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While Software as a Service (Saas) has been delivered to the consumer market for well over a decade, it is a relatively new phenomenon in the enterprise.  For example, more people use web-based email (Yahoo! Mail, Hotmail, AOL Mail, and Gmail) than enterprise solutions (Exchange, Notes, Sendmail).  

The key strategic drivers of SaaS. 

1.  Offers a lower total cost of ownership.  

Let’s assume that the cost of buying, deploying, and maintaining Exchange is a fixed cost of 1,000 units.  If I’m the “IT manager” of my family of 5, the cost per user is 200 units each.  If I’m the IT manager of a medium-sized business with 1,000 employees, the cost per user is 1 unit each.  And if I’m the manager of a 100,000 employee Fortune 500 business, the cost per user is just 0.01 units each.  

My analysis is obviously oversimplified, but the reality is that most enterprise technology vendors make the lion’s share of their revenue (and an even larger percentage of their cash flow) on a very small number of huge customers.  And these huge customers get massive discounts.  So on a per person basis, or whatever other unit basis, the marginal cost of software typically decreases on a per unit basis as the size of the buyer increases.

This is the key reason why web-based email took off.  In the early days of web email, Outlook + Exchange offered dramatically better functionality (this is no longer true).  However, the cost of buying a server, storage, rack space, an Exchange server license, and hiring someone to manage your personal Exchange instance was absurdly expensive.  Remember, that Clayton Christensen’s definition of disruptive technology focuses on lowering the cost of doing something.  Disruption starts with low cost and then, as the technology matures, moves up the value chain.

SaaS will take off first where the benefits of amortizing the fixed costs of prepackaged software are lowest.  SaaS already dominates the consumer market and it will next move into small and medium businesses.  It will then eventually take over the large enterprise. 

2.  Allows for applications that were not previously available.

Existing large software vendors usually view software as a service as a new distribution channel.  But it’s much, much more than a new channel.  With SaaS, you can involve the world in helping you make your product better for your consumers at a far more atomic level than prepacked software.  Salesforce.com’s Force.com is a very good example of making innovation a team sport.  As more and more applications move to web standards-based SaaS, mashups and third party innovation will lead a Cambrian explosion in enterprise innovation.

3.  The web-based software development and delivery model is superior to the prepackaged alternatives.

With web-based software, upgrades are continuous and instantaneous.  In the prepacked software business, upgrades come every 6-18 months.  Because software roll-outs require every customer to join the roll-out process, support and engineering organizations must support multiple copies of a code base for a single product.  And new features must be bundled together and delivered in large packages.  This leads to highly unpredictable software releases as the massive complexity of large software projects makes predicting development time an impossible task.  Worse, as any enterprise software product, engineering, or sales manager will tell you — by the time you have what your customers wanted 12 months ago, you don’t have what they need today…

Finally, selling enterprise software through very expensive sales professionals limits the core audience for software products to the Global 2000.  There are over 8MM businesses in the United States alone.  Just as client-server allowed a new audience of buyers to join the technology party, so too will SaaS expand the audience.  And, this time, everyone on the planet will be invited.

4.  From a vendor’s perspective, the economics of SaaS are not as attractive as prepackaged software (today).

This last point is critical to understanding the SaaS landscape.  Prepacked software leaders assumed that customers would do the math and pay them the same amount through a monthly SaaS subscription as they received today through perpetual prepacked software licenses; of course the payout would be adjusted (on an interest adjusted time value of money basis), but the only real difference would be that they would get more predictable revenue.  Surprise!  Customers, treat SaaS as a rental rather than purchase and discount the sum they are willing to pay accordingly.  Many large company software executives already under severe pricing pressure as their markets mature are collectively saying, “Crap.  Better stick with the old way of doing business.”

New startups have nothing to lose and are more than happy to take the revenue.  But investors are starting to wonder how long it will take these startups to develop an interesting balance sheet and are also starting to pull back on investment.  Is that wise?

The future of enterprise software.

We are at the beginning of a massive shift from client-server to web-based software in the enterprise.  This move will be even more dramatic than the move from mainframe to client-server.  The move to self-service distribution will lower sales costs and make comparable technology available to enterprises of all sizes on an eat-as-you-go basis.  Having all data in a centralized repository with open interfaces will lead to geometric increases in functionality as customers munge data and functionality together themselves or through third part developers (who will also have access to self-service platforms).

In the next five years there will be some very interesting new businesses around the enterprise.  After a period of massive growth, consolidation will follow.  With consolidation, prices will stabilize and SaaS-based enterprise software businesses will have market capitalizations that dramatically exceed those of comparable software vendors today.  Lower costs in sales, distribution, and development will eventually benefit both consumers through lower prices per unit of consumption AND software firms by expanding the available market dramatically.

Just as the last revolution benefited both buyer and the *new entrant* seller, this one will benefit new entrants and buyers.  The only likely losers will be the large existing players who can’t disrupt their own businesses for the same reasons those they disrupted 10-20 years ago couldn’t give up on the previous era.

Finally, I predict that Salesforce.com (CRM) will have a valuation higher than SAP (SAP) in 5 years.  Today CRM is just under $8 billion in market value and SAP is just under $68 billion in market value.  What do you think?