SaaS channel partners have definitely received the short end of the stick compared to their software channel counterparts. With a few notable exceptions like Salesforce.com, Netsuite (and largest, but least recognized as SaaS, Google AdWords) there simply have not been enough customers or enough work to engender a thriving ecosystem of SaaS channel partners, at least not when compared to the sprawling extent of enterprise software channels. I think this is about to change.

Channels Always Follow the Money

There is one universal law that governs all channel management: CHANNEL PARTNERS MUST MAKE MONEY. The biggest channel mistake made by many a SaaS start-up CEO is to fall into the fantasy that SaaS channel partners are there to help your business. They are not. They are there to help themselves. And, how much money they can make boils down to a very simple formula.

SaaS channel money = SaaS channel value-add x SaaS application customers

And right here is the rub. The self-serviceability of many SaaS applications from customer acquisition through deployment significantly reduces the value-add for SaaS channel partners. In fact, if all SaaS vendors embraced SaaS Top Ten Do #3 – Accelerate Organic Growth, then the SaaS channel situation might be even more dire. Moreover, the number of SaaS applications with enough customers to drive SaaS channel development can be counted on your fingers and toes.

Unfinished Business is the Business of Channels

The work required to realize the benefit of your product is the same whether you do it, your customer does it, or a channel partner does it. Channel partners add value by finishing the unfinished work that you and your customer start, but for business reasons can’t complete. They simplify and speed adoption by shouldering tasks that they can do better, cheaper and faster. The greater the gap between your service and your customers’ ultimate needs, the greater the value delivered by the SaaS channel partner and the greater the SaaS channel opportunity.

SaaS Total Cost of Service – Visualizing the SaaS Channel Slice of the Pie

I like to visualize this as the cloud channel partner’s contribution to total cost of service (TCS), because the success of your cloud channel strategy will always hinge on a) your cloud channel partners’ ability to make money and b) your customers ability to realize value that exceeds total cost of service, including the money made by your cloud channel partner.

Developing in the Cloud: The Emerging PaaS Channel Opportunity

The problem with SaaS channels to date is that there simply has not been enough for them to do. I think this is about to change, but I also think it will happen one layer down in the cloud technology stack. If you examine the raison d’etre for the vast array of enterprise software channels it comes down to the fact that enterprise software is delivered in an unfinished state, leaving plenty for enterprise software channel partners to do and lots of it requiring very specialized technical knowledge with which customers simply don’t want to bother.

These attributes are also present in the emerging platform-as-a-service space (PaaS). Whether it is building, deploying and managing a new application on Amazon AWS or simply extending and integrating existing SaaS applications using the ever expanding pool of Web services APIs, the number of opportunities for pure cloud-based development is increasing and is sure to grow to a scale that rivals enterprise software. Unlike SaaS applications that are designed with the business user in mind, PaaS and IaaS offerings are designed for developers. They are by their very nature brimming with potential value, unfinished and highly technical–making them ripe for channels.

Whereas SaaS providers have struggled to develop the interest of potential SaaS channel partners, IaaS, PaaS, and PaaS tool vendors are likely to find their businesses increasingly dependent on cloud channel partners focused on pure-cloud application development and deployment. Moreover, you can expect these cloud channels to spark a proliferation of home-grown development, deployment and monitoring tools that will ignite and accelerate the already hot PaaS tools sector as cloud channel partners product-ize their home-grown systems and take them to market.

So, if you are an enterprise software channel partner and have been scratching your head for the last few years trying to figure out how to jump on the cloud channel bandwagon, then think PaaS channel not SaaS channel. And, get started already or you may miss the boat.

This may sound like evangelical cloud mumbo jumbo, but I’m actually alluding to the central importance of the ongoing customer relationship in the SaaS business model and its direct linkage to the financial success of a SaaS business. In the SaaS business model, the ongoing customer relationship is a continuous source of revenue, cost, business activity and risk. This contrasts sharply with traditional software where the short-term sales transaction has always taken center stage.

A traditional software vendor makes and sells perpetual license copies, whereas a SaaS business makes and sells ongoing service subscriptions. Each new SaaS customer brings a new thread of recurring revenue and cost which are woven into the larger tapestry of customers to create the total SaaS recurring revenue stream and associated SaaS cost of service. This fundamental shift in the unit of value from copies to customers turns the economics of licensed software upside down, and is still an elusive financial concept for the industry when evaluating SaaS costs, profitability, business valuation and capital efficiency.

