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Beware SaaS revenue cliffs, troughs and break-even points

Vendors are staring at an abyss: SaaS subscriptions siphoning off revenue from huge, upfront licenses. Get ready for new flavors of cloud -- and say goodbye to more legacy systems.

How to make money as a developer of software as a service (SaaS) -- or save money if you're a buyer -- is on people’s minds as the cloud becomes the preferred option in many companies and business cases are written. The subscription-based revenue models of SaaS and other cloud flavors like infrastructure as a service (IaaS) are fundamentally upsetting the ROI calculation for software purchasers and vendors, and threatening to put established players out of business. The potential turmoil could remake the software market.

After a decade or so of hype about the cloud, things are finally getting serious. A growing awareness that the cloud shift is happening right now is apparently motivating consultants to go public with the financial metaphors, ROI calculations and rules of thumb they usually share only with paying clients. Scary prognostications and dire warnings are part of it, too.

My favorite is the cloud/managed service provider (MSP) trough, which IDC Program Vice President Darren Bibby showed at the analyst firm’s Directions 2014 conference in Boston. The trough, which looks more like a cliff (see the figure), is the place where license revenue drops off to almost nothing before monthly SaaS revenue can take its place. The inflow from SaaS subscriptions is a trickle compared to what the vendor is accustomed to.

IDC SaaS revenue trough
IDC's cloud/MSP trough depicts the point where software license revenue plummets before SaaS revenue can replace it.

The up-front savings to customers are a disaster for vendors that can't manage costs until SaaS revenue replaces license revenue, which could take years.

Edison Peres, Cisco's senior vice president for worldwide channels quoted by Bibby, sums up the quandary better than most. "Selling cloud and managed services is a new business model. If you move too quickly to a recurring revenue stream model, you will be greeted with cash flow challenges. If you move too slow, you're out of the game."

Case in point: SAP’s not-so-simple cloud strategy

Like most vendors with a lot invested in expensive on-premises applications, SAP may be worried about making it across the SaaS sea, and recent financial results suggest it has good reason. In the latest quarterly earnings report released last month, SAP cloud revenue grew 32% while on-premises went down 2%. Traditional software still accounted for more than four times SAP's software business compared to cloud, but the trends have been clear for a while.

The fact that vendors expect to make more money from SaaS after four years should give pause to anyone who expects to rent the same software for more than four years.

Meanwhile, a similar picture was being painted by SAP's chief rival, Oracle, albeit with broad, Ellisonian strokes that made Oracle seem like the biggest cloud vendor on the planet. In June, Oracle reported 25% growth in cloud revenues for the quarter, but also said the technology is only 3% of total sales. Revenue from new software licenses was flat.

As Oracle president and CFO Safra Catz said after this latest earnings release, the transition to an as-a-service model is necessarily hurting sales in the short run. Pointing to strong growth in Oracle’s cloud business, Catz added: "As our business has transitioned, more software revenues are being recognized over the life of a subscription, rather than upfront."

Revenue drop, uncertainty price of long-term SaaS profitability

Indeed, vendors may find the nerve to brave the rocky shoals by dreaming of just that kind of income stream, which is called recurring revenue. It turns out that getting lots of customers to pay something every month for years can be very lucrative. Companies with recurring revenue can be more profitable, and Wall Street rewards them for their strong cash flows with higher stock valuations, Bibby said, citing vendors like Adobe Systems and CANCOM, a German IT services provider.

SAP was surprisingly transparent about its SaaS revenue dreams and challenges during a February briefing for the investment community, where it said it intends to offer a subscription pricing option for all of its core applications. Luka Mucic, a member of SAP's global managing board, said the company does better in the long run despite giving up the larger, one-time payments from traditional software. He set the revenue break-even point for SAP at around four years, after which SaaS subscription revenue brings in more money. If customers can be enticed to keep renewing past that point, he said, "the cloud business model, from a revenue perspective, just accelerates over that time."

Mucic knows that success will depend on keeping users happy enough to renew their contracts, which typically last three years. "This model is extremely attractive in the long run, provided that we are successful at upholding a high renewal level," he said. Yet even at the end of that three-year contract, SaaS is already beating on-premises in total revenue collected. Mucic showed bar charts in which the SaaS version of one particular application takes in $1.35 million versus $1 million for the on-premises equivalent.

Aye, there’s the rub. When do renewals start to look like just a SaaS-ier version of vendor lock-in from the user's perspective? It's the flip side of the point where subscription revenue becomes more profitable for the vendor than the equivalent upfront license revenue. The two don't precisely line up -- the vendor's break-even point is not the same as the user's -- but the fact that vendors expect to make more money from SaaS after four years should give pause to anyone who expects to rent the same software for more than four years.

The current thinking on how to calculate the ROI of SaaS also calls the long-run benefits into question, or at least cautions against assuming SaaS is nothing but upside. A few years down the road, SaaS can get more expensive than on-premises software, especially if the subscription terms get worse with the steep growth in users. And SaaS often needs integrating with other systems, a substantial investment most companies are reluctant to throw away to switch to another provider. They might also feel locked in by not wanting to force employees to learn new software just because the ROI is about to turn negative.

What might the cloud/MSP trough and vendor break-even points mean for the options available to users? Prediction is a risky game in such a changeable industry, but it seems likely that more on-premises products will be phased out and support put on a short leash. Vendors will make more offers that can't be refused to switch to privately hosted versions or managed services. In fact, Bibby advised software makers to boost their managed services to address the coming revenue crunch, a step SAP, for example, is taking with its HANA Enterprise Cloud.

Recurring revenue may be the next big opportunity for software vendors, but it sounds like a potential trap for users.

Next Steps

Read a guide to SaaS ERP vendors

See what some users said about SAP’s SaaS strategy

Understand what’s behind the Oracle SaaS earnings

Dig Deeper on CPM software