What is the state of SaaS? As the business model only continues to grow, taking the pulse of the current scene is timely and useful, especially as other industries continue to be transformed by software. K&L Gates’ 2017 SaaS Outlook delves into multiple PitchBook datasets on SaaS, including venture capital activity and M&A deal flow, to power analysis of key trends within the vertical. Featuring an extensive Q&A with noted players in the space that traces the history of SaaS and probes current developments.
What Is SaaS?
What is SaaS? Terms that develop into buzzwords get thrown around so often that finer shades of meaning are lost. The word SaaS itself is an acronym that stands for “software as a service”. Salesforce, an early pioneer in SaaS, defines it as “a way of delivering applications over the Internet as a service. Instead of installing and maintaining software, you simply access it via the Internet, freeing yourself from complex software and hardware management.”
Salesforce’s definition of SaaS explicitly highlights the fundamental technology shift away from software that is downloaded and run on the user’s personal computer or local network. The definition only makes passing reference, however, to a shift in business model that accompanied the shift in access method. Traditionally, a software user purchased a perpetual license to use software in a transaction that mirrored the purchase of a physical good. The version of the software licensed by the user may become outdated and no longer supported by the licensor, but the user has permanent access to it so long as the license terms are not violated. However, in SaaS, the user only has access to the software during the term of the license.
To reflect this shift in the business model, we define SaaS as centrally hosted software applications licensed on a subscription basis.
A few further notes on the definition: central hosting is not inherent in the SaaS definition, as software licensed on a subscription basis could be hosted by the user inside its firewall or “on premises”. However, in our view for a company’s service to be considered SaaS, it must primarily be offered over the internet. This software can be hosted by the software provider or through a third party cloud provider, like Amazon or Microsoft, even if it also offers a parallel product that runs behind the customer’s firewall. Application software is also not inherent in the definition, but SaaS usually refers to the application layer of the cloud computing “stack”, i.e. the applications or programs with which the end user interacts. The other two layers of the stack are known as Platform as a Service (PaaS) and Infrastructure as a Service (IaaS). PaaS is a set of tools and services designed to make coding and deploying SaaS applications quick and efficient. IaaS is the hardware and software that powers SaaS and PaaS—e.g. servers, networks and operating systems.
Within our definition of SaaS, there are still many variables. SaaS can be delivered via a yearlong or multi-year contract, or on a month-to-month or “pay as you go” basis. In addition, many SaaS companies that operate on a fee-forservice model offer the service for free at the outset of the relationship, with the goal of converting the free user into a paying subscriber. This is known as a “freemium” model and Slack, Box and Dropbox are well-known firms that use this model. Incorporating the subscription aspect into the SaaS definition helps to understand how the term is used, particularly by venture capitalists and other investors who are evaluating the business model as much as the service itself. For example, both Facebook and Twitter provide continually updated software delivered over the internet. However, because they do not use subscription models and instead monetize through advertising, they are not commonly understood as SaaS businesses.
Benefits of SaaS
User experience benefits:
- The user can more easily access continuously updated software from any device and location.
- The SaaS application is more easily integrated and used with other software applications.
- The SaaS subscription business model permits users to evaluate the utility of the software without making a large upfront financial investment.
- Because of how it is accessed, it is more practical for a company to make available SaaS applications to a small group of its employees.
- Since the software is easy for the application provider to deploy, it can be priced on an as-used basis (versus an upfront license fee) and scaled over time as the customer’s usage grows. This generally works better for the customer and makes the product more approachable.
- Compared to perpetual-license software businesses, and other internet-based businesses, the SaaS model tends to provide a more stable revenue stream. An investor can assess a SaaS business’ R&D costs, user acquisition costs, churn rate and the expected lifetime revenue per customer to build relatively predictable growth and profitability models.
- SaaS companies often require significant upfront investment to develop the service and acquire customers, but once the product-market fit is established, SaaS businesses can scale quickly and profitably.
- Customer loyalty to SaaS companies often runs deep. Because software purchase decisions within the enterprise are now often made at a departmental or even individual level, the fit between the service and user is often high, since the users are the ones deciding whether or not to obtain the service.
Decline from recent peaks
Venture capital activity in SaaS
With many of the key benefits of SaaS models enumerated, it is unsurprising that after the early success of companies such as Salesforce.com VCs flocked to fund businesses tackling various segments and applications in recent years. Venture funding of SaaS startups neared $28 billion in total value in 2016, and although that represents a decline from the heights of 2015, dollars invested remained robust when viewed across a longer timeframe. To take a bird’s-eye view, such a pattern makes sense not only in light of the recent overall VC investment slowdown, but also when considering typical new business model adoption cycles. Flush with commitments from limited partners looking to expand or at the least maintain allocations to alternative asset classes, venture firm partners backed many startups that sought low-hanging fruit in SaaS. Now, with much of the low-hanging fruit picked, SaaS financings are down, but SaaS penetration continues to deepen.
Rise in aggregate deal value suggests a maturing market
M&A activity in SaaS
As IPO window cracks open, M&A door stays wider
SaaS IPO activity & global SaaS versus software revenues
The initial public offering (IPO) window may be opening up in 2017, but up until recently simply hasn’t been welcoming for some time now. Due to market volatility, the relatively more attractive allure of M&A by a strategic buyer and the widespread expectation that public market investors will prioritize short-term profitability over long-term growth, businesses have focused on building out their core offerings and improving their market and fiscal positions before embarking on IPO roadshows.
For those companies poised for liquidity, the current prices available in the M&A market are undeniably attractive—not many publicly traded businesses can command revenue multiples as high as that of, say, AppDynamics and Mobileye. Because demand for new technologies and services on the part of incumbent technology companies is high, that form of liquidity is attractive to SaaS startups and their investors. As others such as Tomasz Tunguz have observed, SaaS valuations are likely to tighten further or stay tight given where we are at in the current cycle. Many of the best-known SaaS companies are simply observing their growth rates slowing, as a natural occurrence of becoming larger, more mature businesses. However, SaaS valuations are still likely to outpace the general software market, given the steady disparity in median revenues over the past few years and especially in 2017 thus far. Accordingly, M&A of SaaS companies will still proceed apace, for the foreseeable future, as the large technology companies continue to invest the cash reserves built up over many years to catch the next waves of technology. What’s harder to assess is if the IPO market will revive—that will likely be contingent upon a much longer period of public market stability and some intrepid businesses debuting to favorable receptions.
Read the full report here.