Customers vs. Copies

In traditional licensed software, value is equated to the intellectual property of the code, and is monetized using copyrights in a fashion similar to books, music, and movies. Volume is measured in licensed copies and value is measured by the price of a license. But in the SaaS business model, volume is measured by the number of customer subscriptions and value is measured by recurring revenue. A software vendor invests in developing code, and then operates a sales and marketing infrastructure that scales to sell more licensed copies. A SaaS business invests in acquiring customers, and then operates a service delivery operation that scales to service customer subscriptions. Mathematically….

software profit = ( license price – transaction cost ) x copies – R&D costs

SaaS profit = ( recurring revenue – recurring service cost ) x customers – acquisition cost

Operational costs that are fixed relative to the number of license copies sold in the software business model are now variable relative to the total number of customers in the SaaS business model, such as product development which in SaaS becomes part of the recurring service cost and extends far beyond the initial source code investment to the entire business infrastructure (see note below: Breaking Down Total SaaS Cost of Service and SaaS Do #5 – Build the Business into the Product). Alternatively, sales and marketing costs that are variable relative to the number of license transactions in the software business model are suddenly fixed customer acquisition costs relative to the total number of customers in the SaaS business model, variable instead with the number of new customers.

Happy Customers Drive SaaS Business Model ROI

Capital efficiency is about achieving the highest possible return on investment (ROI). High ROI in turn is achieved by minimizing the up front fixed costs of a business and then maximizing margin by scaling revenue well in excess of variable costs. Like putting a down payment on a rental property, and then making sure the the rental income covers the operating expenses and interest payments. In the license software model, capital efficiency is measured by product ROI, but in the SaaS business model the best measure of capital efficiency is customer ROI, or the average customer rate of return (aka Joel’s SaaS Magic Number).

Where “ARR” is the average recurring revenue per customer, “ACS” is the average recurring cost of service per customer, and “CAC” is the average customer acquisition cost. Software ROI is achieved by selling more copies to cover your R&D investment. SaaS ROI is achieved by acquiring more customers and maximizing customer lifetime value through upselling and retention to cover your customer acquisition cost.

In the end, it all has to add up to happy customers. Service subscriptions are perishable. They can’t be copied and stored like a book or a movie or a software CD. A SaaS business without customers simply doesn’t exist—like the sound of a tree falling in the woods with no one around to hear it. In the SaaS business model, the customer really is king.

From time to time, I come across what IMHO are really fantastic and enlightening blog posts and SaaS best practice guides that truly stand out above the rest….by authors other than Chaotic Flow . To me the value of these gems is immeasurable, because I generally have to read through a lot of crap to get to them. It’s a big Internet.

In the hope of adding more value than I alone can muster for my loyal Chaotic Flow readers and in the spirit of supporting the authors of these high quality gems by spreading their words to my small corner of the SaaS and cloud computing business community, I’m launching a new SaaS best practices community blog companion to Chaotic Flow dubbed Open Current (cute right?).

Open Current is an open repository of SaaS best practice insights and tools for executives charged with building SaaS and Cloud Computing businesses…moderated by yours truly, so ONLY THE BEST will be make it through the rigorous evaluation process (basically, I have to read it and think it’s earth-shatteringly good…but, please don’t let that deter you….help wanted, submit your favorite SaaS and cloud related posts!)

ANYONE CAN POST to Open Current and I need your help! Please comment on this post, email info[at]open-current.com, or directly submit your favorite SaaS and Cloud Computing blog posts, SaaS best practice guides, and industry research and reports for inclusion.

Pure on-demand software-as-a-service businesses are difficult to build.  It is the rare B2B SaaS startup that masters all the Dos and Don’ts of SaaS Success from the beginning.  When the going gets tough, many find themselves falling back on traditional enterprise software approaches to product delivery and business operations.  However, there is a big difference between making the strategic decision to deliver your product in a hybrid model and stumbling into a hybrid model through tactical mistakes. In the first instance the market requirements demand a hybrid approach, in the second executive management is simply not disciplined and creative enough to avoid it.

