The Software as a Service Dilemma

by

Founder & CEO, Software Advice

Software as a Service (SaaS) presents a classic "disruptive innovation." Of course, in 2010 that's not new news.

What is remarkable is how closely the SaaS market's evolution matches the definition of a disruptive technology that was described by Harvard Business School professor Clayton Christensen in The Innovator's Dilemma (he later replaced the term with "disruptive innovation" in his subsequent book, The Innovator's{C}Solution). In fact, the SaaS dilemma that incumbent software vendors currently face is playing out almost page-for-page from Christensen's books. As a result, we can use the disruptive innovation framework to gain insight into what's to come in enterprise software.

After a decade of deriding SaaS technology as too simple, functionally incomplete and insecure, vendors such as Microsoft, Oracle, SAP and thousands of incumbent "on-premise" software vendors are now embracing SaaS. It's an awkward embrace – one that threatens to cannibalize existing revenue steams, divert resources and eat up profits.

Of course, the innovator's dilemma doesn't destroy every incumbent. These incumbent market leaders are powerful, resilient innovators themselves. But for armchair quarterbacks like us, this the next five years will present a fascinating game to watch.

What is a Disruptive Innovation?
Disruptive innovation refers to new solutions – often technologies – that through a new delivery model, alternate pricing model or target market segment are able to disrupt existing competitive dynamics dramatically. For example, SaaS offers a new delivery model (i.e. hosted "in the cloud"), a new pricing model (i.e. subscription) and initially targeted smaller customers.

Initially, these disruptors target the least profitable customer segments – typically smaller or unsophisticated buyers. These are the only customers whose requirements are limited enough to accept the bare bones feature-set of the new system. Meanwhile, they appreciate the new model (i.e. it's cheap and easy to get started). We certainly saw this in SaaS as small businesses or autonomous departments adopted customer relationship management (CRM) systems like Salesforce.com as early as 1999. For them, SaaS CRM was "good enough."

SaaS Innovation Diagram
The disruptive innovation cycle applied to SaaS.

Over time, however, disruptive innovators improve their performance and feature-set and can meet the needs of more sophisticated customers. Combine that with a little buzz around their new model (e.g. everybody's talking about cloud computing these days), and the incumbent vendors start to take note. Of course, the incumbent still has plenty of ammunition to dismiss the new technology, since it remains functionally deficient relative to incumbent products and the most demanding customer segments (e.g. SaaS penetration into the ERP market remains limited).

I'll posit that SaaS is now entering the penultimate – and most contentious – stage of disruption. At this point, the innovators start to gain serious momentum. Their products approach functional parity and they begin to steal substantial market share. The incumbents finally get serious about defending their traditional markets by releasing their own version of the innovation (in the case of SaaS, that means true web-based, on-demand, cloud computing, not just hosted client/server software). Unfortunately, it is often too late. Incumbents remain apprehensive about cannibalizing existing revenue and they face challenges replicating the innovation. Typically, most incumbents stagnate, decline and fade into obscurity. Only a few nimbly transition to the new model.

The innovator now becomes the incumbent and new innovators emerge. The cycle repeats.

SaaS Disruption Battles are Well Underway
Christensen mentions Salesforce.com in his second book, The Innovator's Solution:

This company, with its inexpensive, simple, Internet-based system, is disrupting the leading providers of customer relationship management software, such as Siebel Systems.

I worked at another leading CRM vendor back when Salesforce.com was just a start-up. I remember meetings where executives derided the system as a toy. Most Salesforce.com implementations were just a half dozen users and most customers paid their subscription fees with a credit card (Gasp!). Since then, Salesforce.com has exceeded $1 billion in revenue and incumbent market-leader Siebel Systems sold out to Oracle after hitting tough times.

While Salesforce.com in the CRM market is the best example, the SaaS dilemma is playing out in numerous software markets. Gmail and Google Apps are nascent yet serious threats to Microsoft's Outlook/Exchange and Office cash cows. We use both of the Google services extensively. NetSuite is a contender in enterprise resource planning (ERP), but hasn't dented SAP or Oracle too badly as of yet.

Most interesting, however, is how this same battle is being waged by innovators in so many lesser followed market segments: SaaS construction project management, SaaS electronic medical records, SaaS property management, SaaS retail point of sale. The list goes on…

Most SaaS Shortcomings are Addressed
As I mentioned earlier, I believe we are entering the final stages of SaaS disruption. The SaaS model and its proponents have not defeated the incumbents, but SaaS solutions have reached functional parity to the point where incumbent derisions are starting to fall on deaf ears.

