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How critical is M&A to software vendor growth today?

More important than it was 3 years ago

Less important than it was 3 years ago

It has been and will always be a key growth tactic


Why Enterprise SaaS Is No Slam Dunk

By Ken Bender, Software Equity Group, LLC

We took careful note of the advance of SaaS as an enterprise IT spending priority in the October 10, 2007 Goldman Sachs IT Spending Survey. Although SaaS had ranked 37 – dead last – in GS’ May 16 survey, it had moved halfway up the list to 18 in only a few months. The GS survey, which we’ve found to be highly reliable, captures the capital spending expectations of certain Fortune 500/large enterprise CIOs – those with the biggest IT capital budgets whose spending habits have a direct and material impact on technology adoption rates and software provider financial performance.

For the past two years, amidst the reality and the hype of SaaS, large enterprise CIOs have held back, reluctant to endorse the new software delivery model with their IT capital budget dollars. For most, we suspect the reluctance was a combination of turf protection, control, and legitimate concern about permitting mission critical data and applications to reside outside the company’s firewall. Many CIOs took a wait-and-see approach, awaiting market feedback about the reliability, performance, security and integrity of SaaS-deployed apps.

In the meantime, small-medium enterprises (SME) resonated with the SaaS model, just as the early SaaS providers had hoped. Lower entry costs, reduced IT infrastructure costs, enhanced employee access and the perceived ability to move seamlessly to another vendor, all served to attract the SME market – which for a decade has been the holy grail of software market opportunity for most vendors. Many smaller ISVs, in response, adapted or rewrote their apps and flocked to the new model, usually targeting SMEs with their new offering. The larger vendors, preferring their perpetual license models, and concerned about how their suites could be SaaS deployed, among enterprise customers used to a high degree of customization, application interface and data integration, remained in denial for some time, but watched closely.

Some of the smaller ISVs, however, began offering SaaS-deployed point solutions to large enterprises. These oftentimes elegant, browser-based, standalone apps were primarily focused on CRM (both sales automation and help desk) and Human Resources (e.g. time and attendance). In the ensuing months, SaaS apps such as expense reporting, benefits enrollment and administration, and employee talent/performance management gained traction with large enterprise CIOs who began to get comfortable with SaaS. More recently, SaaS has been making inroads in security, infrastructure – even corporate treasury!

And so SaaS, the ultimate SME market penetration vehicle, is rapidly becoming the darling of the large enterprise, with its hefty IT budget and appetite. The largest software companies are now articulating SaaS strategies, and in some cases, actually deploying SaaS solutions. And so, SaaS moves from 37 to 18 as an enterprise IT spending priority. It would seem, and many industry pundits would have you believe, SaaS has won the day among large enterprises. Case closed.

Not so fast. Many large enterprises insist upon a high degree of integration amongst certain apps. When those apps reside behind the firewall, that integration can be readily facilitated. But integrating a SaaS deployed application with a large enterprise’s internal applications, which are highly unlikely to feature an SOA/web services architecture, can be a daunting, time-consuming and expensive process that can negate many of SaaS’ benefits for both the software provider and the enterprise customer.

The ultimate success of SaaS in the large enterprise, however, rests not so much with the CIO as with the SaaS provider. Beneath the covers, beyond the hype, lies a deceptively complex business model. Ask a dozen software companies how they’re pricing their SaaS offerings and you’ll get fifteen answers. Most are still wrestling with the trade-off between large, erratically timed, lump-sum perpetual license revenue and considerably lower, more predictable, recurring SaaS revenue. Where’s the crossover point? How much gratification do you defer, while still ensuring a reasonable EBITDA and ongoing product reinvestment to remain competitive?

As important, most SaaS providers don’t have a real handle on infrastructure and deployment costs. It’s expensive to create a secure SaaS infrastructure that can accommodate rapid growth and deliver on the SaaS promise of performance, integrity, security and ease of maintenance. And the model is wreaking havoc in enterprise software company sales organizations. Sales comp plans and super-salesperson mind sets have to be radically altered.

There’s also the issue of accounting. SaaS providers are recognizing revenue differently, based on their understanding of the guidance provided by their accounting firms. Some SaaS providers, reluctant to entirely abandon the notion of up-front revenue, charge an implementation fee. Sometimes that covers training, other times it pertains to data conversion or implementation. Accounting treatment of these various implementation costs varies widely. As a result, many hybrid perpetual license and SaaS providers are wrestling with the concept of bookings for the first time and don’t have a handle on their true GAAP revenue or SaaS margins.

The Bottom Line
SaaS may well prove to be a less profitable than many software companies, pundits and investors anticipate. It’s certainly the case today. As noted earlier, the median TTM EBITDA margin of the 18 public companies in the SEG SaaS index was 6.1%, considerably lower than the 11.2% median TTM multiple of the 211 publicly traded software companies comprising the SEG Software Index. In fairness, the margins should improve as certain one-time expenses are absorbed and subscription renewals kick in.

But it’s the pricing side of the equation that may ultimately prove to be the greatest deterrent for large enterprise SaaS adoption. As SaaS providers begin to fully grasp their higher than anticipated implementation, integration and infrastructure expenses, and as SaaS grows market share among large enterprises, it’s a safe bet SaaS providers will revisit their pricing models – and bite the hand that feeds them. Look for higher – perhaps much higher – subscription fees in the future. Or in lieu of higher subscription fees, look for unbundling – separate fees for maintenance, support, implementation, customer-specific database fields or functions, and the like. Look for new pricing models not based on the number of users or concurrent users, but the number of employees or transactions or aggregate dollar amount processed. In certain vertical markets, such alternative pricing approaches may pass muster, but among many large enterprise customers those approaches will likely elicit a strong backlash.

And so, in the next year or two we anticipate slow, but steady enterprise adoption of SaaS, and we expect median SaaS provider margins to grow beyond the median margins of their shrink-wrapped counterparts. Following that, we expect a backlash, as CIOs experience subscription price inflation and assess the total cost of ownership and return on investment of their SaaS solutions in comparison to their behind the firewall, perpetual license apps. Or perhaps the industry will be more circumspect this time around, preserving the win-win that is SaaS today. Time will tell.

Ken Bender is Managing Director of Software Equity Group, an investment bank and M&A advisory serving the software and technology sectors. Founded in 1992, the firm has represented and guided private companies throughout the United States, Canada, Europe, Asia Pacific, Africa and Israel, and public companies listed on the NASDAQ, NYSE, Toronto, London and Euronext exchanges. Software Equity Group also represents several of the world's leading private equity firms. For article feedback, contact Ken at kbender@softwareequity.com 

Software Equity Group’s Quarterly Reports are now read and relied upon by more than fifteen thousand software industry senior executives, entrepreneurs, venture capitalists and private equity investors in 28 countries around the globe. The 2007 Annual Report carefully analyzes software industry mergers and acquisitions, assesses public software company financial and stock market performance during the year, and identifies key trends that impacted the software equity markets year-to-date. A copy of the 2007 Annual Report can be downloaded from the firm’s web site,
http://www.softwareequity.com/research_annual_reports.aspx.


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