Chaotic Flow

Streamlined angles on turbulent technologies

Being a huge fan of both open source and software as a service, I am often frustrated by the level of tension and debate that occurs between these two communities, because the disputes are pure demagoguery.  At their core, both delivery models are natural market responses to a very simple and disruptive economic force:  the devaluation and commoditization of software over time.

The economics are simple.  Once created, software is easily duplicated, and the software of the past becomes the building blocks of the software of the future.  Thus, the commodity software of the past is rapidly devalued to zero.  Open Source chooses to ride this force by separating out the free component through community ownership and development; it is a fundamentally socialist approach.  SaaS absorbs this cost through vertical integration, and strives to create new value and differentiation by delivering a holistic product; it is a fundamentally capitalist approach.  However, the economic goal of both delivery models is the same:  more stuff for all of us at lower cost.  My frustration arises from the fact that the communities do not seem to recognize that they have this single admirable end in mind, they only differ in their means.

While many open source developers would like to believe there is some ideological heroism in their efforts, the truth is that they are simply solving an economic problem for a very specific market segment, and having fun along the way.  Nothing wrong with that!  But, only companies with strong IT capability can participate in open source development and overcome the market transaction costs implied by this do-it-yourself assembly of a complete, high value system that supports their business.  Companies that create value for their customers far outside of IT, are much better served by SaaS.  No matter how you slice it:  THERE IS NO VALUE IN THE SOFTWARE OF THE PAST COMPONENT.  You only achieve value when you remix it with more current technology and services.  It’s a mashup world—get with it!

Recently, Fred Chong proposed a 4th force to driving Long Tail markets (in addition to the three Chris Anderson identifies in his book), which I attempted to clarify in my last post as corresponding to the Price component of marketing’s 4Ps. One of the unique aspects of this particular “P” is that it is the final piece that must fall into place to close a sale. In some ways, it is the dividing line between products that are sold to a market and products that are sold by a salesperson in that if a list price is not set, then a direct negotiation must take place between buyer and seller.

If we take Fred’s proposal seriously (I asked Chris Anderson to check it out and here is his response: “I agree that there is a fourth force, involving dynamic/flexible pricing. I hinted at that in the book, both with the “Rule 2: Cut the price in half. Now lower it.” theme from the original article and the “economic of abundance” chapter and its embrace of free. And, in a sense, my next book, FREE is all about this grand experiment in making money by giving things away. ), then a natural conclusion is that SaaS/Web applications that provide the ability to automate the negotiation process between individual buyers and sellers and set deal-specific pricing in real-time have the ability to drive the Long Tail to it’s natural limit, a market of one. In other words, Web 1.0 made content/information free, enabling companies to profitably service the long tail, but Web 2.0 is making interaction/communication free, enabling them to push out on the Long Tail from mass market to niche market to individual buyer/seller transactions. While it isn’t necessary to use a Web 2.0 approach to achieve this (e.g., eBay arguably was the first hughly successful offering of this nature), it will be interesting to see how much farther out on the Long Tail we can go by leveraging applications that directly connect individuals, such as social networks, chat, VOIP, etc. and offer very flexible and granular pricing capabilities, such as microfinancing and ad serving.

I can’t take credit for any creative thinking here, but I had such an epiphany reading Fred Chong’s most recent post on the Long Tail that I had to write about it. In his post, Fred proposes a 4th force to be added to the three identified by Chris Anderson in The Long Tail:

• democratize production
• democratize distribution
• connect buyers/sellers

To which Fred proposes to add “democratize capitalism.” My first impulse was confusion,
having had a fair amount of economic theory drilled into me at the University of Chicago,
and knowing that “capitalism” is clearly too broad as it encompases virtually all capitalistic economic theory.

