There are a bunch of new* ways of selling software these days. SaaS (Software as a Service) has been in the consumer space for a while, and is making significant inroads into the enterprise software space today. If you’re considering purchasing or using software, you should understand what SaaS means and how it is different from the software products of the past.*
*Note: None of these are truly new ideas – time-shares on mainframes, “dumb” terminals (like the IBM 3270, aka “green screen”) remote / shared storage have been around since the 70’s. Application Service Providers (ASP) were big (big flops) in the 1990s. But people have short memories, so “new” is how too many people think about SaaS today.
From The Customer’s Point of View
If you’re selling software as a service, you hopefully don’t need a Foundation Series introduction to SaaS. If you’re considering purchasing software as a service, then maybe you do. This article is not an article about the challenges of product management for a SaaS product, nor is it about multi-tenant architectures and other SaaS implementation details.
This article looks to simply compare, from the customer’s point of view, software purchased as a service versus software purchased as a product.
Software as a Service?
Software as a service, is an interesting name. It implies that instead of purchasing the software, you are purchasing a service – and that service is the ability to use the software. You are also (usually) purchasing a hosting and infrastructure service. The SaaS provider will maintain the hardware, perform upgrades, backup your data (sometimes), and otherwise perform all of the “keep the lights on” services and activities required to keep the software running.
Imagine a typical, 1990’s style software purchase. You buy a source code control system. You set up a server somewhere, and install the software. You have ongoing support costs – providing power to the server, keeping the server cool, applying security and operating system updates to the server. You have costs associating with administering the hardware. You also, when you get updates to the software, and when you purchase upgrades to the software, have to spend money (labor costs) to update the software.
You also carry the risk of a botched upgrade. And you carry the risk of a hardware failure causing downtime, or causing you to lose data. You also have to bear the costs of security – do you allow your people to access the software (on the server) from other computers on your network? Do you allow them to access the software when they are not on the network (travelling, working from home, etc)? You have to invest in designing and maintaining a secure system – to prevent your competitors from stealing – or even worse – destroying your data.
Now imagine that you’re outsourcing all of the “keep the lights on” activities above. You pay an IT services firm to manage the hardware and the software for you, including the security model – and you just use it. That’s one of the benefits of purchasing software as a service. To really grasp the economics of SaaS you have to contrast it with the economics of software license purchases.
There is a widespread misunderstanding about purchasing software. In the last section, we used the word “purchase” but that isn’t actually correct. You don’t purchase a copy of the software – you purchase a license to use the software (with restrictions). You probably have heard the phrase “site license”, which means that you are purchasing the right for everyone in your building (or company) to use the software. Sometimes software is sold in terms of “numbers of seats” – the number of people that are licensed to use the software at any one time. You could have 100 engineers, who all share ten seats (single-seat licenses) of analysis software. Since each engineer only spends about 5% of their time using the software, they can easily share licenses. At any given time, five engineers (on average) will need to use the software. With a license for ten simultaneous users, each engineer is likely to be able to use the software whenever they desire.
The point of these examples is to point out that even when you think (or say) you are purchasing software, you aren’t.
Now that we have that behind us, the idea of purchasing a service is not as different from purchasing a license. In neither case are you purchasing software. In both situations, you are purchasing the right to use the software.
Economics of Software Licensing
There are an infinite number of creative ways to purchase a software license. The most common situation is that you purchase a license, and then later purchase upgrades.
An obvious example is Microsoft Office (productivity software). Microsoft releases a new version of Office every couple of years. If you own the previous version, you can purchase an upgrade for less than the cost of buying the software for the first time. You are not required to purchase an upgrade, but you may want to. If the people you work with all upgrade, you may want to upgrade too – so that you can use the documents that they create. Microsoft does a good job of providing free utilities to read documents from the newer versions, and allowing people with newer versions to create documents that can be used by people with older versions. Microsoft, therefore, gives you a choice. They rely on market forces to create the pressure to upgrade, but you never have to upgrade.
Intuit, makers of Quickbooks (small business accounting software), is a little pushier. They release a new version of the software every year. And you can continue to use your old version. Unless, however, you use one of the services that they also sell. Intuit sells services that integrate with Quickbooks. And at least with some releases, when a new version of Quickbooks comes out, they will stop supporting the integration of those services with older versions of Quickbooks. If you need those services, you must upgrade.
When companies sell software (licenses), they usually sell a version of the software, and then make updates to that software with some frequency, from daily to annually. Companies also manage those updates as two distinct types of updates – major and minor. Minor updates are usually free, and major updates usually require you to purchase an upgrade. Minor updates might be bug fixes, or features that were intended to be in the major release, but were delayed. Or they might just be the introduction of capabilities with “small” value to their customers. A lot of software will automatically notify you, download the update, and install it for you. That’s great service. Major updates are usually more significant – they introduce capabilities that have “large” value to their customers, or are intended to make the product appealing to additional markets.
To understand the economics of software license purchases, you have to look at both the value over time and the costs over time of purchasing a software license.
To keep this simple, we’ll assume the model described above – minor updates happen frequently and are free, and major updates require the purchase of an upgrade to the latest version of the software. We’ll also assume that every new update introduces something valuable to you as a customer.
Starting with the value model for the software, from the software company’s perspective:
The axes represent increasing value (up) versus the passage of time (to the right). Time starts when you purchase a license to use the software. You’re immediately getting value. As minor updates are made (and minor releases are made – sharing the updates with customers), the value gets marginally higher. Whenever a major release (a major update) is made, the value curve jumps up dramatically. This represents the introduction of new, valuable capabilities.
