Making SaaS Savvy Investments

The rapid expansion of the on-demand software sector calls for a new a screen to help investors understand which qualities would make a SaaS company a good investment.

By Sarah Friar, Goldman Sachs

Nov. 12, 2007

Software-as-a-Service is the most impactful trend in software currently. SaaS solutions solve many of the problems that traditional software faces, including large upfront license fees, long time to implementation, and access issues by a mobile workforce, outside of the company network. In many instances, customers prefer this style of delivery and the large incumbents have to adjust their strategies accordingly. Over the next several years it will become pervasive in almost all areas of the software market.

As such, investors will need to understand this delivery and business model to properly assess the impact on the software vendor landscape, and will require a new set of criteria with which to evaluate software companies as SaaS investment opportunities.

Market size: A >$100 billion opportunity, but this will be a gradual evolution
The desktop application and enterprise application markets stand at $24 billion and $65 billion, respectively (see figure below).

Total potential market for SaaS applications of about $73 billion in 2005...
$ billions, percentage of total revenue

System infrastructure includes desktop and network security applications, backup and virtualization.

App dev and deployment includes application servers, middleware and integrated development environments (e.g., Visual Studio), and business intelligence.

Desktop applications include authoring and publishing (e.g., Photoshop, Office), entertainment and education software.

Source: IDC Corporation, Goldman Sachs Research

For our market sizing analysis we assume the following:

100% of desktop applications are able to be delivered as on-demand solutions over time. => $38 billion opportunity in 2010.
For the enterprise applications space we assume that approximately 10% of all data will not be able to be accessed on demand per governmental mandates. This would include US government and international government data that is deemed "Top Secret" and thus may not be co-mingled, stored off premise, etc. We also assume that approximately 15% of enterprise applications cannot be designed as on-demand, multi-tenant solutions due to their inherent complexity and highly customized nature. > $76 billion opportunity in 2010.
Thus we get to a $114 billion market opportunity by 2010 (see figure below).

SaaS market expected to grow to $114 billion in 2010
$ billions, percentage of total revenue

Source: IDC Corporation, Goldman Sachs Research

Penetration still low: Currently a $9 billion market, we anticipate SaaS sales will grow at a 23% CAGR over the next four years

We anticipate the SaaS market to reach $9 billion in 2007, growing at a 23% CAGR through 2011, reaching $21.4 billion in that year (see figure below). This dovetails into our total addressable market sizing above by suggesting that 14% of the addressable market will be penetrated by 2010.

Estimated worldwide software on demand revenue (millions), 2007-2011

Source: Goldman Sachs Research estimates and IDC.

Investment screen: The Goldman Sachs SaaS scorecard
Based on insights from conversations with CIOs, VCs, and SaaS as well as on-premise companies, we score a SaaS company's value proposition on the ten criteria that we believe are the most important when judging its likelihood of success. We look at the following characteristics of the application to quickly filter which are particularly well suited for a SaaS model (a higher score indicates a better fit):

The data used by the application either originates outside the firewall or goes outside the firewall at one point in time. If the data is already traveling outside the firewall, this reduces additional concerns the company would have had with the data security. Having the application outside the firewall may also make access easier for all parties who need to use it.
The application is used by a distributed workforce and non-badge employees. The ubiquity of Internet and Wi-Fi connections is making it easy to access on-demand applications on the go, driving adoption of this technology. By hosting the application outside of the company's own network, customers can get help solving the issues associated with compliance and identity and access management with users outside their own company.
A network effect is important. By hosting several customers' data in one place, some SaaS solutions are uniquely positioned to take advantage of potential network effects. For example, seeing security threat information across 100 customers versus just one should provide a better view on the broader threat environment, driving a richer solution for all customers.
Quick implementation required with lower upfront costs to defuse deployment resistance. SaaS solutions can be deployed orders of magnitude more quickly than their classic counterparts and for lower initial deployment costs. For applications that need to be implemented quickly (to meet an impending timeline such as review season or quarter close) this is an attractive attribute.