But, then I realized what Fred was really talking about was pricing, or monetization in
Web lingo. And it hit me! If you add pricing, the long tail forces correspond
EXACTLY to democratizing the 4ps of marketing, i.e., the go to market “forces” that every MBA student learns in marketing 101 and have solid microeconomic underpinnings (just the sort of perfectly structured idea that appeals to an ex scientist geek like me).

More plainly

product = democratize production
place = democratize distribution
promotion = connect buyers/sellers (or how about democratize promotion!)
price = democratize pricing

The microecconomic equivalents being commodity, transaction costs, information, and price
for the other econ geeks in the audience.

The relevance to SaaS and Web Applications being (as Fred discusses in his post) that
often pricing must be adjusted at the customer/transaction/user level in real time to bring SaaS and Web applications, e.g., Search advertising. But, the examples are not limited to SaaS products. Consider eBay and Priceline, both strong Long Tail examples that rely heavily on democratizing pricing, i.e., allowing a Long Tail seller negotiate or set a price directly for an individual buyer.

Notwithstanding my earlier post on the Long Tail, this (arguably more complete) model of the forces that enable the long tail provide the roadmap to mass customization for SaaS and Web applications.

I couldn’t let the much anticipated announcement last week of the final draft of the new Affero GPL go by without making at least a few comments. First of all, I love open source. But, I am unimpressed by the new GNU Afferro GPL for three simple reasons.
1) It is a weak effort
2) It is already obsolete
3) It is irrelevant
While there are 10 pages dealing with everything from patents to liability, largely legacy from the original GPL that was designed for installed, perpetual license software, there is fully ONE SENTENCE that attempts to deal with what is clearly the biggest disruption to the software industry since the personal computer.

“Notwithstanding any other provision of this License, if you modify the Program, your modified version must prominently offer all users interacting with it remotely through a computer network (if your version supports such interaction) an opportunity to receive the Corresponding Source of your version by providing access to the Corresponding Source from a network server at no charge, through some standard or customary means of facilitating copying of software.”

This is a band-aid and indicates a lack of interest in exploring the issue. The elephant in the room is that real value is shifting from the software itself to the fully integrated service offering, and the two are intimately intertwined. The delivery, scalability, integration, configuration, usability and administration of the software have as much influence over the Web user experience as the source code itself. Put another way, whose interests are the FSF really representing, developers or consumers?

While I think it is a truly beautiful philosophy that software should be “free to run…to study…to improve…to redistribute,” it is in reality free because its fundamental economic value is dropping to zero! If you buy into the idea that software-as-a-service is built around the delivery of a commodity offering, then you understand that real economic value and competitive advantage lie outside the functional capabilities implied by the source code, i.e., proprietary assets or IP in service delivery, brand loyalty, or switching costs. Any competitor worth its salt can duplicate another’s functionality in a matter of months, with or without the source code, but can that competitor deliver it to the user.

Alternatively, Web-based SaaS applications bring capabilities to consumers and SMB’s that they would not be able to afford or are perhaps even impossible under an installed, license distribution model. Different proponents of open source (myself being one) each have their own philosophy and motivations, but one underlying theme is making good software available to everyone. While much of the controversy surrounding this new license has been about stopping evil Web companies from taking advantage of open source, I will submit that it just don’t matter. Free software continues to make strong inroads into the installed, enterprise software space (and I will arbitrarily include Web servers in this category), but it is in danger of losing its philosophical underpinnings on the increasingly syndicated, service-driven Web.

The overriding problem with most B2B SaaS vendors today is their inability to reach profitability. Customer acquisition costs in particular often run 50%+ of revenue, and while logic says that one day subscription revenue will overtake this as the market matures (i.e., all prospects are now customers, so they just pay maintenance and we collect the cash), this plan is not playing out in practice. Welcome to the Silicon Valley world of VC-backed software where growth is EVERYTHING. You will never reach a time where you have all the customers. Even if you do, no one will recognize it and there will be unrelenting pressure to spend MORE on acquisition and new product development to gather up that one last customer to increase top line revenue. You can do all the break-even and NPV analysis you like, the psychology of the industry will not let you follow through on this strategy.