As each new customer purchases a license to the latest version of the software, the company gets more revenue. As each existing customer purchases upgrades to their existing software, the company gets more revenue. A company makes money from finding new customers and from keeping existing customers. Companies make more (per purchase) from finding new customers than from getting existing customers to upgrade. Until a product builds a large base of existing customers, the company’s financial focus will be on finding new customers. Satisfying existing customers is at risk of becoming a secondary priority, purely based on economics. And yes, this is an incomplete picture, there are indeed other factors. But it is absolutely an influence.
Software License Benefits
We started this article with a promise to look at this from a customer’s perspective. If the model above represents how a software company views its products, here’s how a customer would view the same thing. Remember – in our example, we have a perfect product manager – every update has the same perceived value to customers as it does to the company. This chart shows the same value-model, but overlays your purchasing behavior as a customer.
As a customer, you make an initial purchase (the left-most callout), and then get free incremental increases in value from each minor release. You also purchase an upgrade to the latest version of the software as soon as it is available. You then start getting incremental value from the minor updates to that version of the software. The older version does not keep getting updates, so if you don’t purchase the upgrade, you don’t get the benefits of the latest minor releases. A second major release happens, but you don’t purchase it for a short while. Then a minor release is made, with a fix to an annoying bug that really bothers you. So you purchase another upgrade.
The value to you looks like the following:
The green area represents the value you get*. Notice that you did not get the value of the last major release until you actually purchased it. You also did not get the incremental value of minor releases that happened after that release. Once you did purchase the upgrade, you immediately got the benefits of all the minor releases. You got “back in the game.”
*The value is often a function of how much you use the software (enabling the benefit), and as such, it is a function of time. The more you use it, the more value you get. So showing this as an area is informative.
Software License Costs
Your costs over time are also important.
The obvious costs are the checks you write to the software company to pay for the software and for the major upgrades. The chart above can be a little misleading – we are depicting “one time costs” that add up over time. Showing this as a stair-step area instead of a series of spikes will make sense in a moment. The key thing to appreciate is that once you make a purchase, your license purchasing costs do not go up again until you make another purchase.
At the start of the article, we identified several “cost of ownership” costs – supporting the software and hardware, for example. It is critical that you keep those costs in mind when evaluating software license purchases. These costs are ongoing costs – the more you use the software, the more the costs add up.
There are also training costs – the cost of lost productivity as people learn to use the software and adapt to changes in the software.
When you combine these, you get a model for the total cost of purchasing a software license over time. The jargon term for this is Total Cost of Ownership (TCO).
As you can see, “purchasing” software one time actually has a continuously increasing total cost of ownership. Different types of software will have different relative costs for infrastructure support, training expense, and license fees. But generally, training expenses are much lower than the other costs of ownership.
SaaS – A Simple Definition
Software as a service is usually provided as follows:
- A company creates a software product and hosts that product on multiple servers. The company manages the hardware and software – and realizes the cost of that management.
- Customers subscribe to the service – getting the right to use the software, for as long as they continue to pay the recurring subscription fees.
- The company makes both major and minor updates to the software, and the customers automatically get those updates as part of their subscription.
Software as a service is purchased with the same mechanics as subscribing to a magazine or cable television or satelite radio. You pay a recurring fee for the right to use the software, just as you pay a recurring fee for the right to watch cable television. You might even get a discount for purchasing a longer-term subscription and paying up front. When you want to stop using the service, you stop paying the fee.
The model for creating value with SaaS products is the same as with licensed software.
The graph looks the same as the first one in this article, because it is the same graph. Where things change slightly is in the value model from the perspective of the customer.
There is a single trigger to the realization of value – starting the subscription. You automatically get the minor and major updates “for free” by continuing to pay the subscription fee.
SaaS Costs Are Different
Where software as a service differs from the purchase of a license to use software is on the cost side.
The training costs associated with using software have nothing to do with the mechanism for payment, so those costs are the same. The cost of subscribing to the service (blue cross-hatched region) is new, and goes up over time. It is also typically higher than the training costs. Note that there are no “large purchase” spikes in the costs – because you never purchase a license. And there are no infrastructure costs, because the company that provides the service realizes those costs.
The idea is that this approach is more cost-effective when it comes to infrastructure costs, so the company can pass on those savings to you.
Comparing the two cost models side by side is the way to really see the difference:
Both models have costs that increase over time. For many technical reasons, the SaaS architecture is more efficient and has lower costs for the software company – which tends to result in lower costs for the customers. This is not always the end result, but it is directionally correct.
Another interesting factor to consider is the financial pressure on the SaaS provider. Where a software licensing model creates pressure to prioritize finding new customers, a SaaS model creates pressure to keep existing customers. SaaS providers get the same revenue from a new customer as from an existing customer, instead of the “new vs. upgrade” dynamic seen with software licensing models. It is always cheaper to keep an existing customer than to find a new one. The net result – financial pressure to retain existing customers. This can drive a different behavior, more like that of a retail sales model, where keeping your existing customers is critical.
The SaaS model ultimately provides the same type of products as a software licensing model. But with a better economic model – one that is lower in cost to me, and one that is structurally inclined to keep getting better for me with every new release.
Personally, I really like the idea of purchasing from a company that is financially motivated to keep me happy, not one who’s pressured to find another customer as soon as I’ve written my check.
The best companies try to reinvent themselves and improve their products continuously. Over time, the best companies will move to SaaS models, which align their financials with their objectives.
Check out the index of the Foundation Series posts for other introductory articles.