In an earlier post, I presented the relationship between pure on-demand SaaS and it’s closest hybrid cousins: managed services, packaged software, and enterprise software. The four models differ along the dimensions of pure commodity product (SaaS and packaged software) and pure online delivery (SaaS and managed services).  When a business travels down the hybrid path, it is making a choice to deviate from pure on-demand along one or both of these dimensions.  The farthest deviation being enterprise software. Seems straightforward enough.  So, why avoid a hybrid approach?  Let me state up-front that there are markets that absolutely demand a hybrid model—-a great example is anti-virus software, which requires a fat client for rapid response (packaged software), Internet delivery of virus definitions, software updates and threat alerts (SaaS) and a semi-automated, labor-intensive process for collecting, analyzing and categorizing threats (managed service). However, it is much more often the case that complex market requirements provide the rationalization for poor management rather than the rationale for good business strategy.

The Perils of Hybrid Models
Competitive advantage in SaaS is built by leveraging the Internet to lower costs through economies of scale or to develop differentiation through network-native capabilities. Moving away from a pure commodity product (toward managed services) breaks economies-of-scale, while moving away from pure online delivery (toward packaged software) breaks network-native capabilities.  Deviation due to a lack of discipline without compelling market requirements results in the textbook failure of competitive strategy:  getting stuck in the middle.

“The firm stuck in the middle…is almost guaranteed low profitability
…probably suffers from a blurred corporate culture.”

Sound familiar?  This is the primary reason that some of today’s most well known SaaS companies have yet to attain profitability.  It has nothing to do with the so-called up front investment costs of building a SaaS business (seriously…do NetSuite, Omniture and Success Factors ever plan to stop posting losses?).  They have given up too much competitive advantage in pursuit of revenue from markets where they are not competitive or from customers that they cannot serve profitably (as evidenced by this nice little financial analysis by Bob Warfield).

The Right Way to Go Hybrid
Many markets present challenges along both the dimensions of product uniformity and online delivery.  Unique customer processes,  complex technologies and heavy integration requirements for example can all create serious strategic hurdles.  To overcome them successfully, it is essential to be clear about exactly the business you want to be in and exactly where your competitive advantage truly lies.  If your competitive advantage comes from Internet-based innovation, but you have very unique and demanding customers that require you to customize your product or services, then mixing SaaS with a managed services approach might be the right choice, because the premium you can charge will cover the hit to your cost structure. If you are a low cost, commodity SaaS player, buy our product requires lots of configuration and integration to be useful, then having some offline software components and on-site professional services for on-boarding and account management might be the preferred solution as long as they are highly standardized and don’t undermine your fundamental cost advantage by breaking the uniformity of your primary SaaS infrastructure.  But, don’t get stuck in the middle by chasing revenue that forces you to give up your core competitive advantage and results in the loss of long-term business profitability.

I consistently find myself lamenting the dearth of creativity in the SaaS community. Too many SaaS applications that could be as exciting as the Internet itself are offered up as enterprise software pushed through a browser, simply cheaper (and slower) than their otherwise indistinguishable client-server predecessors.

However, creativity is not easy to come by in any profession. Several years back, I found myself working in Delhi for about a month. In addition to work, my wife Christy and I set out to experience as much Indian culture as the trip would allow, visiting all manner of villages, markets, museums, shrines and the like. Christy, who is an artist, spent a great deal of time being driven around by the local Delhi taxi drivers in search of Indian miniature paintings, and never failed to bring back an interesting cabbie story as a bonus–mostly about wrestling with the driver in order to go where she wanted to go as opposed to where he wanted to take her…always a very special shop. While out on one of these adventures, she decided to go see a real Bollywood film at a local Delhi movie heater. The driver (who preferred to take her to a shop) said “Why would you want to do that? Have you seen one before? There are much more interesting things to do while you are here. Those films are all the same. If you have seen one, you’ve seen them all. There is a good brother and a bad brother. And, a pretty girl. In the end, the good brother gets the girl. Then, dancing! The end.”

