The Economics of Software as a Service (SaaS) vs. Software as a Product

November 25, 2008

This article is not about the challenges of product management for a SaaS product, nor is it about multi-tenant architectures and other SaaS implementation details. This article looks simply to compare—from the customer’s point of view—software purchased as a service versus software purchased as a product.

Software as a Service?

Software as a Service is an interesting concept. It implies that, instead of purchasing the software, you are purchasing it as a service—which really means the right to use the software.

You are also (usually) purchasing a hosting and infrastructure service along with the rights to use the software. SaaS providers maintain the hardware, perform upgrades, backup your data (sometimes), and otherwise perform all of the “keep the lights on” services and activities required to keep the software running.

Imagine a typical, 1990s style software purchase:

  • You buy a source code control system.
  • You set up a server and install the software.
  • You pay ongoing support costs: providing power to the server, keeping the server cool, applying security and operating system updates to the server.
  • You pay costs associated with administering the hardware and labor costs to update and upgrade the software.
  • You carry risks—a botched upgrade or a hardware failure—which can cause downtime or lost data.
  • You bear the costs of designing and maintaining a secure system. Do you allow your people to access the software (on the server) from other computers on your network? Do you allow them to access the software when they are not on the network (traveling, working from home, etc.)? How do you prevent your competitors from stealing or, even worse, destroying your data?

Now imagine that you’re outsourcing all of the “keep the lights on” activities above:

  • You pay an IT services firm to manage the hardware and the software for you, including the security model.
  • And you just use the software.

That’s one of the benefits of purchasing SaaS. To really grasp the economics of SaaS you have to contrast it with the economics of software license purchases.

Widespread misunderstanding

There is a widespread misunderstanding about purchasing software. In the last section, we used the word “purchase,” but that isn’t completely correct. You don’t purchase a copy of the software; you purchase a restricted license to use the software.

You probably have heard the phrase “site license,” which means that you are purchasing the right for everyone in your building (or company) to use the software.

Sometimes software is sold in terms of “numbers of seats”—the number of people that are licensed to use the software at any one time. You might have 100 engineers who share ten seats (single-seat licenses) of analysis software. Since each engineer only spends about 5% of his or her time using the software, they can easily share licenses. At any given time, five engineers (on average) will need to use the software. With a license for ten simultaneous users, each engineer is likely to be able to use the software whenever he or she desires.

So, even when you think you are purchasing software, you aren’t. As with SaaS, you are purchasing the right to use the software.

Economics of software licensing

There are infinite creative ways to purchase a software license. The most common situation is that you purchase a license, and then later purchase upgrades.

An obvious example is Microsoft Office (productivity software). Microsoft releases a new version of Office every couple of years. If you own the previous version, you can purchase an upgrade for less than the cost of buying the software for the first time. You are not required to purchase an upgrade, of course, but you may want to in order to capitalize on the latest features and fixes—and to stay current. If the people with whom you work all upgrade, you may want to upgrade, too—so that you can use the documents they create.
Microsoft does a good job of providing free utilities to read documents from the newer versions, and allowing people with newer versions to create documents that can be used by people with older versions. Microsoft, therefore, gives you a choice. They rely on market forces to create the pressure to upgrade, but you never have to upgrade.

On the other hand, Intuit, makers of Quickbooks (small business accounting software), is a little pushier. Intuit releases a new version of the software every year. Once a new version of Quickbooks is released, support for some or all of the integrated online services is dropped for older versions of the product. You can continue to use your old version, unless you want to use one of the integrated services.

When companies sell software (licenses), they usually sell a version of the software, and then make updates to that software with some frequency—anywhere from daily to annually. Companies also manage those updates as two distinct types of updates:

  • Minor updates are usually free and often include bug fixes or features that were intended to be in the major release, but were delayed. Or they might just be the introduction of capabilities with “small” value to their customers. A lot of software will automatically notify you, download the update, and install it for you. That’s great service.
  • Major updates usually require the purchase of an upgrade. Major updates are usually more significant; they introduce capabilities that have “large” value to their customers or are intended to make the product appealing to additional markets.

To understand the economics of software license purchases, you have to look at both the value over time and the costs over time of purchasing a software license.

To keep this simple, we’ll assume the model described previously—minor updates happen frequently and are free, and major updates require the purchase of an upgrade to the latest version of the software. We’ll also assume that every new update introduces something valuable to the customer.


Figure 1 (left) demonstrates the value model for software over time from the software company’s perspective.

The axes represent increasing value (up) versus the passage of time (to the right). Time starts when you purchase a license to use the software. You’re immediately getting value. As minor updates are released to customers, the value gets marginally higher. Whenever a major release is made, the value curve jumps up dramatically. This represents the introduction of new, valuable capabilities.

As each new customer purchases a license to the latest version of the software, the company gets more revenue. As each existing customer purchases upgrades to their existing software, the company gets more revenue. Clearly, a company makes money both from finding new customers and from keeping existing customers.

Companies typically make more (per purchase) from finding new customers than from getting existing customers to upgrade. Until a product builds a large base of existing customers, the company’s financial focus will be on finding new customers. Satisfying existing customers is at risk of becoming a secondary priority, purely based on economics. Yes, this is an incomplete picture; there are other factors, but it is absolutely an influence.

