A growing number of enterprises are giving the strongest possible endorsement to the sofware as a service (SaaS) model: their checkbooks.

Allured to benefits of faster deployment, lower total cost of ownership, lower risks, faster innovation, and better service, enterprise are increasing investments in SaaS solutions more than 20% annually (IDC). And with no software or hardware to install or maintain, SaaS has alleviated resource burdens and moved application investments from capital to operating budgets. (A recent Aberdeen Group report also quantifies the advantage of SaaS solutions hold over traditional installed applications in enabling supply management groups to increase spend under management.)

This heighted investment has caught the attention of leading market watchers: 

• IDC expects SaaS to be a $10 billion market within three years and says that 79% of enterprises are currently purchasing or reviewing SaaS solutions.
• Gartner Group predicts that, by the end of the decade, nearly a third of all software revenue will be derived from SaaS offerings.
• And Triple-Tree argues that such projections are underestimating the size of the SaaS market by as much as 80%.

These estimates — coupled with declining revenues and market valuations — have many well-known business- and supply-management application providers announcing intentions to support SaaS. 

But, as noted in a recent Line56 article, transitioning to a SaaS model won’t be easy. Rewriting legacy (and often proprietary) installed applications into a multi-tenant architecture that can support all customers from a single application instance will be challenging enough. But embracing the SaaS delivery, pricing, and service model will be even more daunting.

Now, Microsoft Corporation’s Don Dodge examines the financial hurdles to becoming a SaaS provider. Referencing a recent presentation by venture capitalist, Michael Skok, Dodge reveals that it takes 70% to 100% more capital to fund a SaaS company. He also notes that it takes two to three times longer for a SaaS company to reach liquidity than a traditional license company.

Skok should know. His VC-firm, North Bridge Venture Partners, has funded eight SaaS companies. He has also funded traditional software and technology firms. He offers the following insights into the challenges facing traditional software firms attempting to reinvent themselves as Saas companies:

• Profitability will suffer: “Established traditional software companies must deal with “renting” their software for something like $5 per user/ per month versus selling it for $20K. This effects quarterly profitability and sales compensation…” and “ the strategy conflicts are pervasive.”
• Retraining the sales culture is a challenge: “If you are a sales person with a $1M quota and you have the choice of selling a $100K perpetual license, or a $2K a month SaaS subscription, which would you do?” Traditional software companies will need to change their sales metrics and commission structure to balance ratable revenue, profitability, and a productive sales team.
• Engineering costs and challenges will be higher: ”Most enterprise software is customized in some way for each customers environment. Traditional companies sell consulting services to do this. SaaS companies must build the customization features into the base software.”
• Hosting is expensive and difficult: “Suffice it to say that it is very expensive and complex to build and manage a 24X7X365 service that is always up. Most companies outsource this, but it is not free. It must be factored into your pricing model and cashflow model.”
• Making service Job 1 is not easy: In my mind, AMR Research nailed the biggest inhibitor to legacy application providers becoming SaaS vendors: culture. Specifically, AMR wrote: “SaaS has created a new culture within the software community where customer service, user adoption, and easier implementations are the new gold standards.” Legacy application providers accustomed to large upfront licenses, even larger implementation service fees, and perpetual maintenance will need to brush up on their manners and their customer service capabilities. Dodge agrees, saying shifting to SaaS will require traditional software vendors to overhaul their contracts to consider “automatic renewals, termination clauses, SLA (Service Level Agreements), privacy issues, data loss, data export, and a variety of other issues must be addressed in your subscription license.”

Faced with these factors (and an unwilligness to give up on their installed approach and perpetual license, and maintenance streams), traditional application providers will continue to do a two-step shuffle. And comments from experts like Dodge and Skok suggest that traditional application providers undertaking such moves run the serious risk of failing to master either dance.