the SaaS business model to really work and truly deliver on its revolutionary promise, SaaS companies will have to stop operating like software companies and start acting like service companies. That means that every department, from strategy and marketing to operations and finance, will have to learn new rules. Software companies are going to have treat customers as partners and learn how to provide the right level of customer service without a surcharge. This is a major affront to the industry standard of charging for premium support.

Imagine a mechanic or doctor charging one rate to perform their services, but then adding a surcharge to provide service at the highest level. This is akin to how software companies have been treating their customers for years. SaaS promises a change for the better for the customer and for software companies if they learn the new rules. Software companies will either change and adapt or go the way of other technology companies that did not evolve on par with customer demand; examples include DEC, Atari, Osborne, and Data General.[3]

Suggested below is a new set of rules designed for managers as they enter the SaaS space. These rules are culled from 15-plus years of experience in service-based businesses and extensive management experience with software companies.

Although the rules are written with business software providers in mind, they translate very well to consumer software companies. To long-time software veterans, some of these rules might sound like heresy, but as with every revolution, change is required, even if that change causes some discomfort.

Indeed, this shift requires a monumental change in thought processes and operations.The underlying philosophy for the rules matches that of a service company as opposed to a product company. A service company comes with a higher level of responsibility to customers over the long term, versus the one-time delivery of a product. The SaaS business model relies on recurring revenue, so long-term customer satisfaction is mandatory for ongoing success.

Additionally, SaaS requires adding value beyond the software functionality and hosting by proactively integrating with complementary service providers, providing non-software outsourced services (in-house or strategic partner), and other value-added services dictated by the industry.

The New Rules

1. Creative Pricing

Pricing, a simple exercise for most traditional software companies, is a much more challenging issue for SaaS. SaaS should not be charged by the seat or number of users, the traditional form of software pricing. The challenge is that different users derive varying levels of value from SaaS, so pricing should be based on how much the system is used, with users then billed monthly.

For example, a CEO who logs into a SaaS customer relationship management (CRM) system a couple of times a month to look at sales figures uses the service quite differently from a sales manager who accesses the site daily to collect the data necessary to do his job. If pricing is contingent on the seat or user, customers can game the system by using one login for all non-sales related managers. Ultimately, this amounts to less revenue and, more detrimentally, less integration and greater dispensability in customer operations. A much more logical and customer-friendly method is to charge based on a metric that reflects how much a customer uses the system, as well as the value they receive. Examples include billing by the number of transactions or by the value derived per transaction.

It is completely logical to assume that revenue and retention would increase and turnover would be reduced if SaaS companies priced based on usage and value received. Unlike packaged software companies, which generate most of their revenue from license sales, SaaS’ total contract value is amortized over a period of time. This would also require companies to manage financial projections and planning differently.

2. Target SMBs

Small and medium-sized businesses (SMB) are the lifeblood of the U.S. economy, but they can be difficult and expensive to market and service. As a result, most software companies have focused their efforts on large firms. This is a risky strategy since a company’s survival may depend on just one or two customers and the competition is fierce.

According to the U.S. Census Bureau, there are close to six million SMBs with employees in the United States.[4] Thus, the real market potential for SaaS companies is with SMBs. The SaaS model is well-suited for SMB’s for many reasons, including simplified support, lower implementation costs, and reliably recurring revenue. Additionally, selling to SMBs is easier due to shorter sales cycles and more direct access to decision-makers. Lastly, competition from large software companies is much less of a factor in the SMB space because large firms do not have the right structure to service SMBs. While everybody competes for the whales’ attention, SaaS companies would be best served by aiming for the minnows.

3. Design Matters

Industrial-looking user interfaces that are designed by engineers and programmers and require formal user training will not work with SaaS. Both business and consumer users have come to expect very sophisticated but easy-to-learn interfaces from the web. A great-looking, user-friendly interface helps win new customers and provide shorter sales cycles. As with buying a car, software customers are attracted to sleeker and quicker models. Additionally, an easy-to-use interface also reduces demand on support services.

While form must still follow function, and flash without substance will still fail, in this new space, function without form will also fail. Winning SaaS companies will need to deliver great user experiences that are attractively packaged, easy to use, and robustly engineered.

From the $4.95-per-month consumer application to the enterprise solution, potential customers want and should be able to access a fully functional demo of the web application. If it is too difficult to use without extensive training, the SaaS solution is not ready for commercial release.

Concern over competitors gaining access to the software is unfounded; a competitive advantage in software is no longer contingent on exclusive functionality. With inexpensive offshore development resources and the readily available development platforms, it is easy for most, if not all, functionality to be copied by competitors. Therefore, SaaS companies should build strategies around this expectation. The days of proprietary technology and functionality providing defensible competitive advantages are fading fast. Everything can be reverse-engineered; the only way to maintain a competitive advantage is through continued innovation, superior customer service, and added value.

