The Software as a Service Dilemma

Software as a Service (SaaS) presents a classic “disruptive innovation.” Of course, in 2010 that’s not new news.

What is remarkable is how closely the SaaS market’s evolution matches the definition of a disruptive technology that was described by Harvard Business School professor Clayton Christensen in The Innovator’s Dilemma (he later replaced the term with “disruptive innovation” in his subsequent book, The Innovator’s Solution). In fact, the SaaS dilemma that incumbent software vendors currently face is playing out almost page-for-page from Christensen’s books. As a result, we can use the disruptive innovation framework to gain insight into what’s to come in enterprise software.

After a decade of deriding SaaS technology as too simple, functionally incomplete and insecure, vendors such as Microsoft, Oracle, SAP and thousands of incumbent “on-premise” software vendors are now embracing SaaS. It’s an awkward embrace – one that threatens to cannibalize existing revenue steams, divert resources and eat up profits.

Of course, the innovator’s dilemma doesn’t destroy every incumbent. These incumbent market leaders are powerful, resilient innovators themselves. But for armchair quarterbacks like us, this the next five years will present a fascinating game to watch.

What is a Disruptive Innovation?
Disruptive innovation refers to new solutions – often technologies – that through a new delivery model, alternate pricing model or target market segment are able to disrupt existing competitive dynamics dramatically. For example, SaaS offers a new delivery model (i.e. hosted “in the cloud”), a new pricing model (i.e. subscription) and initially targeted smaller customers.

Initially, these disruptors target the least profitable customer segments – typically smaller or unsophisticated buyers. These are the only customers whose requirements are limited enough to accept the bare bones feature-set of the new system. Meanwhile, they appreciate the new model (i.e. it’s cheap and easy to get started). We certainly saw this in SaaS as small businesses or autonomous departments adopted customer relationship management (CRM) systems like Salesforce.com as early as 1999. For them, SaaS CRM was “good enough.”

The disruptive innovation cycle applied to SaaS.

Over time, however, disruptive innovators improve their performance and feature-set and can meet the needs of more sophisticated customers. Combine that with a little buzz around their new model (e.g. everybody’s talking about cloud computing these days), and the incumbent vendors start to take note. Of course, the incumbent still has plenty of ammunition to dismiss the new technology, since it remains functionally deficient relative to incumbent products and the most demanding customer segments (e.g. SaaS penetration into the ERP market remains limited).

I’ll posit that SaaS is now entering the penultimate – and most contentious – stage of disruption. At this point, the innovators start to gain serious momentum. Their products approach functional parity and they begin to steal substantial market share. The incumbents finally get serious about defending their traditional markets by releasing their own version of the innovation (in the case of SaaS, that means true web-based, on-demand, cloud computing, not just hosted client/server software). Unfortunately, it is often too late. Incumbents remain apprehensive about cannibalizing existing revenue and they face challenges replicating the innovation. Typically, most incumbents stagnate, decline and fade into obscurity. Only a few nimbly transition to the new model.

The innovator now becomes the incumbent and new innovators emerge. The cycle repeats.

SaaS Disruption Battles are Well Underway
Christensen mentions Salesforce.com in his second book, The Innovator’s Solution:

This company, with its inexpensive, simple, Internet-based system, is disrupting the leading providers of customer relationship management software, such as Siebel Systems.

I worked at another leading CRM vendor back when Salesforce.com was just a start-up. I remember meetings where executives derided the system as a toy. Most Salesforce.com implementations were just a half dozen users and most customers paid their subscription fees with a credit card (Gasp!). Since then, Salesforce.com has exceeded $1 billion in revenue and incumbent market-leader Siebel Systems sold out to Oracle after hitting tough times.

While Salesforce.com in the CRM market is the best example, the SaaS dilemma is playing out in numerous software markets. Gmail and Google Apps are nascent yet serious threats to Microsoft’s Outlook/Exchange and Office cash cows. We use both of the Google services extensively. NetSuite is a contender in enterprise resource planning (ERP), but hasn’t dented SAP or Oracle too badly as of yet.

Most interesting, however, is how this same battle is being waged by innovators in so many lesser followed market segments: SaaS construction project management, SaaS electronic medical records, SaaS property management, SaaS retail point of sale. The list goes on…

Most SaaS Shortcomings are Addressed
As I mentioned earlier, I believe we are entering the final stages of SaaS disruption. The SaaS model and its proponents have not defeated the incumbents, but SaaS solutions have reached functional parity to the point where incumbent derisions are starting to fall on deaf ears.