Several weeks ago, Christy and I enjoyed seeing the film Slumdog Millionaire, which last night won Oscars for Best Picture, Best Director, Best Screenplay, etc. To our unbridled amusement, this was exactly the plot of the film. In truth, the film not only appears to lack originality, it is also highly derivative.  Produced out of the UK, it incorporates a wide array of European and Hollywood tricks. So, what makes it a great movie? The real creativity lies in its synthesis, not its originality. The decision to reuse this worn out Bollywood motif right down to the dancing that evidently even the Delhi drivers know as well as any film critic was clearly done with intent, perhaps for irony or humor or formulaic box office success or for all of the above. But, the film also weaves together a wealth of authentic India modernity from slum children and organized crime to reality TV and the indeterminate values of the new Indian middle class, while simultaneously staying true to its traditional genre.

It seems to me that if a little creativity can transform a mundane plot line into an award-winning film (and book), and for that matter if a kid from a Mumbai slum today can dream of being a millionaire, then software-as-a-service can aspire to be more than a cheap client-server application delivered through a browser. If a software entrepreneur is willing to risk savings and security in pursuit of a vision, then that vision should be well worth the risk. What makes software-as-a-service exciting is not the ability to deliver a tired old business application at a lower total cost of ownership, but the power to tap into the potential of the Internet and synthesize something new that alters the business landscape. From e-commerce to social media, the Internet offers a copious supply of ideas from which to borrow and blend into creative opportunity. For example, while most business customers now reside a single mouse click away, no leading SaaS customer relationship management system actually reaches out to them in any meaningful way–unless of course you count Internet advertising platforms. Which I do, because they are probably the best example of the transformation to which every software application should aspire as it moves to the Web. And, the fact that Google did not invent Internet search or search advertising, but instead evolved and synthesized them into what they have become is a lesson that should not be lost on any of us.

Since it’s inception, software-as-a-service has labored under an identity crisis. What truly distinguishes SaaS from software? How should it be priced, sold and serviced? Is it possible to succeed with a hybrid approach where a vendor offers both SaaS and software versions of a product? Recently, Jeff Kaplan reported that Google will be offering Gmail as an installed service–flying in the face of the current conventional wisdom that SaaS players should stay true to their model. Alternatively, Oracle is finally making a serious challenge to salesforce.com with its Oracle CRM OnDemand (I know because their sales reps keep calling me, but I’m still not buying it).
What does it all mean?

First and foremost I would like to say that IF YOU ARE A STARTUP, it doesn’t matter if you are offering enterprise software, B2B software-as-a-service, online games, or even hardware—STICK TO ONE BUSINESS MODEL!!! Handling multiple business models almost always entails increased organizational complexity and heightened internal politics. It is often essential to separate organizational functions (e.g., sales, marketing, engineering, etc.) or even entire P&Ls (e.g., divisions, spin-offs, etc.) in order to achieve the right cost structure and culture required to be successful in each line of business. In short, it is death to a severely resource constrained company.

The most common software technology distribution models arise naturally from the economics of information goods. Computer software does three basic things: copies data, transforms data, and moves data. But, the unique thing about software (unlike hardware) is that it just happens to be made up of data itself. Why is this important? Because the costs of copying, transforming and moving data around is decreasing everyday, and in many circumstances it is economically equivalent to zero. This is why so many Internet applications are free! The more a software application lends itself to this sort of self-referential automation, the lower it’s cost. Pretty theoretical, so here it is in plain English. Custom applications are hard to deploy (copy and transform) and fat or data-intensive applications are hard to deliver over the Internet (move). And, here is the picture.

How costs give rise to different software distribution models.

The more you can align your business model with the underlying economics of the technology, the better off your will be. Perfect alignment is rarely achievable, because your customers will pull your business in one direction, while your technology will pull it in another. So, choose your customers and your technologies wisely! However, here is how the most common software business models line up with the technology choices above.

Aligning the business with the technology distribution model
increases competitive advantage and profitability.

Now let’s say you’ve done everything right. You’ve built it, but will customers come?  Ultimately, it is the alignment between your offering and your customers’ needs that should determine your business model. Even if you follow all the Top Ten Dos and Don’ts of SaaS, if you offer an on-demand product that no one wants to buy or use over the Internet, then you still have a clear recipe for failure. Alternatively, selecting the approach that best fits your customers’ needs, but then failing to execute cleanly on key business or technical dimensions of your chosen model can lead to an inferior competitive position and poor profitability. Success depends on first choosing the right customers, then choosing the right business model for those customers and finally achieving coherent alignment between your customers, your business and your technology.