4. Innovation over Litigation

It still seems amazing to hear about one software company suing another for some minor intellectual property (IP) infringement. Certainly, IP should be protected, but companies should choose their battles carefully. Spending thousands, if not millions, of dollars on lawyers and wasting management’s time is not going to place the company in a better position in five years. That time and money could be better spent on issues that customers care about, such as superior customer service and new functionality.

For example, when Research In Motion (RIM, maker of the ubiquitous Blackberry smartphone) was sued by a “patent squatter,” they chose to litigate instead of finding an alternative solution.[5] After the judge selected an injunction date, it took less than 30 days for RIM to say they had a technical workaround, but in the end they decided to settle. Either way, it still cost them many millions of dollars in legal fees and, more detrimentally, hurt their brand reputation by making many of their customers very nervous. It is a safe bet that they could have spent a few million dollars as soon as the suit was filed to re-engineer some of their technology and processes, avoiding most, if not all, legal costs. Like service companies, a software firm’s brand reputation is more valuable than any technology, so it should be protected above all else.

5. Service Done Right

Technical support should not cost extra; in the service industry, service is service, good or bad, and SaaS companies are service companies. Pricing the product correctly to allow for the “right” level and type of support required to maintain high customer satisfaction is mandatory.

As part of that support, training should be available online in the form of free web-based modules for customers. Web-based training is highly effective and the ongoing cost is negligible. If web-based training is not free, customers will turn to calling the company for support, a more costly proposition. A well-developed and easy-to-use web-based training program, along with a well-integrated online help system, is crucial for controlling costs in a SaaS business model.

It is also wise to leverage customers’ knowledge of support and product planning by connecting them via online user groups. While there may be some negative comments from customers, it is better to hear and respond to complaints now than ignore the fact that customers are unhappy and lose them later on. Learn from the support load and user comments. If support levels are high or there are a lot of negative user comments, then either the product is not working properly, its usability needs to be improved, or its training/online help program needs work.

Measuring the piggybank — Photo: Mathieu Viennet

6. Operate Lean

The appeal of receiving large amounts of venture capital coupled with poor management results in many software companies being notoriously overstaffed. Conversely, service companies generally do not hire for a position until they perceive a 90 percent or greater long-term utilization rate for that employee.

Overstaffing is a sign of poor management. No matter how much funding a company receives, restraining the desire to hire a person for every task is necessary. Having too much staff can lead to poor employee morale and, subsequently, poor customer service employees lack purpose if not tasked adequately and correctly. Whether it be outsourcing, offshoring, freelancing, or strategic partnering, there are other ways to service customers and complete all the necessary tasks. Running lean requires advanced planning skills complemented by superior managerial talent to leverage the most out of the available resources. The reward for operating lean is better valuations (less dilution), less time spent raising capital, and fewer growing pains.

7. Keep It Simple, Stupid (KISS principle)

While not a new rule, software companies have neglected this common-sense business concept for too long. Complexity does not impress customers or improve your bottom line. Customers do not like overly complex pricing, contracts, training, interfaces, or relationships. Senior-level executives and other decision-makers are generally not technical gurus: to close deals and obtain the greatest user acceptance, it is best to keep it simple. If all of the other rules are ignored, keep this one in mind or risk being added to the growing list of failed software companies that did not listen to their customers.

Conclusion

Customers are demanding it and the technology is ready now is the time for the SaaS revolution. However, it will be a huge failure if software companies do not learn to act like service companies. For the SaaS revolution to live up to its promises, software companies and management will need to learn a new set of rules. These new rules will be hard for many existing software companies to adopt, so many of the successful SaaS companies will probably be new companies or spin-offs. For companies willing to learn and live by the new rules, margins far beyond those of traditional software await.

[1] B. Rubenstein. “Worldwide and U.S. Hosted Application Management Services 2007–2011 Forecast,” (link no longer accessible). IDC, 206371, (04/2007). (available for purchase only)

[2] Sharon A. Mertz, Chad Eschinger, Tom Eid, and Ben Pring. “Dataquest Insight: SaaS Demand Set to Outpace Enterprise Application Software Market Growth,” (link no longer accessible). Gartner, G00150222, August 3, 2007.

[3] Wikipedia. “Defunct computer companies of the United States,”http://en.wikipedia.org/wiki/Category:Defunct_computer_companies_of_the_United_States.

[4] U.S. Census Bureau. “Statistics about Business Size (including Small Business) from the U.S. Census Bureau,” http://www.census.gov/epcd/www/smallbus.html.

[5] Barrie McKenna, Paul Waldie, and Simon Avery. “Patently Absurd: The Inside Story of RIM’s Wireless War,” Globe and Mail, February 21, 2006. (available for purchase only)