Transitioning to a SaaS Model

Software companies have historically generated revenues through traditional license based models. With a traditional license based model, a company selling the software would receive either a one-time payment for a perpetual license or a monthly fee for each month of a term license contract. In both instances, the customer would be responsible to install, run and maintain the software on their own computer hardware. A recent development in the software industry has created a migration from this traditional license based model to a model known as Software as a Service (SaaS). The introduction of this SaaS model has swung the pendulum with respect to how software companies are thinking about their business models. The SaaS model is closely related and similar to the models of both application software providers and on-demand delivery.

The SaaS model provides for the vendor selling the software to host the application on its computer network via the Internet. Customers do not take possession of the software; they alternately pay a monthly subscription fee to gain access. This model creates advantages to both the vendor as well as the customer.

The main advantages of this method with respect to the vendor are that earnings are more consistent and easier to forecast. In addition, the volatility in earnings process is alleviated due to the fact that SaaS provides for a subscription model for revenue recognition. Revenue is recognized on a monthly basis as the services are performed (i.e. as the customer has the ability to access the hosted application). According to an article authored by Sarah Friar from Goldman Sachs, “SaaS solutions solve many of the problems that traditional software faces, including large upfront license fees, long time to implementation, and access issues by a mobile workforce, outside of the company network.” It must be noted however, that the vendor must integrate contractual terms into the entire revenue process from order entry through financial forecasting in order to make this model work. In other words, simply moving to a SaaS model from a traditional license based model without reorganizing the accounting and computer software infrastructure will cause great difficulties in the software vendor’s ability to accurately and timely report financial information.

Customers can also take advantage of this model. In the traditional license based model customers are required to undertake significant fees up front in order to purchase the software from the vendor. On the other hand, SaaS allows the customer to pay a monthly subscription. Therefore the customer does not have to outlay a significant amount of cash at one time, and can still enjoy the benefits of the software that they were initially inclined to purchase. SaaS is usually priced on a per user basis, sometimes with a relatively small number of users. Additionally, the customer does not have to undergo the effort of maintaining and supporting the software. With this being a hosted solution whereby the vendor maintains these responsibilities, the customer can concentrate and devote time to their business activities and not on the software.

The most critical accounting policy that software companies include in their financial statements is revenue recognition. Companies utilizing this software as a service model must follow the revenue recognition guidelines in the Security and Exchange Commission’s Staff Accounting Bulletin (SAB) 104 Revenue Recognition as well as the AICPA’s Statement of Position (SOP) 97-2 Software Revenue Recognition. In most cases the revenue generated from these subscription contracts will be recognized ratably over the contractual term as long as all of the other basic revenue recognition criteria have been met. Such criteria include the following: (1) existence of persuasive evidence of an agreement, (2) delivery has occurred or services have been rendered, (3) the seller’s price to the buyer is fixed and determinable, and (4) collectability is reasonably assured.

In November 2007, Goldman Sachs described Software as a Service model as “one of the most important trends in software at present, and will become pervasive over the next several years,” as reported by Barron’s. Goldman Sachs continued by stating “We expect SaaS to expand the total addressable market for enterprise application software, with growth in SaaS outpacing growth of the overall software market for the next three to five years.” A Gartner Group report published earlier in 2007 said the same thing in a different way: SaaS sales soared to $6.3 billion in 2006 and now predicts the market will eclipse the $19 billion threshold by the end of 2011. IDC has similar expectations, pegging annual compound growth of roughly 32 percent for the next four years and total SaaS market of roughly $15 billion by 2011.

The industry buzz surrounding SaaS has definitely changed the landscape of the software industry. Companies that never considered this model are now seriously evaluating the pros and cons to determine whether this model will provide for increased value to shareholders and owners.

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