Short list of customer needs that align well with each respective business model,
e.g., Does the customer’s business derive competitive advantage from the application?
Does the application automate a process unique to the customer?
Can the customer transfer risk associated with the application to the vendor? etc.

Confusion usually arises when you start with the technology, but it doesn’t align coherently with your chosen business approach or your chosen customers, i.e., we have this cool new technology, let’s find someone who needs it, and then see if we can get them to pay for it. It’s OK to start with the technology first, that is the nature of innovation, but the customer need and business model economics should be vetted prior to writing a single line of code if you want to maximize your chances of success.  But, it’s usually a lot clearer when you can start with the customer need and work your way back to the right business and technical approach.

Finally for the SaaS and software zealots alike. As the costs of data replication, transformation and distribution continue to decrease, the technological pressure to move everything online will become more and more irresistible. But, when customer needs are intractably unique, risky and complex, on-site software will remain the preferred alternative.

At the end of 2008, I promised a special new year post on SaaS Model Economics 101, so here it is.  Introducing the SaaS Scorecard, an online test to estimate the competitive advantage of your software-as-a-service business.

Click on the image above to go to the SaaS Scorecard and take the test.

The SaaS Model Scorecard is designed to help software-as-a-service entrepreneurs and investors evaluate the competitiveness of their businesses relative to licensed software and other SaaS competitors using the principles of SaaS Model Economics 101 and the Top Ten Dos and Don’ts of SaaS Success. Every attempt has been made to create a test that accurately reflects these economic principles, however, the goal is simply to provide feedback as opposed to analysis. That is, it’s really just a game. Have fun!

Scores are calculated across 20 key business dimensions that impact low cost advantage, differentiation, adoption costs, switching costs and network effects. For each dimension, a score is calculated for the potential competitive advantage that can be achieved, the current performance of the SaaS vendor in achieving it, and the combination of potential and performance resulting in the actual competititive advantage that is realized.

I’ve recently been asked a lot of questions like the following:

• Are there some applications that don’t fit the SaaS model ?
• When is the SaaS model appropriate ?
• Is it possible to have a “mixed” SaaS model ?

Mostly these are asked by startups that are struggling for growth or profitability and having difficulty actually achieving my Top Ten Dos and Don’ts of SaaS in practice.

To answer these questions accurately, it’s essential to have a strong understanding of how the SaaS model creates economic value over in-house, licensed or home grown software.  If you can create value, then the model is appropriate.  If you can’t, then in-house software is an equal or better choice.  And, as a SaaS vendor you will have no competitive advantage.

Be warned, that there will be few fluffy marketing tips in this post and the saas model economics series to come, and you are likely to encounter some very specific economics terminology.  This is SaaS model economics 101! It’s going to get a little heavy.

The only difference between software and software-as-a-service is that SaaS is delivered over a standards-based network called the Internet.  Therefore, all new economic value and competitive advantage must flow from this difference.  SaaS model economic value over software comes in two Web-enabled flavors:

1) A lower cost structure from economies-of-scale that derive from aggregating customers via the Web onto a single, vertically integrated infrastructure i.e., hardware, software, maintenance, etc. This cost savings is generally passed on to the customer through a low subscription price and is generally referred to as the SaaS model lower total cost of ownership (TCO)

2) Reengineering business processes by leveraging network automation e.g., online trial, integrating local offices, support chat, etc. and network effects, e.g., crowdsourcing, support forums, revenue-sharing monetization, etc.

Both of these sources of value can create sustainable competitive advantage for the SaaS vendor, 1) is a low cost advantage and 2) is a source of product differentiation.

However, when the nature of your customers, application or technology limit your ability to create value from either of these sources, then you have reached the boundaries of the SaaS model for your business, because beyond these limits there will be no competitive advantage over in-house software.

Some markets have customer’s whose needs are so unique and applications that are so complex that they are intractably fragmented and customers cannot be aggregated onto a single, uniform infrastructure. For these customers, the SaaS model would simply be a foolish choice.  Alternatively, a market may be appropriate for software-as-a-service, but the SaaS vendors may not be building their product to leverage the potential of customer aggregation and the general principle that their SaaS offering is part of the Internet.  In either case, the only possible business result is failure.

If you read between the lines of my Top Ten Do’s and Don’ts of SaaS, you will see one or both of these economic truths shining through.

