SaaS and the Innovator's Dilemma

Looking back on SaaS in 2008, the most interesting thing wasn't the inexorable increase in SaaS's market share, but the vocal backlash against SaaS from the large legacy on-premise software providers:

• First, Larry Ellison reiterated that Oracle won't be aggressively pursuing SaaS because it's not profitable enough.
• Then, SAP followed up on the delayed rollout of its SaaS offering, BusinessByDesign, with comments about needing to optimize it and automate the sales/delivery process so it could be profitable.
• Finally, Lawson CEO Harry Debes trumped everyone with the ridiculous pronouncement that the SaaS market will 'collapse' within two years after Salesforce.com misses its growth targets.

I wondered, if SaaS is such a big part of the future, why are the big players hesitating to jump into SaaS due to profitability concerns, and even dispraging it?

So I pulled down my copy of "The Innovator's Dilemma" by Clayton Christensen, and all was explained within a few pages:

"...despite established firms' technological prowess in leading sustaining innovations... the firms that led the industry in every instance of developing and adopting disruptive technologies were [new] entrants to the industry, not its incumbent leaders."

Very interesting.  Why don't the incumbent dominant vendors invest in disruptive technologies?

"First, disruptive products are simpler and cheaper, they generally promise lower margins, not greater profits. Second, disruptive technologies typically are first commercialized in emerging or insignificant markets. And third, leading firms' most profitable customers generally don't want, and indeed initially can't use, products based on disruptive technologies. By and large, a disruptive technology is initially embraced by the least profitable customers in a market."

So is SaaS a disruptive technology? Absolutely - SaaS meets all of these definitions:

"...disruptive innovations are technologically straightforward. They generally package known technologies in a unique architecture and enable the use of these products in applications... [that] previously had not been technologically or economically feasible."

"Products based on disruptive technologies are typically cheaper, simpler, smaller, and frequently more convenient to use."

"Disruptive technologies bring to a market a very different value proposition than had been available previously."

SaaS repackages software functionality onto a lower-cost multi-tenant infrastructure and a new delivery mechanism (via web browser over the Internet) that greatly improves the value proposition for the customer - faster time-to-value, lower infrastructure cost, and ongoing operating costs rather than huge up-front licenses.

For the SaaS vendor however, the economics are far less attractive than shipping CDs for millions of dollars - SaaS margins are lower than on-premise offerings, due to SaaS's up-front infrastructure investment and deferred subscription payments.

So the major ERP providers are looking at decreased profitability from SaaS offerings, and they are prevented by investor expectations from moving strongly into SaaS. For example, even though SAP has V2.0 of Business ByDesign ready, their CEO said that if they were to start pushing it, "we would be hurting our margin, and hurting our stock."

In addition, "The Innovator's Dilemma" states that incumbent vendors' org structures and skillsets (i.e., what they focus on and do well) are internal impediments to adopting a disruptive technology.

Finally, the ERP providers' most profitable customers don't want SaaS, which "The Innovator's Dilemma" says leads to long-term disaster:

"...the leading firms are held captive by their customers, enabling attacking entrant firms to topple the incumbent industry leaders each time a disruptive technology emerges."

So since he can't offer the SaaS disruptive technology, Lawson's Harry Debes instead puts down SaaS to try to delay SaaS adoption and his firm's inevitable decline. Harry has seen a lot of changes in the software industry over the years, but in comparing SaaS to service bureaus and ASPs he is ignoring two decades of Moore's law that have fundamentally restructured the economics of operating software for customers (i.e., personnel time is now much more important than hardware costs), which makes SaaS's time-efficient value proposition very compelling to customers. Plus, SaaS is lower-cost to deliver than the ASP offerings during the bubble, since SaaS is built for time-efficient configurability and cost-efficient multi-tenant delivery.

SaaS has a better value proposition and better economics for customers, leading to ever-increasing customer demand but lower margins for SaaS providers - the formula for a disruptive technology that topples the market leaders. So my view is that Lawson is much more likely to collapse than the SaaS industry, signalled by the brewing ERP backlash.

Comments

[John F. Martin]

Thanks for the comment and insights on why ISVs are reluctant to switch, Jeff! There's another key reason that makes switching difficult and also allows SaaS companies to deliver more innovation, which I'll address in my next post.

[Jeff Kaplan]

Great analysis! When it comes right down to it, there are three primary reasons why on-premise software vendors are generally reluctant to move to a SaaS model: fear of potential product cannibalization, sales channel conflicts and cultural/operational barriers to success. However, a growing number of established ISV are recognizing that they have no other choice and must confront these challenges. In some cases, this will lead to some bastardization of the SaaS principles. But, it will also bring a new level of competition to the SaaS market.

[John F. Martin]

Mike and Peter, thanks very much for your comments and thoughts. It will be interesting to see how on-premise vendors try to make the move to SaaS. I agree the faster the better - for the reasons in your comments, the most likely approach to succeed is "all new customers after date X must be on SaaS."

[Peter Cohen, SaaS Marketing Strategy Advisors]

Thanks for the insightful analysis. There are, of course, other good examples of this resistance to innovation in the computing market. In the glory days of the minicomputer market, Ken Olsen of Digital Equipment referred to the PC as a "toy."

I'd suggest that the on-premise vendors may be making the move toward SaaS more difficult for themselves by trying to offer both options at the same time. They're thinking about SaaS simply as a different delivery mechanism, not as an entirely new business model which requires changes across the entire organization. As anyone who's waded across a fast-running stream knows, you're OK on one side or the other, but standing in the middle or trying to straddle both banks is very difficult.

[Mike Dunham]

Good write up - a couple of things that make the case stronger:

Infrastructure for a SaaS offering don't need to lead demand by a great deal if the instructure itself is cloud based and can both expand and contract to meet demand.

Subscriptions doen't have to be deferred, they should lead usage or be transacation-based, but it is certainly right to say that it is a big change for ISVs tied to a version upgrade cycle and big cash licenses. Premise-based ISV skills too are very hard to align with SaaS. Along with the economy, companies of all sorts need to operate lean and mean. The question for a lot of ISVs is - can we afford to run a development cycle for the next version and then lose sales to a SaaS alternative?

Unfortunately, for most the quesiton will be pushed aside and as you point out, the advantage will go to break out innovators. There will be a lot of thrash over the next couple years.