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SaaS Companies Vulnerable in a Recession

by: MGI Research

Whether a real recession hits the US and spreads to the global economy or the US economy simply slows down in 2008, all software companies - enterprise-license oriented and software-as-a-service (SaaS) on-demand vendors alike will see a meaningful impact in terms of license revenue growth and maintenance renewals.

SaaS on-demand companies' revenue models are typically based on a number of user seats, so in an expanding economy with growth in hiring, SaaS companies are able to grow within their installed base and capture revenues as their clients expand with the economy. In a declining economy, SaaS companies may take a triple hit as they will see their initial transaction sizes trimmed, upsell opportunities reduced or eliminated, and then there is a possibility that users will aim to reduce the number of subscribed seats.

In practice, it may be difficult for users to instantly dial down the number of subscribed seats, as most contracts are for 12-24 month intervals and there is the pesky issue of SaaS vendors holding the user data making migrations painful. History suggests that if the downturn/recession lasts longer than nine months, we will likely witness a meaningful negative impact on SaaS companies. This is not to say that vendors oriented towards traditional enterprise licensing models will do much better in a recession, but just to point out that SaaS vendors are far from immune to an economic decline.

When it comes to software company performance in a recession, the results will stem from management experience and economic efficiency of the business model. Some of the early SaaS companies were “christened by fire” in the technology meltdown of 2000-2002. The few of these early SaaS adopters that are still run by the original management team are likely to do well if the economy takes a dip. On the other hand, the bulk of the pure-play SaaS vendors were funded between 2004 and 2007, and their management teams will have a steep learning curve when it comes to adjusting their business model to deal effectively with an economic downturn. This is in part due to pure psychological conditioning as industry press and many analysts and investors have already designated the SaaS business model as “superior”.

In reality, “execution is everything” – regardless of the business model. And so far, the economic efficiency of SaaS companies has clearly lagged behind the rest of the applications software industry. In a recent benchmark of applications software companies, the business model efficiency (as measured by the MGI Index benchmark score - the MGI-X) of SaaS application providers has trailed behind the traditional enterprise software licensing oriented suppliers and the sector averages. For example, (NYSE: CRM) placed only 11th out of 65 applications software vendors benchmarked in the study - behind "traditional" enterprise license & delivery model vendors such as Oracle (Nasdaq: ORCL), Microsoft (Nasdaq: MSFT) and Amdocs (NYSE: DOX). Less well known, but a much better example of a well-managed software company with a SaaS/On-demand model is Vocus (Nasdaq: VOCS). Of the sixty five application software vendors we benchmarked, only four out of thirteen pure-play SaaS vendors rank above the sector median.

Some of the reasons why SaaS vendors are not as efficient as their "traditional model" competitors have to do with how revenue is booked on a deferred basis, but in part the inefficiency stems from heavier support and infrastructure burdens that many SaaS vendors have been privately complaining about. In an enterprise model, the user provides the first level of support, but in the SaaS model, most - if not all - support is the domain of the SaaS vendor. SaaS vendors have to run an operations center that hosts the system (or manage a third-party hosting provider). In discussions we have held with some SaaS CEOs, many have expressed a desire for a hybrid business model, a notion that is often at loggerheads with what they are being told by their VCs.

Bottom Line: In the event of an economic downturn, SaaS vendors will be sharing the pain with their enterprise model brethren. With the exception of one SaaS company, MGI Index benchmarks for most SaaS application providers reveal mediocre efficiency scores that are well behind the overall economics of the applications software sector.