This will be the first post in a (thankfully) short series where I try to hone in on the economics of competitive advantage in the SaaS model.  The next three posts in this series will dig deeper into each of the following economic factors that can determine the long term success or failure of a SaaS business.

• Aggregating customers for a low cost advantage
• Leveraging the Internet for differentiation
• Reducing adoption and switching costs

Expect a new SaaS Model Economics 101 post each week in December (minus the holidays)
…and a surpise final post right after the new year!

JY

It has taken almost a decade for the software industry to absorb all the ramifications of moving from perpetual license pricing to SaaS subscription pricing. The longer payback period for investors, the headaches of high acquisition costs, and the upfront pre-revenue investments in infrastructure being just a few of the issues with which SaaS entrepreneurs and VCs have had to wrestle.
So, why go out on a limb looking for new revenue and higher margins by experimenting with even more unconventional monetization models? Won’t this just make a bad situation worse?

To temporarily borrow a well known trademark, the reason is simple: it’s the network. If there is a common theme emerging from this short list of dos and don’ts then this is it. It’s the network. It’s the Web. SaaS is not software. New business value arises from the characteristic that your software-as-a-service offering, unlike licensed software, can become a network hub that can connect any business entity, user or system it touches to any other: your prospects, your customers, your partners, your customers’ customers, your customers’ vendors, your customers’ partners’ customers, and so on all the way out to the edges of the Web. Given that value is created by the network, it follows that new network-based monetization opportunities are also created. Here is a quick (and very incomplete) list of new monetization opportunities open to software-as-a-service businesses.

Network-enabled services

• Advertising
• Syndication (content/applications/data)
• Benchmarking and market intelligence
• Integration
• Cloud services
• Marketplaces

Revenue models beyond subscriptions

• Referral fees
• Transaction fees
• Consumption-based pricing
• Performance-based pricing
• Reseller margin
• Revenue sharing

The monetization opportunities open to you will depend on many factors, including the nature of your business, the attitudes of your customers and the sophistication of your product. But most importantly, it will depend on your own creativity.

In the first post in this series, I presented a somewhat trick question in the hope that anyone who digested the entire series would have no difficulty coming up with the right answer.

Quiz: What is the most successful enterprise SaaS application to date?
Hint: It’s not Salesforce.com

For those of you who have read all 5 posts in this series, thank you for your patience. And, if you haven’t guessed it already, the answer is…

Answer: Google Adwords

If you own, manage or are considering starting a software-as-a-service business, then you can’t afford NOT to check out these fundamental rules of the game and cutting-edge tips for success.
Hot off the presses!
Enjoy,
JY

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Click the image above to download the SaaS Top Ten PDF.

Or, click to read the SaaS Top Ten Dos and Don’ts online >>>

Because B2B SaaS roots are in enterprise or office software which have traditionally been delivered on a CD, i.e., like any offline commodity that is physically seperate from the business itself, the opportunity to change the game by building your business into the product is one of the most overlooked by SaaS vendors.

When you move your software product online into a software-as-a-service delivery model it enables you to connect the product directly to your customers on the outbound side and directly to your internal systems on the inbound side.  I’ll dig deeper into how you can leverage this for your customers to create disruptive economic shifts in the market in another post, but for now I want to focus on how this enables you to reengineer your fundamental business processes by building them out from your product.

Perhaps the best role model for building the business into the product is one of the earliest Internet success stories: Amazon.com.  Although most of what you can buy at Amazon is a physical product, the fact that it gets shipped to you is almost an afterthought–you could achieve the same purpose by ordering through an offline catalog.  What you are really buying when you shop at Amazon is convenience and credibility, and these capabilities are fundamentally features of Amazon’s SaaS application.  It includes affiliate referrals, product search, offers, recommendations, one-click checkout,  order management, support and nurturing. More specifically, it automates the buying process. Amazon’s affiliate programs spread points of entry (links!) all over the Web, and when you reach the Amazon website you are naturally led through every stage of the purchase cycle. These are the automated business processes you want to build out from your SaaS product.

Chances are that your business is different from Amazon’s in some fundamental ways, e.g., target customers, product complexity, community involvement, etc.  and you will need to tailor your approach to your market.  But, I’ll bet if you study this success story and fully understand the implications, you will find analogies that you can apply to your business. For example, crowd-sourcing has become a very popular approach to international translations, but Amazon was crowd-sourcing automation of the decision stage of the book purchase process10 years ago by encouraging customers to create reviews and top 10 lists.