Software license benefits

This article starts with a promise to look at SaaS economics from a customer’s perspective. If the model in Figure 1 represents how a software company views its products, consider Figure 2 (below), which reflects how a customer might view the same thing. Remember—in our example, we have a perfect product manager—every update has the same perceived value to customers as it does to the company. Figure 2 overlays customer purchasing behavior on the value model.


As a customer, you make an initial purchase (the left-most callout), and then get free incremental increases in value from each minor release. You also purchase an upgrade to the latest version of the software as soon as it is available. You then start getting incremental value from the minor updates to that version of the software.

The older version does not keep getting updates, so if you don’t purchase the upgrade, you don’t get the benefits of the latest minor releases. A second major release happens, but you don’t purchase it for a short while. Then a minor release is made, with a fix to an annoying bug that really bothers you. So you purchase another upgrade.

The value to you, the customer, looks like the steps reflected in Figure 3 (below).


The green area represents the value you get. It’s worth noting that the value is often a function of how much you use the software (enabling the benefit); and, as such, it is a function of time. The more you use it, the more value you get.
In Figure 3, you will notice that you do not get the value of the last major release until you actually purchase it. You also do not get the incremental value of minor releases that happen after that release. Once you purchase the upgrade, you immediately get the benefits of all the minor releases as you get “back in the game.”

Software license costs


Your costs over time are also important. Figure 4 (left) shows that the obvious costs are the checks you write to the software company to pay for the software and for the major upgrades. But this chart can also be a little misleading—as we are depicting “one time costs” that add up over time. Showing this as a stair-step area instead of a series of spikes will make sense as you keep reading. The key thing to appreciate is that once you make a purchase, your license purchasing costs do not go up again until you make another purchase.

At the start of the article, we identified several “ownership” costs—supporting the software and hardware, for example. It is critical that you keep those costs in mind when evaluating software license purchases. These costs are ongoing costs—so the more you use the software, the more the costs add up.


There are also training costs—the cost of lost productivity as people learn to use the software and adapt to changes in the software. Figure 5 (right) reflects the ongoing infrastructure and training costs as they expand over time.
When you combine these costs, you get a model for the total cost of purchasing a software license over time. The jargon for this is Total Cost of Ownership (TCO), reflected in Figure 6 (below).


As you can see, “purchasing” software one time actually has a continuously increasing total cost of ownership. Different types of software will have different relative costs for infrastructure support, training expense, and license fees. But generally, training expenses are much lower than the other costs of ownership.

SaaS economics

SaaS is purchased with the same mechanics as subscribing to a magazine or cable television or satellite radio. You pay a recurring fee for the right to use the software, just as you pay a recurring fee for the right to watch cable television. You might even get a discount for purchasing a longer-term subscription and paying up front. When you want to stop using the service, you stop paying the fee.

The model for creating value with SaaS products is the same as with licensed software (Figure 1). Where things change slightly is in the value model from the perspective of the customer as shown in Figure 7 (below).

Here, there is a single trigger to the realization of value—starting the subscription. You automatically get the minor and major updates “for free” by continuing to pay the subscription fee.

SaaS costs are different


Where SaaS differs from the purchase of a license to use software is on the cost side in Figure 8 (left).

The training costs associated with using software have nothing to do with the mechanism for payment, so those costs are the same. The cost of subscribing to the service (yellow region) is new, and goes up over time. It is also typically higher than the training costs. Note that there are no “large purchase” spikes in the costs, because you never purchase a license. And there are no infrastructure costs, because the company that provides the service realizes those costs.

The idea is that this approach is more cost effective when it comes to infrastructure costs, so the company can pass on those savings to you.
Comparing the two cost models in Figures 8 (above) and 9 (below) is the way to really see the difference.


Both models have costs that increase over time. For many technical reasons, the SaaS architecture is more efficient and has lower costs for the software company, which tends to result in lower costs for the customers. This is not always the end result, but it is directionally correct.

Another interesting factor is the financial pressure on the SaaS provider. Where a software licensing model creates pressure to prioritize finding new customers, a SaaS model creates pressure to keep existing customers.
SaaS providers get the same revenue from a new customer as from an existing customer—as opposed to the “new vs. upgrade” dynamic seen with software licensing models. In most cases, it is cheaper to keep an existing customer than to find a new one.

The net result: financial pressure to retain existing customers. This pressure can drive a different behavior, more like that of a retail sales model, where keeping your existing customers is critical.

Conclusion

The SaaS model ultimately provides the same type of products as a software licensing model—but with a better economic model, one that is lower in cost to the customer and structurally inclined to keep getting better for the customer with every new release.

Personally, I like the idea of purchasing from a company that is financially motivated to keep me happy, not one that is pressured to find another customer as soon as I’ve written my check.

The best companies try to reinvent themselves and improve their products continuously. Over time, the best companies will move to SaaS models, which align their financials with their objectives.


SaaS — a simple definition

Software as a Service is usually provided as follows:

  1. A company creates a software product and hosts that product on multiple servers. The company manages the hardware and software—and realizes the cost of that management.
  2. Customers subscribe to the service—getting the right to use the software for as long as they continue to pay the recurring subscription fees.
  3. The company makes both major and minor updates to the software, and the customers automatically get those updates as part of their subscription.

There are many examples of SaaS; some obvious ones are Salesforce.com, Kadient’s inciteKnowledge, and 37signals’ Basecamp.


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