A paradigm shift is required in the minds of both SaaS executives and VCs if on demand enterprise software is to reach the level of success of traditional licensed software: growth follows efficiency, not the other way around. Everyone gets excited about a stable subscription revenue stream, but they forget that the requirement of profitability implies a stable cost structure that is below that revenue line. If you’re annual subscription fee is $1000, then your average annual cost of sales, marketing, support, development, operations and administration better be under $900/customer. Too many companies and investors are trusting too much in the inherent technological economies of scale of SaaS and are waiting to see how the rest of the SaaS cost structure shakes out. This is foolish, because the subscription fee that your target customer (usually SMBs) is willing to pay for your service is completely unrelated to your technology or your cost structure. It is your job to make them meet at a profitable price. I believe SaaS vendors should be targeting and driving toward a stable, lower cost structure throughout their operations—from day one, or if not day two.

If you annual customer acquisition cost exceeds 50% of sales, you should focus on increasing the efficiency of your sales and marketing processes to reduce cost/lead (or increase leads/cost!), shorten sales cycles, and reduce or eliminate labor costs. The days of the high-flying, all powerful enterprise sales star are over. SaaS is a cost-reduction play and your organization must strive to be a customer creation and product delivery machine. Drive leads through low cost Web 2.0 PR and viral marketing techniques, develop an effective, low touch sales process with extensive self-service, and most importantly avoid prospects that are too expensive to acquire—they may look like your target market, but they are not, because you cannot sell to them profitably. Chasing risk-averse buyers in an early adopter market, over-marketing to prospects that are too difficult to reach, and wasting precious selling time on prospects that have requirements beyond your current product offering are all scenarios that must be routinely qualified out of your sales process.

One example I like to share with SaaS executives who believe this is a pipe dream is Atlassian. Demonstrating strong year-over-year growth, this company is selling what might be thought of as traditional license enterprise software under a shrink-wrap model at SaaS prices! How do they do it? By applying Web-centric, low-cost, prospect-driven, grass-roots sales and marketing techniques that creates a strong inbound lead flow and keep out-of-pocket marketing and sales labor costs to a minimum.

There has been a fair amount of pondering over how Chris Anderson’s thesis on the Web’s transformation of the Long Tail in consumer markets might be applied to their business-to-business counterparts, and to B2B on demand software in particular. I’d like to take a slightly different approach and try to clarify where it does NOT apply, in order to better highlight its potential impact in areas that it does.

In my first post to this Blog, I stated that SaaS was fundamentally a mass market, commodity business. On the surface, this statement seems to run completely contrary to the Long Tail thesis. How can I possibly cite Google, Amazon, eBay and MySpace, the most notable enablers of the Long Tail phenomenon, as commodity SaaS providers. The answer lies in which products/services we are talking about.

The table below illustrates the potential source of confusion:

Put a different way, while every Web page, song, and friend may be unique and appeal to a specific group of individuals (niche market), HTML code, MP3 files, and XML profiles are essentially the same and shuffling them around cyberspace is a mass market, commodity business. In fact, this inherent sameness is a critical element of the interoperability that has driven down the cost of information distribution and processing to nearly zero and thereby enabled the Long Tail phenomenon.So, how does the Long Tail fit with SaaS? In his thought-provoking book, Anderson identifies three primary forces driving the Long Tail: democratization of production, democratization of distribution, and connecting supply and demand. Or, in terms of on demand software: tools ala TypePad, aggregators ala Amazon, and filters ala Google respectively. All you have to do is ask yourself one question: “Am I a tool, an aggregator, or a filter?” For the majority of B2B SaaS application providers, such as Salesforce.com or WebEx, the answer is obvious: “I am a tool.” (Sorry, too easy ;)) In fact, under this framework, it becomes clear that B2B SaaS mashup and mult-tenant platform plays, such as Salesforce’s force.com, are not only tools, but they are tools designed specifically to go after the Long Tail opportunity by democratizing production through self-service mass customization.

