The days of downloading software to your desktop or a local server now seem like a distant memory. Today, software is increasingly hosted in a remote datacenter (aka the “cloud”) and accessed on the Internet via a web browser or mobile app. The implications are far reaching. The shift has not only changed who buys and sells software, but also how it gets sold.

In this blog post, we explain what ‘Software-as-a-Service’ (SaaS) is, discuss the enormous growth potential that remains, and describe a few areas we are seeking to capitalize on for client portfolios.

Software-as-a-Service

In the past, software vendors sold expensive licenses allowing customers to download a specific copy of the application to a local server. This meant customers had to invest in data centers to host the software, as well as pay staff to maintain, secure, and customize it.

SaaS vendors flipped this model on its head. Instead of the customer investing in servers and networking gear, the hardware running the software resides in a remote datacenter managed by the SaaS provider. The software application is then delivered “as-a-service” to the end-user in exchange for a monthly or annual subscription fee.

This new cloud-based SaaS world is a win-win. Customers win by always having access to the most up-to-date software, increased security, and a lower total cost of ownership (by virtue of outsourcing hosting and maintenance). For vendors, SaaS improves the consistency and visibility of revenues while simultaneously enabling them to generate more revenue over the life of a customer.

Software Eating the World

This win-win situation is driving an explosion of SaaS solutions throughout seemingly every category of enterprise software. These include traditional corporate applications in sales, customer service, marketing, project management, human resources, finance, and more.

The flexibility and agility provided by SaaS solutions is also expanding the total addressable market (TAM) for software vendors, enabling them to target new customers and end-markets. For example, small businesses who historically couldn’t afford the relatively high up-front costs associated with building data centers and buying software licenses can now subscribe to a wide variety of SaaS applications online without any up-front investment. These purpose-built, easy-to-use SaaS apps are increasingly replacing heavily manual and/or labor-intensive processes that historically relied on emails and spreadsheets. As a result, software is experiencing a ‘Cambrian explosion’ that is dramatically increasing the breadth and diversity of vendors and applications.

Growth at All Costs

From an investment perspective, SaaS vendors who have reached scale operate a highly attractive business model characterized by steady recurring revenue streams, low marginal costs, and high incremental margins (operating margins of 30-40% are not uncommon).

These attractive characteristics are also a strong inducement for SaaS vendors early in their lifecycle to invest heavily in new customer acquisition, hoping to recoup their investment over time in the form of recurring subscription fees. This revenue-cost mismatch often obscures the underlying economics of SaaS companies that are growing quickly, increasing the importance of identifying those vendors who benefit from high switching costs and/or barriers to entry.

Not all SaaS businesses are created equal. We believe there remains opportunity for investors, despite the high valuation multiples currently sported by most public vendors. Distribution, developer/partner ecosystems, and network effects are all sources of sustainable competitive advantage in this industry, and often serve as a signal that customers acquired today will stick around well into the future. But conviction in the long-term durability of SaaS revenues and cash flows only occasionally justifies the market’s enthusiasm for these businesses, and identifying durable competitive advantages is easier said than done.

Our approach is very particular, and we are choosy about the businesses we invest in. In general, we are looking for opportunities where investors are underestimating the durability of growth and the potential for significant margin leverage over time. Among those we consider investment candidates include vendors of sales-enablement tools, workflow automation/service management platforms, and forecasting/planning solutions.

As always, our investment teams will continue to monitor the entire enterprise software space for emerging opportunities and rising risks, keeping in mind our time-tested, valuation-conscious disciplines.

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