This is post number three in a series of five.

For more on how to build your business into the product, check out…

• Software as a service is all about the product
• Build for the long tail and get the rest for free

Succeeding in SaaS requires a fundamental shift in sales and marketing mindset from push to pull revenue generation.  Lower revenue per transaction, and even lower first year subscription revenue creates intense pressure to decrease average customer acquisition cost.  It is not possible to drive revenue through the high-cost offline marketing and sales approach that is well known to enterprise software.

This shift entails an unpleasant loss of control over the sales process and forces SaaS companies to focus more keenly on facilitating purchase than on driving sales.   If this sounds like semantics, consider how you personally develop interest in and buy products on the Web.  Are you more likely to respond to an unsolicited email and attend a Webinar or click on a link in a blog post?  How often do you click on sponsored search links versus organic results?  Your prospects don’t behave any differently.  You as the customer are in control, and there is no marketer or salesperson present to wrestle that control away from you.

With the customer firmly in control, the role of sales and marketing shifts from chemist to catalyst—from driving revenue to accelerating organic growth.  Accelerating organic growth entails stimulating demand and facilitating the purchase process by understanding and leveraging a prospects natural buying behavior. The goal is to eliminate purchase barriers and to respond on-demand with whatever information or motivation is necessary to encourage the prospect to take the next step in the buying process.

Being at the right place at the right time requires up-front investment in so-called free marketing tactics, e.g., SEO, public relations, blogging, social marketing, video, automated nurturing, newsletters, case studies, interactive demos, product trial, etc., so that content is ready and waiting to be served up when needed.   In reality these activities are not free; they are simply free at the time of use, shifting the economics of revenue generation from direct, variable sales and marketing costs to indirect, fixed costs.  In fact, this characteristic provides a convenient financial definition of organic growth:

Organic Growth = New Revenue generated with (near) Zero Marginal Acquisition Cost

No advertising, no outbound marketing campaigns, no sales calls, no technical inquiries, and no manual order processing.    This viewpoint clearly highlights the primary benefit of accelerating organic growth: leverage.  Increasing organic revenue decreases the average acquisition cost per deal and increases overall profitability.  Moreover, accelerating organic growth and lowering marginal acquisition cost systematically expands available market potential by enabling the business to sell to the outer reaches of the long tail.

SaaS business owners and managers should continually ask themselves the simple question: How can I get more prospects to find my product, evaluate my product and buy my product over the Web even if no one comes to work in the morning.

This is post number 2 in a series of 5 on transforming SaaS for Web 2.0 success.

Building a successful software-as-a-service business requires an extreme cultural focus on the product that has more in common with consumer packaged goods than enterprise software.  In my last post, I provided a summary contrast between SaaS and enterprise software business models.  If you look down the SaaS side quickly enough, you should see a tight correlation of ideas around the product itself.  In fact, if you can get your head around two fundamental assumptions about SaaS products, pretty much everything else follows.

1)    There is only one instance of the product…it is a commodity
2)    The product is tightly coupled to operations, because EVERYTHING happens online (ideally).

I believe almost all significant SaaS failures can be attributed to violating one or both of these product fundamentals.  Here are some absolutely deadly mistakes that are a direct result of failing to adhere to these tenets.

Business plan failure – Insufficient demand
Typical Cause
Designing the product for a niche market that is too small and too demanding

Launch failure – High cost per lead and low conversion
Typical Cause
Failure to master online marketing and to build it into the product, e.g., ignoring SEO because it is some kind of black art and prioritizing advanced product features over the ability to provision a trial account and buy online

Adoption failure – Poor organic growth
Typical Cause
The product was designed for the sophisticated buyer, not the long tail.  So, it is too complicated and the purchase process has not been automated.  Prospects cannot find you online, understand the value from your website, try your product, buy your product and start using your product…all without your assistance.