Let's examine each of the top five objections to SaaS:

  1. Web browsers are not interactive enough. This was true when web applications required a full page refresh to complete a transaction, but the maturation of JavaScript, AJAX, Adobe Flex and other web user interface technologies addressed this. HTML 5 will put this one to rest for good. I find my SaaS apps faster and more dependable than any on-premise app.
  2. Hosted data is not secure enough. This one always perplexed me, since so many of us were comfortable with web banking as early as ten years ago. Few systems could be more valuable than financial transactions. Moreover, very few software buyers can afford to implement the same security infrastructure as a professional SaaS data center.
  3. It's not possible to integrate SaaS. This was true when few SaaS vendors had built APIs and there was no middleware for SaaS. Nowadays, API integration to SaaS applications is non-trivial, but not any more difficult than on-premise integration. I should know; we just finished a successful integration to Marketo, a SaaS marketing vendor.
  4. You can't customize SaaS systems. Again, this is changing. Many SaaS applications remain fairly "packaged," but many vendors have successfully positioned this as a benefit (i.e. "adopt our best practices"). At the same time, SaaS customization tools are maturing. Salesforce.com has built an entire development environment, force.com.
  5. Big companies want to own the software, not rent. This may be still be true in some cases, but in this economy the recurring nature of subscription payments is attractive. It also puts more of an onus on the vendor to earn their future subscription payments. I'm not convinced that this presents a concrete competitive advantage for incumbents.

Incumbents are Now Challenged to Counter SaaS
Now that SaaS vendors and incumbents are locked in a real battle – the gloves are off and incumbents are releasing their own SaaS systems – our analysis turns to the big challenges that incumbents will face. Let's examine the five most significant characteristics of SaaS systems, and then explore why they are great for SaaS purists and a real challenge for incumbent on-premise vendors.

Great for SaaS companies
Tough for incumbents
Browser-basedThey can promote the benefits of not installing and maintaining client-side software. Plus anyone can use a web browser!Moving to a web-based architecture is a near-complete rewrite. "Web-enabled" options are temporary, at best.
Subscription pricingNot needing to justify a big purchase up front means fewer approvals and fewer risk-averse buyers to assuage. Also, great recurring revenue.This is the core cannibalization issue: moving to subscription pricing will stall growth and maybe lead to revenue declines for some time.
Multi-tenant architectureWith all users on one codebase and database, changes are made in one location, but roll out globally. Also, computing resources are shared.With thousands of installs, it's impossible to consolidate. There are incremental benefits to multi-tenancy, but the legacy customers remain.
Rapid release cyclesWith changes being made to one codebase/database, releases can be rolled out weekly, even nightly. More releases = better products.The quarterly, bi-yearly or annual release cycle is deeply ingrained in the DNA of an on-premise development organization.
Bought by business, not ITIt's far easier to sell to business units with their own budget, without the need for IT approval or budget. Faster sales cycles = growth.IT relationships are a core advantage of incumbents. With SaaS, those relationships are less relevant - a competitive barrier is lifted.

It's Not Over Yet – Not Even Close

Microsoft, Oracle and SAP still own the large enterprise market and the SME market. In hundreds of niche software markets, on-premise incumbents dominate. Even ten to fifteen years into the evolution of SaaS, SaaS vendors still possess minimal market share relative to incumbent vendors. While still powerful and often growing, all of these incumbents face the daunting challenge of SaaS disruption. Moreover, each of the major incumbents has started in earnest on credible SaaS offerings.

Microsoft has released Microsoft Dynamics CRM Online – the first Dynamics family application to be offered in a SaaS model. Microsoft has also released Microsoft Office Online as a counter to Google Docs.

Oracle, meanwhile, continues to grow its Oracle OnDemand solution set. While much of Oracle OnDemand consists of managed services for traditional on-premise solutions, their SaaS CRM offering (acquired through the Siebel deal) is true SaaS. So too are other solutions they acquired in recent years.

Finally, SAP's Business ByDesign appears to be a pure SaaS, on-demand offering that is operating independently from the SAP mothership. Our own conversations with SAP employees have shown that the company is maintaining an arms-length relationship with the Business ByDesign team so that this in-house "start-up" can truly function as a nimble SaaS entity, unconstrained by SAP's on-premise legacy.

If the disruption examples and case studies in Christensen's book are a guide, we can expect to see a massive number of incumbent vendors stall, fade and become irrelevant over the next decade. Others will deftly navigate the transition.

In our comments section below, I'd like to start a conversation about which incumbent vendors will fade and which will transition. Please share your opinion.
 
