Published December 2020
As we close out 2020, it became apparent that companies expanding remote-work arrangements performed strongly in the stock markets, such as communication platforms Zoom and Twilio. These cloud-based SaaS platforms generate recurring revenue, which adds business resiliency amid the global pandemic. SaaS solutions can also be offered as part of a cloud ecosystem, making it more efficient for companies to manage data, perform analytics, and drive automation for business processes.
With growing demand for SaaS solutions, the digitalization of the economy provides immense opportunities for specialized industries, such as healthcare, insurance, finance, and real estate to reap outsized value by operating through SaaS “like” models. The management team of tech-enabled businesses can consider growing the business from a SaaS perspective. With time, SaaS concepts such as Business Process as a Service (BPaaS) has emerged, helping to drive investor attention into this area. To tap into this opportunity, senior management teams need to adopt a SaaS mindset to help boost their valuations.
Transitioning Towards SaaS Models
At its core, the SaaS model is about cloud-based subscription billing. Software is hosted on cloud servers, which companies can access by paying a subscription fee for a fixed duration. In contrast, the traditional perpetual licensing model allows customers to use on-premise software in perpetuity after making a one-off payment. Companies thinking about transitioning will want to consider what products or features they can migrate to the cloud, putting in place a subscription-based payment process. Initially, it could be as simple as embedding Quickbooks into the existing product to provide SaaS-based accounting features.
Companies will also want to consider a sales strategy that emphasizes on long-term contracts, which adds a degree of revenue stability to the business. To close long-term deals, companies may need to include discounts or unique product bundles for the offering to be attractive. In terms of product management, founders should always explore ways to provide high value features for clients. This could take the form of partnerships or API integrations, so that the resulting product benefit from synergies or ecosystem networks. For example, CloverDX was founded in 2002, providing a data management platform based on a perpetual licensing model. The company has since provided an additional subscription option, including integration with SalesForce. The necessary data will be automatically loaded from the software into SalesForce, saving clients time and reducing operational costs in the long run.
Companies in digitalizing sectors acknowledge the need to transition towards SaaS models to compete effectively, but there remain significant hurdles that may take years of effort to overcome. Once a company starts to onboard existing customers to the cloud, the customers would consider the product features against competitor platforms, resulting in a degree of churn. Furthermore, SaaS pricing will eventually result in higher operating costs for the customers, compared to previous licensing models. When Adobe released its SaaS-based Creative Cloud platform in 2012, a petition was submitted to Change.org with as many as 50,000 supporters. To overcome this backlash, Adobe provided both cloud and licensing products for Creative Cloud over several years before retiring the latter in 2017. The successful transition has been pivotal in catapulting the company’s market capitalization from $15 billion in 2012 to over $200 billion in late 2020.
Other than putting in place customer-friendly policies, companies also need to spend aggressively on innovation while endure lower growth rates in the near term. The enterprise software giant SAP initiated its SaaS transition over a decade ago, embarking on a series of acquisitions (SuccessFactors, Concur, Hybris etc.) as the company re-packages its solutions into a SaaS-based business suite. Despite its digitalization efforts, on-premise licensing still accounts for a heavy revenue share. Last month, the company announced weak licensing revenue as it tries to align its pace of digitalization to the changing needs of its clients. This has caused a huge dent in its stock price, declining significantly over recent months.
SaaS-based Metrics to Consider for Companies in Transition
Although SaaS providers benefit from recurring revenues, some may not be performing optimally. There are numerous metrics to consider when evaluating business outcomes for these firms, with the most important one being monthly recurring revenue as a measure of steady cash flow based on monthly subscriptions. Businesses with growing recurring revenue may be doing well in general, but without considering other metrics, the management could be unaware of operational problems that need to be addressed.
Customer churn, or percentage of people who leave every month, is an important metric to consider as well. A business with growing recurring revenue may be losing customers, but with lost revenue compensated by strong acquisition strategies. By diving into churn data, companies can identify fundamental product deficiencies that results in customers switching to other platforms.
The other side of churn is acquisition, as companies strive to lower their customer acquisition cost. To analyze acquisition costs, companies can perform a segmentation analysis based on type of cost and acquisition channel. Acquisition costs include expenses for marketing campaigns, sales commissions, and onboarding customers. Acquisition channels can include digital, print, affiliate, and organic channels. By segmenting costs into these attributes, companies can identify ways to improve business processes and channels which are most efficient in driving revenue.
To take another step further, high acquisition costs can be balanced by even higher value generated over the lifetime of a customer. Acquisition costs may be high if there is a lot of expense incurred from heavy product personalization. However, it can also result in strong customer engagement that helps to retain a customer for the long term. If a customer sticks to a software indefinitely, companies can choose to calculate the payback duration needed to break even on the initial acquisition costs; the shorter the better. Companies that succeed in retaining customers can possibly justify relatively high acquisition costs.
Finally, when considering customer retention, we can also drill down to different types of cohorts. Customers are not necessarily a monolithic group, with different cohorts exhibiting different sets of characteristics. Earlier, we considered cohorts based on acquisition channels, but we can also evaluate based on acquisition period. The period of acquisition not only reflects the acquisition strategy of the time, but also prevailing economic factors. For example, cohorts in 2020 can reflect a broader trend of remote offices, which include more traditional types of firms that can no longer resist the currents of digitalization. Cohort analysis based on geographical regions can generate marketing ideas based on regional pop culture or behavioral traits.
Challenges to Anticipate when Transitioning to the Cloud
At Evolve, we frequently see older companies work towards growing SaaS-based revenue, with decreasing emphasis on service-based offerings and perpetual licensing models. SaaS platforms can facilitate customer retention via several ways. Firstly, the end users get used to operating the system and becomes reluctant to switch providers, which requires learning how to operate a new software. Secondly, SaaS platforms are constantly upgraded with new features, without causing any business process disruption for clients. Those with specific needs can also request for a customized product. Thirdly, integration with data and other platforms can further enhance business capabilities and efficiencies, while also making it more difficult to switch to a similar alternative.
In our November monthly newsletter, we showed that estimated 2021 P/E multiples for incumbent software providers (including SAP) is 20x, compared to about 30x for other enterprise software firms. To keep up, SAP will increase spending on the cloud transition, with growth slowing down before picking up in 2023. Smaller companies that find it challenging to keep up may want to consider a PE buyout exit, potentially as part of an add-on approach to tap into advanced technology and large amounts of financial backing.
SaaS models can provide valuable insight to grow businesses, as digital transformation continues to accelerate throughout the economy. However, speed is of the essence in the race towards the cloud. SAP’s Enterprise Resource Planning (ERP) system has been transitioning for years, in part due to the complexity of ERP processes. Its competitors Oracle and Microsoft have moved much more swiftly to expand their enterprise offerings. With COVID-19 significantly impacting SAP’s revenues, the management decided to accelerate the cloud transformation process. While margins and profits will be more depressed in the short run, there is hope that the company will outcompete its rivals in the longer term.