Tuesday, December 31, 2013

Challenges For On-premise Vendors Transitioning To SaaS

As more and more on-premise software vendors begin their journey to become SaaS vendors they are going to face some obvious challenges. Here's my view on what they might be.

The street is mean but you can educate investors

Sharp contrast between Amazon and Apple is quite clear. Even though Amazon has been in business for a long time with soaring revenue in mature categories the street sees it as a high growth company and tolerates near zero margin and surprises that Jeff Bezos brings in every quarter. Bezos has managed to convince the street that Amazon is still in heavy growth mode and hasn't yet arrived. On the other hand despite of Apple's significant revenue growth—in mature as well as in new disruptive categories—investors treat Apple very differently and have crazy revenue and margin expectations.

Similarly, traditional pure SaaS companies such as Salesforce is considered a high growth company where investors are focused on growth and not margins. But, if you're an on-premise vendor transitioning to SaaS the street won't tolerate a hit on your margins. The street would expect mature on-premise companies to deliver on continuous low double digit growth as well as margins without any blips and dips during their transition to SaaS. As on-premise vendors change their product, delivery, and revenue models investors will be hard on them and stock might take a nosedive if investors don't quite understand where the vendors are going with their transition. As much as investors love the annuity model of SaaS they don't like uncertainty and they will punish vendors for lack of their own understanding in the vendor's model. It's a vendor's job to educate investors and continuously communicate with them on their transition.

Isolating on-premise and SaaS businesses is not practical

Hybrid on-premise vendors should (and they do) report on-premise and subscription (SaaS) revenue separately to provide insights to investors into their revenue growth and revenue transition. They also report their data center related cost (to deliver software) as cost of revenue. But, there's no easy way, if at all there's one, to split and report separate SG&A costs for their on-premise and SaaS businesses. In fact combined sales and marketing units are the weapons incumbents on-premise vendors have to successfully transition to SaaS. More on that later in this post.

The basic idea behind achieving economies of scale and to keep the overall cost down (remember margins?) is to share and tightly integrate business functions wherever possible. Even though vendors sometime refer to their SaaS and on-premise businesses as separate lines of businesses (LoBs), in reality they are not. These LoBs are intertwined that report numbers as single P&L.

Not being able to charge more for SaaS is a myth

Many people I have spoken to assume that SaaS is a volume-only business and you can't charge customers what you would typically charge your customers in your traditional license and maintenance revenue business model. This is absolutely not true. If you look at some of the deal sizes and length of SaaS contracts of pure SaaS companies they do charge a premium when they have unique differentiation regardless of volume. Customers are not necessarily against paying premium - for them it is all about bringing down their overall TCO and increasing their ROI with reduced time to value. If a vendor's product and its delivery model allow customers to accomplish these goals they can charge them premium. In fact in most cases this could be the only way out. As a vendor transitioning from on-premise to SaaS their cost is going to go up; they will continue to invest into building new products and transitioning existing products and they will significantly assume the cost of running operations on behalf of their customers to deliver software as a service. They not only will have to grow their top-line to meet the growth expectations but to offset some of the cost to maintain the margins.

Prime advantage on-premise incumbents have over SaaS entrants

So, what does work in favor of on-premise vendors who are going through this transition?

It's the sales and marketing machine, my friends.

The dark truth about selling enterprise software is you need salespeople wearing suits driving around in their BMWs to sell software. There's no way out. If you look at high growth SaaS companies they spend most of what they earn on sales and marketing. Excluding Workday there is not much difference in R&D cost across vendors, on-premise or SaaS. Workday is building out its portfolio and I expect to see this cost go down in a few years.

Over a period of time, many on-premise vendors have built a great brand and achieved amazing market penetration. As these vendors go through SaaS transition they won't have to spend as much time and money educating the market and customers. In fact I would argue they should thank other SaaS vendors for doing the job for them. On-premise vendors have also built an amazing sales machine with deep relationship with customers and reliable sales processes. If they can maintain their SG&A numbers they will have enough room to deal with a possible initial hit on revenue and additional cost they would incur as they go through this transition.

Be in charge of your own destiny and be aggressive

It's going to be a tough transition regardless of your loyal customer base and differentiating products. It will test the execution excellence of on-premise vendors. They are walking on a tight rope and there's not much room to make mistakes. The street is very unforgiving.

Bezos and Benioff have consistently managed to convince the street they are high growth companies and should be treated as such. There's an important lesson here for on-premise vendors. There is no reason to label yourself an on-premise vendor simply making a transition. You could do a lot more than that; invest into new disruptive categories and rethink existing portfolio. Don't just chase SaaS for its subscription pricing but make an honest and explicit attempt to become a true SaaS vendor. The street will take a notice and you might catch a break.


Vijay said...

Great blog - one quick addition

A major problem for on prem vendors getting into SaaS is their compensation models for sales people . Till that gets settled - it's hard to execute .

Chirag Mehta said...

Thanks for reading the post and leaving the comment, Vijay. Appreciate it.

You're right about the sales compensation model. I have talked to a few sales leaders of hybrid on-premise vendors and they shared the same sentiment. However, this was not a deal-breaker to them because this is an internal cost/incentive issue that they could deal with (and had a good handle on) without sending any distressed signal to the market.

Some of the ways vendors have resolved this issue is by restructuring compensation that is based on booking value and length of contract and not just the recognizable revenue in that fiscal year. Increasingly I see sales compensation tied to customer retention (contract renewals) as well. One of the challenges someone described to me and I fully agree with is a possibility of misaligned incentives where sales people benefited more if they were to sell on-premise license + maintenance software as opposed to SaaS or vice versa. Explicit cannibalization is fine as long as vendor understands the implications but an accidental cannibalization due to misaligned incentives is a situation that they should avoid. I have seen many ineffective sales overlay models where vendors project an internal (vendor's) view of what they want to sell and how as opposed to listening to customers and understand what they truly want.

Dax Nair said...

Good to see the blog focusing on the pains of on-prem vendors and SPs making the transition to SaaS services. Moving from large one-time revenue opportunities plus recurring support contracts to pure deferred revenue streams is a real challenge for many companies.

Short term pain for long term gain!

Chirag Mehta said...

Thanks, Dax! Yes, it is indeed short tern pain for long term gain. But, unfortunately, the street doesn't tolerate short term fluctuations.

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Moving from large one-time revenue opportunities plus recurring support contracts to pure deferred revenue streams is a real challenge for many companies.
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