  • http://www.wohl.com Amy Wohl

    This is a very interesting article that manages to round up most of the issues for discussion. I don’t agree with every assertion (for example, some SaaS companies aimed for enterprise companies early and had some success), but this is well worth reading and can serve as the basis for further discussions.

  • http://www.kinaxis.com Trevor Miles

    Thanks for the synopsis Don. As Amy says, it rounds up most of the issues for discussion.

    I have been in the enterprise software market, principally with supply chain management vendors, for 20 years so have lived through the rapid adoption of this technology. There is no doubt in my mind that the biggest distruption caused by SaaS is transitioning to a subscription model. This is so tied up with cash flow and maintenance, not to mention Wall Street expectations amd methods of evaluating performance, that the transition to subscription pricing has to be handled extremely carefully.

    I see the technology aspects as related to cost and therefore somewhat easier to manage.
    One can still deliver and on-premise solutions, but use subscription pricing. Without a doubt, over the long term a transition must be made to web technologies so that the solution can be hosted.

    For solutions that are computationally heavy I am not yet convinced that virtualization is not a suitable substitute for multitenancy. The operating costs will be higher because of the need to deploy software updates on each of the instances, but this can be automated. Multitenancy has gained a strong foothold in computationally light applications such as CRM. I am not sure what would happen if an MRP run was thrown at a multi-tenant engine. Can the clock cycles be managed as effectively in a multitenant model as they are in a virtualization model?

    We are seeing quite a bit of interest in SaaS from large multi-billion dollar companies. Some legacy customers have moved from on-premise to on-demand, and there is increasing interest in on-demand from prospects. As your graph shows, large enterprises are slower to adopt SaaS.

    Regards
    Trevor Miles
    Kinaxis

  • Greg Kall

    Don, this analysis is spot-on. The incumbent software vendors have painted themselves into a corner with 90%+ margins on s/w, and margin-rich maintenance contracts. Quarterly top-line and overall margin contribution is under serious threat… so SaaS pure-plays can take heart in the tremendous opportunity they have vis-a-vis the 800 lb gorillas in the market.

    My question is: who among the incumbent ISVs have made the transition successfully from the traditional on-prem/perp license model to SaaS?

    Thanks for your insights.
    GKall

  • http://worldclasstech.wordpress.com Todd

    I like the synopsis – it is well written. I think you are right in the way the world is headed.

    I don’t have to like all of it though. I am dissapointed in the move to the single browser to run all my applications. I think there are better solutions with more freedom out there; even ones that don’t make you install and update code on every PC.

  • http://www.virtual-partners.com Ken

    Don,

    Excellent summary. The SAP BbyD scenario does bear watching. Despite the appearance of a start-up inside the large co, the main revenue streams still get the management attention. The sales teams selling into existing accounts along with those chasing new full blown SAP implementations are VERY expensive. They have extremely high costs tied to very long sales cycles.

    I cannot imagine they will be very happy if another part of the company is selling against them in new divisions of existing accounts. Clearly, there is a huge risk of civil war – despite any management edicts to the contrary.

    I do not expect BbyD to replace a full blown implementation in the near future, but the direction is clear and the cost case is compelling.

    If IBM acquires SAP in the middle of the current uncertainty, then the enterprise app landscape will become very interesting.

  • http://www.proisv.com Niels Skjoldager

    Don,
    This is a very good analysis and presentation of how disruptive innovation really slaps major software vendors in the face. They are all very slow at reacting, and once they do so, it really is too late. SalesForce CRM speaks for itself, similar stores can be told soon in the ERP market space.
    That more the reason why we at ProISV have developed our own disruptive technology, which is designed to provide an opportunity to Microsoft to get back into the Cloud game in the ERP space.

    I also believe by the way, that far more businesses, also major corporations, will shift faster from “on premise” and traditional licensing to “rent” models and deploy their business solutions in the Cloud. Data, in my opinion, can be stored and handled with much greater security in the Cloud, versus self-hosted “on premise”, where so many things can go wrong and influence the actual “real life” security level. At least that is my experience, also with on-premise ERP.

  • louella

    where can i get a statistic on actual manufacturing sotware actually utilized by end users?

  • http://www.hntb.com Linda Rolfes

    Interesting article. I have also seen the attempt to embrace SaaS by the larger companies – who see their marketshare threatened by the smaller, more nimble new firms.

    From an engineering project standpoint, new SaaS companies will need to prove themselves financially stable over an extended period in order to reassure clients whose projects span 5-10 years. If a startup ‘disappears’ in the middle of a project, your assets and your workflows/metadata could go with it.