The core value proposition of the vast majority of enterprise SaaS application vendors, who are uniformly targeting the SMB market, lies in their ability to deliver basic (read commodity), enterprise-class capabilities ala to Siebel, Oracle, and SAP at a fraction of the cost. Attempting to address the Long Tail too early in their evolution could easily undermine this cost advantage and drag them into the “customization hell” that plagues traditional enterprise software vendors. That said, SaaS vendors are by far the best positioned to go after the B2B Long Tail as the sector evolves, because their base offering is a commodity. Into this plain vanilla code base, they can easily inject any number of unique flavors through mass customization techniques, such as extensive self-service configuration and standards-based interoperability.

There is a corollary to this proposition. Tools by their nature are flexible. They can be used to build a lot of different things, even other tools. If you are providing a B2B SaaS application that can easily be duplicated by more general, democratic tools, such as mashups, force.com apps, etc. Get out! You are about to get wacked by the Long Tail, because you will soon be competing with a multitude of do-it-yourself SaaS applications, widgets, and mashups. Better yet, take your thinking to the next level and become an aggregator or a filter. If the Long Tail phenomenon has any legs at all in B2B SaaS, one day there will be more on demand micro-apps than we know what to do with. (BTW, if you think this sounds crazy, get your creative juices flowing by paying a visit to sourceforge.net to see what a real, Long Tail software aggregator looks like in the open source world.)

Henry Ford once said: “Any customer can have a car painted any colour that he wants so long as it is black.” Then, in 1923 Alfred Sloan of General Motors came along and handed him his shirt by offering a tremendous variety in colors and models. But, GM didn’t do it one customer at a time. GM redesigned its manufacturing line with the required flexibility to produce a multitude of models and colors without compromising the inherent economies of scale of Ford’s assembly line innovation—a practice that has evolved into the concepts of flexible manufacturing and mass customization.

The primary enabler of mass customization is the elimination of setup costs. Setup costs occur from the labor, time and tooling it takes to switch a production line from one product to the other. High setup costs encourage long production runs to cover the expense incurred in switching over. By reducing them, production runs can be shortened. If they are eliminated, production runs can be reduced to a single unit. That is you can make the variations A, A1, A2, … An of a product (think GM models) for the same costs as making n units of A (think Ford Model Ts). If you apply this idea to enterprise software, taking each customer installation as a “unit” and the associated, customer-specific implementation, configuration, customization, and ongoing maintenance time and effort as the setup costs, then the roadblocks to mass customization in SaaS become clear: eliminate, automate and generally squeeze the cost out of your ability to handle unique customer requirements.

This business need entails an architectural requirement that is as essential to an SaaS vendor’s success as system security and the scalable, single-instance, multi-tenant architectural imperative. It requires automated deployment that consumes minimal resources, extensive, easy-to-use, self-service configuration and complete interoperability built on open, standards-based APIs. It cannot be off-loaded to VARS or customers. This shifts the costs downstream and undermines competitive advantage, because from the customer’s perspective, total cost of ownership is not reduced relative to installed software.

If you buy into the idea that on-demand software is the next evolution of software into an industry characterized by mass commodity markets and interchangeable parts. Then, your next concern must be “How can I make money in a commodity market? How can I create a sustainable competitive advantage?” This post is the first in a series that attempt to address this question.

In a nutshell, competitive advantage in SaaS will not come as easily as it has in the past for enterprise licensed software vendors and it will not come from traditional methods such as creating wiz-bang features, protecting source code, obfuscating product information, or arbitrarily locking in customers with unique customizations. The main reason B2B SaaS providers are struggling today—while their B2C counterparts are thriving—is that as commodity suppliers, B2C SaaS vendors are much more in tune with the traditional sources of competitive advantage. B2B SaaS has as much in common with computer hardware, telecommunications, financial services, and consumer packaged goods as it does with the old craft world of enterprise software. Maintaining a cost advantage, cultivating brand loyalty, network effects, service quality, mass customization, reduced time-to-market and continuous disruptive innovation are the keys business success. And, they are much harder to achieve.