Let’s examine each of the top five objections to SaaS:

1. Web browsers are not interactive enough. This was true when web applications required a full page refresh to complete a transaction, but the maturation of JavaScript, AJAX, Adobe Flex and other web user interface technologies addressed this. HTML 5 will put this one to rest for good. I find my SaaS apps faster and more dependable than any on-premise app.
2. Hosted data is not secure enough. This one always perplexed me, since so many of us were comfortable with web banking as early as ten years ago. Few systems could be more valuable than financial transactions. Moreover, very few software buyers can afford to implement the same security infrastructure as a professional SaaS data center.
3. It’s not possible to integrate SaaS. This was true when few SaaS vendors had built APIs and there was no middleware for SaaS. Nowadays, API integration to SaaS applications is non-trivial, but not any more difficult than on-premise integration. I should know; we just finished a successful integration to Marketo, a SaaS marketing vendor.
4. You can’t customize SaaS systems. Again, this is changing. Many SaaS applications remain fairly “packaged,” but many vendors have successfully positioned this as a benefit (i.e. “adopt our best practices”). At the same time, SaaS customization tools are maturing. Salesforce.com has built an entire development environment, force.com.
5. Big companies want to own the software, not rent. This may be still be true in some cases, but in this economy the recurring nature of subscription payments is attractive. It also puts more of an onus on the vendor to earn their future subscription payments. I’m not convinced that this presents a concrete competitive advantage for incumbents.

Incumbents are Now Challenged to Counter SaaS
Now that SaaS vendors and incumbents are locked in a real battle – the gloves are off and incumbents are releasing their own SaaS systems – our analysis turns to the big challenges that incumbents will face. Let’s examine the five most significant characteristics of SaaS systems, and then explore why they are great for SaaS purists and a real challenge for incumbent on-premise vendors.

	Great for SaaS companies	Tough for incumbents
Browser-based	They can promote the benefits of not installing and maintaining client-side software. Plus anyone can use a web browser!	Moving to a web-based architecture is a near-complete rewrite. "Web-enabled" options are temporary, at best.
Subscription pricing	Not needing to justify a big purchase up front means fewer approvals and fewer risk-averse buyers to assuage. Also, great recurring revenue.	This is the core cannibalization issue: moving to subscription pricing will stall growth and maybe lead to revenue declines for some time.
Multi-tenant architecture	With all users on one codebase and database, changes are made in one location, but roll out globally. Also, computing resources are shared.	With thousands of installs, it's impossible to consolidate. There are incremental benefits to multi-tenancy, but the legacy customers remain.
Rapid release cycles	With changes being made to one codebase/database, releases can be rolled out weekly, even nightly. More releases = better products.	The quarterly, bi-yearly or annual release cycle is deeply ingrained in the DNA of an on-premise development organization.
Bought by business, not IT	It's far easier to sell to business units with their own budget, without the need for IT approval or budget. Faster sales cycles = growth.	IT relationships are a core advantage of incumbents. With SaaS, those relationships are less relevant - a competitive barrier is lifted.

It’s Not Over Yet – Not Even Close
Microsoft, Oracle and SAP still own the large enterprise market and the SME market. In hundreds of niche software markets, on-premise incumbents dominate. Even ten to fifteen years into the evolution of SaaS, SaaS vendors still possess minimal market share relative to incumbent vendors. While still powerful and often growing, all of these incumbents face the daunting challenge of SaaS disruption. Moreover, each of the major incumbents has started in earnest on credible SaaS offerings.

Microsoft has released Microsoft Dynamics CRM Online – the first Dynamics family application to be offered in a SaaS model. Microsoft has also released Microsoft Office Online as a counter to Google Docs.

Oracle, meanwhile, continues to grow its Oracle OnDemand solution set. While much of Oracle OnDemand consists of managed services for traditional on-premise solutions, their SaaS CRM offering (acquired through the Siebel deal) is true SaaS. So too are other solutions they acquired in recent years.

Finally, SAP’s Business ByDesign appears to be a pure SaaS, on-demand offering that is operating independently from the SAP mothership. Our own conversations with SAP employees have shown that the company is maintaining an arms-length relationship with the Business ByDesign team so that this in-house “start-up” can truly function as a nimble SaaS entity, unconstrained by SAP’s on-premise legacy.

If the disruption examples and case studies in Christensen’s book are a guide, we can expect to see a massive number of incumbent vendors stall, fade and become irrelevant over the next decade. Others will deftly navigate the transition.

In our comments section below, I’d like to start a conversation about which incumbent vendors will fade and which will transition. Please share your opinion.