SaaS: Key Pricing Considerations (Part 1)

Software as a Service (SaaS) is growing rapidly as an alternative to licensing on-premises software for corporate customers. As reported by Forbes earlier this year, analysts are forecasting that global SaaS revenues will reach $10.6B in 2016, representing a 21% increase over projected 2015 spending levels. By 2018, 27.8% of the worldwide enterprise applications market is projected to be SaaS based.

SaaS solutions are attractive to customers because they substantially reduce the upfront investment and risk associated with licensing and implementing on-premises software and avoid the ongoing costs of maintaining the infrastructure and implementing upgrades for the licensed software. In a SaaS solution, those costs and risks are transferred to the supplier.

SaaS combines elements of software licensing, outsourcing and hosting into an integrated solution. The pricing models for SaaS solutions have certain distinct characteristics that are driven by the economics of those solutions and differentiate SaaS pricing from pricing models for software licensing, outsourcing and hosting services.

This is the first of two postings that addresses some of the key considerations relating to SaaS pricing. This posting discusses the underlying supplier-side economics of SaaS services and their implications for how SaaS services are priced. The second posting will identify some key considerations in negotiating pricing for SaaS services that can help lower subscription costs.

SaaS Economics

From a supplier standpoint, the economics of SaaS solutions are very different than software licensing. In a typical software license, the supplier receives a large upfront payment in the form of one-time license fees that help offset investments in sales, marketing and product development. In contrast, under a SaaS model those fees are spread over the contract term (typically 1 – 5 years for SaaS offerings to corporate customers).

This explains why established software licensors are taking significant hits to earnings as their on-premises software revenue is being replaced by SaaS subscription fees. For example, the Wall Street Journal reported recently that SAP’s first quarter net profit in 2015 fell 23% even though overall revenue increased by 22% and cloud subscriptions and support jumped by more than 100%.

From a supplier standpoint, the economics of SaaS solutions are also very different than outsourcing and hosting services. Outsourcing or hosting is typically a “one-to-one” service that is customized to meet the specific needs of a customer and in which the direct cost of delivering service represents a substantial portion of, and is directly correlated with, the supplier’s charges for the service. In contrast, SaaS is a “one-to-many” service that is not customized for individual clients and in which the direct cost of service delivery represents only a modest portion of the supplier’s fees.

To understand the economics of SaaS solutions, it’s helpful to look at the income statements of some of the leading SaaS providers. The lion’s share of costs is for sales and marketing to acquire new customers. As reflected in their 10-Ks, sales and marketing as a percentage of revenue for salesforce.com, Workday and Netsuite ranged from 40 to 53%. Combined costs for product development (R&D) and general and administrative (G&A) expenses accounted for somewhere between 30 to 53% of revenue for these companies. The direct cost of delivering the SaaS service is relatively low in relation to revenues, ranging from 17 to 19% of subscription revenue.

Each of these companies had gross profit margins of over 80% on subscription revenue, but had substantial net operating losses due to sales and marketing, R&D and G&A costs. This is a reflection of the high growth trajectory of these companies and the time it takes to recover their investments in customer acquisition, R&D and the assets required to deliver the service. The road to profitability depends on high customer retention rates and expansion of business with existing customers.

Pricing Implications

These economics have several implications for how SaaS services are priced:

• Size Matters (a lot) – while large customers can always expect to receive higher discounts for IT services than small customers, this dynamic is magnified for SaaS services. The lifetime value (LTV) of a customer in relation to the cost to acquire a customer (CAC) is much higher for large customers than small customers. At 80%+ gross profit margins on subscription revenue, the revenue stream from a large customer has a much greater impact on the supplier’s earnings than, say, a large outsourcing or hosting customer (where gross profit margins are lower due to higher direct costs of service delivery in relation to revenue). Even though it typically costs more to acquire a large customer, these are one-time costs that are more than offset over time by the revenue stream of a large customer. Large customers also have longer retention rates for SaaS services. Therefore, large customers should expect to receive substantially higher discounts on subscription fees and considerably more flexibility on other pricing and non-pricing related terms. In this respect, SaaS pricing is analogous to pricing on software licenses where a large client may pay half of what a small client pays on a per unit basis.
• Minimum Revenue Commitment – the payback on the supplier’s investment in acquiring a SaaS customer can take many months (in some cases over a year) of subscription fees to break even. Therefore, minimum revenue commitments are particularly important for SaaS providers. A typical SaaS agreement will obligate the customer to purchase a specified volume of SaaS services for a committed single or multi-year term. Suppliers normally attempt to avoid or limit termination for convenience rights and the ability of customers to reduce volumes below baseline levels. Since the cost of service delivery is relatively low in relation to subscription fee revenue (e.g., only 17 to 19% for salesforce.com, Workday and NetSuite), there is very little opportunity for the supplier to shed costs when a customer terminates or reduces volumes. As a result, the traditional outsourcing or hosting services model – which generally provides a high degree of flexibility for customers with respect to termination and volume reductions – does not translate well to SaaS service offerings.
• Payments Start When the Service is Made Available (not at “Go Live”) – SaaS providers normally insist that the full subscription fee commence on the date that the service is turned on for a customer (i.e. made available to a customer to begin the configuration and implementation work to be able to use the service). Customers often argue that they should not have to pay the full subscription fee prior to their “go live” date in production since the customer will be consuming fewer resources of the supplier prior to that date. This is a legitimate point. However, given the relatively low cost of service delivery in relation to the subscription fee (e.g., typically under 20%) with a substantial portion of those service delivery costs being fixed infrastructure investments, there is likely only a modest amount of savings to be achieved in pursuing this line of argument.
• Payments in Advance (not arrears) – many SaaS providers insist on payment in advance, either annually or quarterly. This is to help the supplier with cash flow issues associated with the upfront investments in customer acquisition, R&D and service delivery infrastructure – which can be particularly important for suppliers with rapid growth trajectories. In addition, payment in advance tends to make customers more invested in actually using the SaaS products they purchased and working to overcome initial transition challenges.

Although SaaS pricing can be inflexible in some respects, one benefit to customers of the economics of the SaaS model is that suppliers have a particularly strong incentive to maintain competitiveness in pricing their products even after the customer has subscribed to the service. Retention and expansion of business with existing customers is critical to SaaS providers in generating returns on their upfront investments. Since it is generally easier for customers to change SaaS solutions than on-premises software (in which the customer may have made substantial capital investments) or even outsourcing or hosting solutions, SaaS providers cannot necessarily count on their customers becoming “captive” to them in the same way that customers become captive to their major software licensors or outsourcing providers. This can provide leverage to customers in negotiating favorable pricing for expanded business and renewals.