The application needs very little or no integration with other applications. Currently this seems to be the biggest barrier to SaaS adoption, in our opinion. One customer we spoke with said, "The thing that is always a challenge with Software-as-a-Service vendors is integration. It's even a challenge with Salesforce." We believe that as applications are become more standards based, with standard APIs and the like, this will become less of an issue. For now, however, we would avoid SaaS focused offerings that require too much integration.
The application, in most situations, does not require heavy customization. The architecture of SaaS solutions does not lend itself readily to customization. These types of applications will likely remain on-premise for the near term.
Addresses a business process that should embody a strict process and industry-wide best practices are well suited to SaaS delivery as well. SaaS solutions have limited ability to be customized, so companies that are looking to improve their internal process by adopting standardized best practices will be well suited with SaaS deployments.
Require relatively little training. Intensive training is a hurdle to adoption, which, in the case of a subscription service, can lead to customer churn.
Applications that can be readily adopted by an individual or a small department rather than a whole enterprise. Low subscription costs and quick and easy implementation allows one or a couple of people within a company to try the product easily, without the need to run a budget by higher-ups. No minimum seat requirement should also spur this type of viral adoption.
Are not heavy computationally intensive/time critical. SaaS solutions do not deal well with large amounts of data that need to be processed and passed back and forth between the database and the program. Over time, as speeds increase and bandwidth becomes more readily available, this should become less of an issue.

Scorecard takeaways: In full growth swing; consolidation in leading areas, new company creation rife in middle sections
The SaaS shift is in full growth swing, with certain application segments fairly mature, with others still exhibiting high investment and hence high company creation. We evaluated potential software verticals to see if an on-demand delivery of software is more suitable than on an-premise one. We caveat that in some cases, however, a single attribute (such as a strong network effect, for instance) may trump other considerations, thus we use this is a screen to help narrow a funnel of potential investments but not an absolute right answer. Furthermore, this screen does not address other important stock investment factors, such as management, valuation, product cycles and so forth.

Application segments where SaaS provides a natural fit: Customer Relationship Management, Learning Management Systems... Application segments where the SaaS delivery and business model may provide an advantage over on-premise solutions include Customer Relationship Management, Learning Management Systems, Partnership Relationship Management, and Web Conferencing, while it is likely less suited as a delivery model for Content Management or Data Warehousing solutions.
Horizon 1: Some application segments already have "more mature" industry structures... These application segments are already characterized by fewer new market entrants, consolidation already ongoing (or accelerating), and entry/significant presence from the large software incumbents.
Horizon 2: ...while some are highly dynamic, and in "full throes of combat"... Areas in the middle of our scorecard are seeing significant investment and hence have spawned a large number of market participants, but "the battle" among incumbents is far from decided and fully-blown M&A is yet to take place. Human Capital Management, with all its various flavors, is a key example of this.
Horizon 3: ...while for others the opportunity lies a further out. Segments scoring the lowest on our scorecard (and thus most to the right) have characteristics that are most readily addressed, today, with on premise solutions. That said, as the underpinning technology evolves (higher connection speeds, lower cost datacenters, and business processes that benefit increasingly from a strict process) these too may become ripe for an on-demand transition.
Larger companies are already present in more than one application segments. This mirrors the on-premise software landscape, whereby successful players tend to offer suites of applications--and customers tend to prefer purchasing readily integrated offerings from one vendor.
Not all scorecard criteria need to be present for thriving SaaS offerings. Some verticals, with scores in the 4-7 range, have dynamic, rapidly growing SaaS offerings. Investors should be mindful of one dominant criteria becoming the all important factor for success. A network effect in particular is a facet we would apply a heavier weighting to.

Sarah Friar is a high technology analyst at Goldman Sachs. This is an excerpt from "Getting SaaS savvy—successful investing in on-demand." To receive a copy of the full report, including the Goldman Sachs SaaS scorecard, email Sarah at sarah.friar@gs.com.