Updated: Jul 9, 2020
There is often a significant disconnect between SaaS pricing and what it actually costs the SaaS vendors to host and support their application. SaaS customers have been trained to believe that moving solutions to the cloud will realize tremendous savings and efficiencies, as data center, infrastructure and support costs can be reduced or eliminated. However, in many cases, they’re being exploited. And it only gets worse at renewal time.
Many SaaS suppliers, such as Salesforce and Workday, store their user data on Amazon Web Services (AWS), because it’s cheaper and more secure than hosting it themselves. At the same time, IaaS providers like AWS take advantage of the dynamic cost reductions caused by decreasing infrastructure costs, improved operational efficiencies and increased fixed cost leverage. We’ve seen AWS’ operating margin almost double from 12.5% in Q1 2015 to 23.5% in the same period 2016.
Researchers at Seeking Alpha (a provider of stock marketing insights and financial analysis based in New York City) predict AWS’ operating income will continue to increase sharply: “The rack storage systems at AWS have reached the critical tipping point where their cost is already heavily amortized and could be passed along,” notes a December 2016 report. AWS is passing along some of these cost savings to their SaaS customers, but the savings are not trickling down to the SaaS vendors’ end users. Instead of passing along the savings to their customers, SaaS vendors use these savings to improve margins.
“Gross margins increase gradually over time and reach 63% after five years of operations. This is a result of accumulating subscription revenue and the (SaaS supplier’s) ability to amortize its hosting costs over more customers…. We note that for the software suppliers we interviewed, gross margins ranged from 40% to 70%, and these gross margins were achieved after five-plus years of selling SaaS products.”
According to a 2016 Forrester Total Economic Impact Study (commissioned by Amazon to document how building SaaS solutions on AWS can play out): What – if anything – can SaaS customers do to capture more value from their SaaS suppliers? First and most importantly, we know that they must negotiate with leverage to ensure they get the lowest price possible, and make sure their renewal rights take advantage of the decreasing costs in IaaS. However, they only have leverage when they start early, are organizationally aligned in the purchasing process and bring a long-term financial discipline to SaaS decisions. The purchase decisions must be TCO-based, and benefit from the cost elasticity that the vendors are experiencing.
Further, customers benefit when they can:
Use competing suppliers where possible and not "single thread" their vendor evaluation
Develop viable alternative solutions early in the term of the contract
View the cloud as an annuity spend, not as term spend
Inspect usage model carefully and start small (you can always buy more)
Lock in renewal rates and functionality at the start of the contract
Ensure a "soft landing" in SaaS contracts that maintains leverage after the purchase and allows option to terminate with minimal disruption if necessary
In short, SaaS customers are encouraged to become more expert at modeling, analytics and finance. They are being asked to think and speak in business terms, not in terms of technology. They must broaden their knowledge of deal making beyond the price of the solution, and fully understand all aspects of the SaaS spend over the long term. This includes the legal obligations in the contract, future product price holds, security requirements, disposition of key data at contract end, and subscription payment timing. Add to this list the possibility of changing licensing metrics, or your company may expand or contract affecting demand models, or the SaaS company itself could get acquired by another company, all of which would impact your agreement.
All of these variables must be considered and factored into the deal at the beginning, otherwise it’s too late. In other words, companies must exercise sound financial discipline from pre-deal all the way through the sunset of their investment, often many agreement cycles in the future.