Growth failure – Inability to keep up with demand
Typical Cause
Building an incomplete product with lots of features, loose ends, poor quality and an architecture that wasn’t planned to scale from day one

Maturity failure – Inability to turn a profit because labor costs are too high
Typical Cause
Adding labor BEFORE self-service automation, e.g., hiring too many sales reps instead of developing website content, trial and online purchase or hiring dedicated support staff without full leveraging blogs, forums and instructional video

Overcoming these obstacles requires the realization that SaaS businesses are product-centric, and that the product itself is a living, breathing member of the Web.  The operational implications of this are dramatic, entailing a shift in investment from high labor sales, marketing and support processes to business automation and innovation through the product.

In many ways, marketing a software-as-a-service (SaaS) application is more like marketing packaged software, computer hardware or consumer electronics than enterprise software.  Failure to make this paradigm shift has meant the death of many a SaaS startup.  The reasons are simple.  First and foremost, enterprise software is usually delivered in an unfinished state.  The so-called product is delivered and then configured, customized, integrated and QA-ed onsite to deliver a unique solution–a product of one.  This is more akin to the artisan products of a cottage industry than to manufactured commodities.

The fact that SaaS is a commodity delivered via the Web entails a shift in business model that affects everything from product design to organization design.  Below is a summary of characteristics that contrast the traditional enterprise software business model to the new SaaS business model.

In the world of SaaS multi-tenant architectures and bargain basement prices, the entire business model hinges on having a single commodity sold at high volumes.  Moreover, SaaS is marketed and delivered primarily within a single channel, the Internet.  This creates incredibly tight coupling between the product, business strategy and operations.  In particular, there is an unusual itermingling of the product itself with the other 3P’s of marketing:  price, promotion and place.  For example, a change in pricing model will usually entail simultaneous changes to both your Web ordering code and your license management code.  And, search engine optimization (SEO) is likely to impact how your product is designed and delivered over the Web, not just your marketing website and landing pages.

I was recently asked the question of what is the ideal cost structure for an on-demand software business.  There are very few benchmarks out there of successful mature SaaS companies, so I’d like to propose the following as the cost structure to which on-demand software companies should aspire.  Whether you can actually achieve it in your business is likely to be a result of market demands, technology and sadly enough company culture (as many SaaS business are still saddled with enterprise habits)

Below is what I would characterize as the typical enterprise software company cost structure.  This model is no accident, and it has proved to be immensely profitable over the last 20 years (just ask Oracle and Microsoft).  It is characterized by drivers that work synergistically to create the whole: perpetual license pricing, feature competition, solution selling and customization.  All of these characteristics (and their ensuing complexity and costs) derive from the underlying buyer belief that the system will deliver some level of competitive advantage.  While this may have been true 20 years ago, and may still be true for some fundamental business processes, it is patently untrue for 90% of most IT infrastructure today.  Hence the rise of SaaS and Open Source.

Unfortunately, the preceding paradigm is a self-reinforcing business model that naturally evolves toward this equilibrium.  It is incredibly difficult to break out of economically and culturally.  Below is what I am proposing to be the natural equilibrium cost structure of a well run on-demand software business.

This SaaS business model is equally self-reinforcing and composed of a number of drivers that work together synergistically:  subscription-based pricing, product simplicity, and the continuous automation and integration of marketing, sales and service processes throughout the product and the company’s overall Web presence based on catalytic learning. By catalytic learning, I mean that while sales and marketing still have the tactical role of closing everyday business, they also have strategic role of structuring the purchase process, identifying roadblocks and eliminating them through product-based and Web-based automation.   There should be very little division between the product and the company’s overall Web presence–they should be seamlessly integrated into a single, highly-automated customer experience.  For example, if a customer is forced to pick up a phone or send an e-mail to talk to a person in order to try, buy, deploy, integrate or maintain your product, then your business is not truly on-demand will be bleeding cash from the higher labor costs.  I will also propose that a company is better off starting with this cost structure from the get-go and resisting the urge to chase revenue by adding excessive direct labor resources to the sales and marketing process.  Doing so merely undermines the culture required to build a successful on demand business.  Labor should be highly leveraged through product and the Web automation, so before adding a high-touch resource to hold a customer’s hand directly, you should look for Web/product-based solutions to remove roadblocks to demand generation, trial, close, and use.

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 changed the rules of the game 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 the SaaS model 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 for vendors choosing the SaaS model 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 the SaaS model as the underlying approach to 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 the SaaS model 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.

Fundamentally, the SaaS model 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 success under a SaaS model. 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.