How to make money in software
Leading SaaS vendors are following a familiar playbook
In software, data = lock in = $$$
The surest way to make money in software is to build a product that houses a chuck of critical business data.
If a company architects its financial reporting system around SAP, it’s never changing vendors. It’s invested millions into customizing SAP to its purposes and trained teams of people to use it. That’s not to mention the risk of implementing new software and transferring data to a new system. Risky projects get leaders fired. Companies have little appetite for them.
The combination of captive customers and negligible marginal costs has made enterprise software a great business. Vendors historically charged a big upfront payment, along with a perpetual license fee that reoccurred forever. An ERP software installation from 1996 has been spinning off cash to SAP for a decade.
The profitability endgame for on-premise software
I don’t mean to pick on SAP, they’ve just one of many vendors employing the same profitable model. Oracle is the company that’s tested the boundaries of enterprise software’s profitability. Larry Ellison was one of the first to really appreciate the opportunity this customer lock in afforded Oracle. Since 2005, perpetual license revenue and margin growth have far outstripped new license growth as Oracle has raised prices and cut support costs. With no additional selling costs, old software installations became margin machines. Not content with its own installed base, between 2005 and 2009, Oracle spent more than $30B consolidating software application providers. Using similar tactics with newly acquired customer, Oracle is now worth $165B with operating profit margins over 35%.
The more things change, the more they stay the same
Why are we even talking about Oracle, SAP and on-premise software? Perpetual licenses are dead. Savvy companies use SaaS applications and pay on a monthly basis. They’ve ditched Siebel for Salesforce. They can change vendors whenever they want. Businesses have learned their lesson about software lock-in. It’s different now.
Except SaaS isn’t different. Marc Benioff, a former Oracle employee, stole a few tricks from his old company. While Salesforce is delivered as a service, businesses still build their go-to-market reporting infrastructure around the data stored in the application. It’s painful to switch out a company’s CRM because it holds critical business data. Those flexible monthly fees? They’re often tied to binding annual contracts, making them look a whole lot like perpetual licenses.
Salesforce’s annual renewal rates are over 90%. The company is worth $55B with operating profits of only 1.5%. Those margins are low because Salesforce is still spending on sales and marketing to grow its customer base. However, Salesforce is already starting to implement parts of the Oracle playbook. They are getting acquisitive, spending $2.5B on ExactTarget, $2.8B on Demandware and $750M on Krux. Just like Oracle before it, if Salesforce stops growing new licenses, it will raise prices. It will struggle to keep its acquired technology best-in-class. It will be tempted to cut R&D and product support to augment margins. Unfortunately, Salesforce customers don’t have many choices. All CRM systems are designed to hold critical business data, which keeps customers paying for the software.
