SaaS, Subscription, and On-Premises Software - Don’t Confuse Subscription with SaaS

June 11, 2020

You hear the terms SaaS, subscription, term licenses and perpetual license software tossed around frequently.  The terms aren’t universally understood, nor are the implications of each on the financial model of a company, so the following is an effort to provide an overview. At OPEXEngine, we pull apart the different nuances of each business model to make sure we are benchmarking companies correctly.  

We sometimes hear companies call themselves “SaaS” companies, because they sell subscriptions, but they do not host software.  In addition, we help companies understand these different models, so they can compare themselves to the right peer cohort in our database.  When there is not a perfect peer cohort for a particular company’s model, we help them interpret the data to understand the differences.

Software-as-a-Service (SaaS) encompasses both product, product delivery and financial/contractual aspects of the vendor/customer relationship. In addition, it affects cash flow. It changes sales and marketing organizations and their execution.  SaaS companies have to focus both on new customer acquisition as well as retaining and delighting customers throughout the customer relationship.  The SaaS company needs to have the functional structures in place to support the full continuum of customer relationships.In a SaaS model, the customer “rents” the use of a software product – the customer has the right to use the software but does not own it.   The product is hosted by the vendor or a 3rdparty (like AWS).  The customer has access to a continually updating product and pays the vendor a subscription monthly, quarterly, or annually.  Most SaaS companies do not charge additionally for maintenance or support, although some companies have an additional charge for higher-level support with faster response times, etc.  However, many SaaS companies charge for a “premium” version, which in effect, is charging extra for additional services but those services are part of the product pricing.SaaS affects the vendor’s financials primarily in that the vendor is carrying the cost of the hosting and updates of the product (COGs), and the vendor has to invest in customer success and other programs to ensure retention (can affect COGs, Sales, and Marketing.  Subscription payments are smaller and cash flow is reduced initially, but once a base of recurring revenues is established, it can generate a great deal of cash flow.  This affects cash metrics, revenue recognition, and expense ratios at differently at different stages.SaaS affects revenue recognition inasmuch as the revenue is recognized ratably over the course of the subscription term, instead of being recognized all upfront.  This throws off traditional expense ratios and typically makes the ratio appear higher than in on-premises software.  In SaaS, spending - the numerator - is upfront, and payment - the denominator - is drawn out over the course of the subscription term.

Subscription models typically mean that the customer installs the product as in on-premises software sales, but pays the vendor in increments instead of all upfront.  The vendor does not incur the cost of hosting or integrations with other applications. Moving to a subscription model is often the first stage for traditional software companies transitioning to a SaaS model.

Term licenses are similar, inasmuch as the customer pays for installed software for some period, typically one, two or three years.  Subscription models typically include maintenance and updates like in SaaS and term licenses do not.  There is no rigid definition of Subscription versus Term Licenses, though, so we’ve seen companies use the terms interchangeably.Both subscription and term (and SaaS) payment contracts may or may not include a right to cancellation and refund of fees already paid.  These terms affect revenue recognition.

In on-premises software, the vendor does not have the cost of hosting the software but has to ship out the software to the customer somehow.  Distribution costs, ie. Cost of Revenues, are different.  On-premises companies are more likely to use a partner channel to distribute, install and support their sales.  While SaaS vendors are growing the use of channel sales as well, channel still is typically a smaller percentage of overall revenues.

On-premises software models typically require the vendor to support integrations with other installed systems and to upgrade products.  These investments by the vendor may fall into COGs (and affect gross margin) or into R&D or be allocated between the two.  In SaaS, where these kinds of development are necessary, they typically fall into COGs, although if the SaaS vendor positions it as “new” development for a new version, then it would fall into R&D expense.

Different Models Affect Sales & Marketing

SaaS sales historically started at the departmental level, since SaaS customers do not have to go through a centralized IT organization to buy and install the application, but just use a browser to access a cloud-based product.  This leads to shorter sales cycles and faster revenue growth for SaaS companies.  As the SaaS model has become more entrenched, central IT organizations are becoming more involved which may lengthen sales cycles.On-premises sales cycles are typically longer as they sell both the IT department and the business user. More decision-makers and influencers in the purchase process makes for longer and more expensive sales cycles. On the other hand, the longer sales cycle and installation and integration can work in the vendor’s favor and make it difficult for the customer to change.  A SaaS customer can relatively easily end a subscription and move to another vendor without having to go through a long decision-making and installation process.  Plus, the massive amount of capital that has been invested in the SaaS sector by venture and PE firms over the past 20 years means there can be tremendous competition among SaaS vendors.

SaaS companies are typically able to track customer usage and engagement closely because they are hosting the customer and can monitor customer activity.  Good SaaS vendors better support and engage the customer than on-premises vendors whose engagement with the customer falls off after installation.

SaaS sales and marketing organizations must invest both in attracting new customers as well as on existing customers.  Traditional software companies typically invest most of their sales resource on finding and closing new customers.  After-sales support and engagement with customers is often a poor stepchild of the sales or services organization in traditional software companies.  Partner and ISV channels may be better supported than end-user customers.

SaaS and “Subscription” Models Are Not The Same

It is important to understand the differences in each model and make sure you are comparing your company to peers when benchmarking your own performance and operating model.