  • http://www.MyOnlineToolbox.com Brian Javeline

    Don,
    This is extremely well worded. The one thing I would like add is that “Certain industries are simply much more adaptable to SaaS than others.” I have a SaaS platform called http://www.MyOnlineToolbox.com that targets contractors in the home repair, maintenance and remodeling industry. The most important note is that the VAST majority of the people in this business are mobile, leading towards a perfect SaaS opportunity. So instead of contractor software, we provide contractor software-as-a-service. Many of these people simply do not have the time and resources to manage updates for their software, again a perfect SaaS opportunity. And of course there are price considerations. While I do believe SaaS opportunities are in every industry, there are others that are simply much more adaptable. Nice writing.
    Brian Javeline
    President & Co-founder
    http://www.MyOnlineToolbox.com
    2008 Dell Top 10 Innovator
    2009 Forbes America’s Most Promising
    2010 Entrepreneur Magazine Feature Story

  • http://www.boyerassoc.com Jack Boyer

    Don,

    Great insight. It’s hard to believe that you wrote this at least 8 months ago.

    The only thought that I would share is that many analysts don’t point out the huge benefit of products such as MS CRM and Acumatica (ERP) that allow deployment in a SaaS model OR in a traditional “buy the license” and run on-premise model. 

    Sometimes firms need to change and it is nice for a user to be able to go back and forth between running on premise (your own cloud with these two products-MS CRM and Acumatica) and “in the cloud”.

    Please visit my blog entry on 1/1/2011 to see a VAR’s perspective in the dilemma you eloquently describe with SaaS. http://jackboyer.blogspot.com/

    The video I told you about is on this site if you are interested.  It’s only  6 minutes long.  http://erpcloudnews.com/2010/10/cloud-erp-debate-by-boyer-and-associates/

    Jack Boyer
    http://www.boyerassoc.com

    Jack Boyer, CPA (inactive), MCP
    President
    Boyer & Associates
    3525 Plymouth Blvd, Suite 207
    Minneapolis, MN  55447
    Direct: (763) 412-4307
    Fax:      (763) 412-4301
    jboyer@boyerassoc.com

  • Nexus

    An understanding of the value of a ‘shared’ ICT infrastructure has been understood for a long time. However, there are a number of points that need to be considered:

    1. Large organisations like the SaaS model and would like all their applications (inside and pulled through the firewall) to all have SaaS characteristics;

    2. Internally deployed SaaS based applications (managed behind the firewall) would tend to be attractive to larger organisations that have their own ICT infrastructure and be less appealing to mid size and small organisations, and;

    3. Hosted information services (via the Internet/Cloud) would be attractive to smaller organisations as they can then get access to the type of functionality that only large organisations can purchase and support via dedicated ICT resources – this has the potential to revolutionize how small organisations use information systems to operate their business.

    The real issue is actually building the types of applications that are Internet ready, real time and can exploit the capabilities of new hardware 64 bit, multi thread, parallel processing, etc). The author simply says (understates the challenge) that what is involved is a complete rewrite to a browser based application that is multi tenanted (and also person centric so that each person has their own unique view into the system).

    This is not as simple as it first appears as the real impediment to the emergence of Web based multi tenanted applications is the way we actually currently build software applications. This requires a shift in the way we ‘manufacture’ software applications from one that is high labour intensive to one based on a ‘factory’ approach that eliminates all downstream development cost (eliminates all programming effort). This can be done today and would represent the next big industrial shift and as unlike manufacturing the software industry is still really a cottage industry.

    The implications for such a change would be quite profound – if the means to adapt applications rapidly are internalised within organisations – large corporations and government for instance, then the IPR created can be owned by these entities rather than a software vendor. Organisations like SAP, Oracle, etc, have a business model that has a high barrier to entry as trying to replicate (not that you would want to) what they have would cost hundreds of millions. However, if you change the software development model their cost and technology barriers would be eliminated and they would see revenues and customers evaporate unless they adopted the same approach.

    The emerging SaaS model coupled with innovations in application development is a profound threat to the current generation of application vendors and the costly ICT support model that supports their applications.

  • Mike S.

    good article. it couldn’t be more true today than it was when it was written. Procurement is especially an area that has seen tremendous interest in a Saas flavor. early start-ups like eBid Systems have been providing these niche services since 2000 and found lots of interest from government organizations and small to mid-sized businesses looking for solutions at a price that get them into the software without having to go through a budget eval and don’t require IT departments. The current trends are proving Saas is a viable solution when compared to ROI of the enterprise, all-in-one solutions.

  • http://www.jetstreamapp.com Payton S

    Great article on SaaS’s disruptive nature. Desktop-based solutions are scrambling now to catch up

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