Simplicity and cost efficiency come first in SaaS

A word of warning before you attempt to be different, make sure you have your cost structure in line. If you are competing against traditional licensed software, lower cost is your competitive advantage. If you are competing against another SaaS player, product complexity and higher cost will eventually kill any other advantage you try to achieve. Why? Because there are (or will soon be) many other choices just like you. Change happens, consumers are fickle and expect their software for free, and business buyers have even less loyalty when it comes down to price.

There, I said it. Difficult customers with highly specific requirements who expect to derive competitive advantage from your offering need not apply. If your target market consists of a list of fewer than 500 control-freak customers with sophisticated IT organizations, and lots of unique requirements, then you are wasting your time thinking of SaaS as the fundamental aspect of your business model. At best, you are a “managed service” where the underlying cost structure is identical to customized, licensed software, i.e., it really doesn’t matter if you run it or they run it, it will take the same number of people, the same number of servers, and the same number of lines of code.

It is important to note that the term “commodity” refers to the fact that SaaS is a mass market, high volume business where by and large “one size (read code base) fits all.” We don’t have to look any further than Google search to demonstrate this. How much more “one size fits all” does it get! Type in what you want to find, push button. Also, I am not precluding the possibility that you can attempt to overlay another competitive advantage on top of the inherent cost advantage SaaS entails (see below). But, your efforts will be visible to all your competitors and often short-lived. The proposed idea is that cost efficiency trumps product differentiation, and you deviate from this principle at your own risk.

Fundametally, SaaS is the further commodifation of software achieved by freeing it of physical distribution and increasing interoperability through interchangeable parts (services) to create a disruptive software delivery model with new economies-of-scale and business models that achieve a significant cost advantage—not a functional advantage—over traditional licensed, installed software. It is typicially characterized by the following attributes:

• Commodity capabilities
• Remote, network-based delivery
• Massive economies-of-scale
• Easy adoption
• Interoperability
• Usage–based revenue (subscription, transaction, advertising, etc.)

The closer you get to achieving these requirements, the stronger your cost advantage over licensed software vendors and the greater the opportunity for SaaS. These basic requirements include a much wider set of applications than most people think of when they think SaaS. It obviously includes salesforce.com, the poster child for SaaS, but it also includes Google, eBay, Amazon, MySpace, web hosting, social networks, syndicated widgets, and seemingly all things your borrow or rent over the Web. But don’t be deceived, these businesses are successful, because they meet these criteria. The truly successful ones often combine the fundamental SaaS cost advantage with some other source of strategic advantage such as a proprietary “secret sauce” to your service offering, brand loyalty, mass customization (one of the many concepts here that I am un-repentantly borrowing from the manufacturing world), or or a first-mover advantage. So, here’s the SaaS elephant in the room: It is already here!! There are hundreds, if not thousands of successful SaaS companies. It is the essence of the Web. The small set of struggling B2B enterprise software wannabe replacements comprise but a handful of vendors in the SaaS landscape. And, they would do well to look to their successful B2C counterparts for creative solutions to their problems.

One might argue that this definition encompasses such a large variety of companies and business models that it loses its value. I don’t believe this is the case, because it recognizes the underlying essence of these businesses and provides a framework for creative thinking and rigorous analysis when considering the myriad strategic and tactical options for building your own SaaS business. For example, when the first challenge you face as the developer of a B2B on demand scheduling and collaboration platform is “How do I build awareness and draw leads to my Web site?”, you are just as likely to find the solution to your problem by looking to vendors like eBay or Amazon, in addition to the obvious salesforce.com.