GigaOm recently published an interesting article on Oracle’s challenges of shifting towards a “metered pricing” model. From my perspective it raises a series of fundamental issues addressing how enterprises buy and consume software: 

  • Is the classic enterprise software licensing model a dying vestige of a prior generation?
  • Can legacy enterprise software-driven firms make the cultural transition to a more flexible, SaaS-based approach?
  • Can publicly-traded firms constrained by quarterly earnings targets make the painful financial transition implied by this shift?

Oracle’s circumstance is merely a microcosm of the larger issue. As a business owner, would you rather:

  • Have multiple parties from which to choose with relatively low switching costs, thereby minimizing lock-in?
  • Only pay for the stuff you actually need instead of purchasing at all times for peak capacity?
  • Be able to ramp up and ramp down users and usage on an a la carte basis?

The answers seem fairly clear. The “as a service” (aaS) model is, in general, preferable to enterprise-wide software licensing due to smaller upfront investments, lower switching costs and greater flexibility for managing scale. This also enables centralized software upgrades, the ability to manage either in-house or cloud deployments and yields smoother operating cash flows.

So if more and more customers want software as a service, then why is the transition by the biggest incumbents, such as Oracle, taking so long? 

Selling enterprise software is like a drug. Big ticket sizes. Hefty annual maintenance charges. Heavy switching costs. This is why big-time enterprise software sales professionals get paid massive commissions and are often the best-paid people in the company. It is hard treadmill to jump off of, however, because the cash flow dynamics of enterprise software vs. SaaS are very different, and the impact of shifting from one model to the other is dramatic. Enterprise sales are about closing the big license then moving onto the next one (until the periodic upgrade, of course!). The result is large yet choppy cash flows (as annual maintenance is a fraction of upfront license value) unless you can continue to churn out big-ticket sales year in, year out at an increasing rate. Great companies can do it for years by continuing to sell license upgrades and closing new deals in a greenfield market. However, as the market gets saturated this becomes harder and harder, and when compounded by a sea change in the way businesses actually want to buy software the forces of gravity become too strong to withstand.

So what about shifting to SaaS? Well, there is good news and bad news. The good news is that SaaS companies, such as Salesforce, have successfully built huge amounts of something called CMRR - Committed Monthly Recurring Revenue. What this means is that as they sell more seats under 1 and 2-year agreements, they are building an ever-increasing cash flow annuity that is easy to value and kicks off large amounts of free cash flow. Selling costs are far smaller than in enterprise software because the upfront commitment is measured in the hundreds or thousands of dollars, not hundreds of thousands, millions or tens of millions of dollars. Let’s just say that the CIO and CFO aren’t getting involved in the procurement decision for a long, long time. Further, there are often big up-sell opportunities within existing accounts as they often start with small numbers of seats to test out the service and then grow over time, so it is not merely a game of finding a whole new set of companies to generate top-line growth. This is all good stuff.

HOWEVER, the bad news is that those big upfront sales that the legacy enterprise software model generated? Gone. And the time it would take for high-quality, recurring monthly SaaS sales to begin to approach the lumpy but large enterprise software sales is significant. This is a level of creative destruction that is hard to see being embraced by a large software company, particularly a public company. In fact, I think it would be almost impossible without building a Saas business line along side the legacy business line and eventually selling the legacy business to private equity investors who will see it as a valuable but depleting asset (not unlike an oil well). This way, the old-line company could leverage its long-term relationships during its SaaS transition before casting off its original but antiquated business. Alternatively, Mr. Market might eventually make the decision blindly straightforward. If the service-based software model does become the format of choice for acquiring a particular set of capabilities, then enterprise software multiples will plummet and render these companies takeover targets for private equity investors, anyway. Either disrupt oneself or become forcibly disrupted. This is the feature of fast-moving, innovative and highly competitive markets. Good for customers. Good for growth.

I personally saw this painful transition in one of my angel investments, a company called Global Bay Mobile Technologies. They have a great mobile data collection product that was initially sold into Government agencies. These deals were sold either direct or as a packaged solution through systems integrators. The sales cycles were painfully long. The working capital required to fund the business was significant. But when these licenses were sold, they were very profitable. However, the company saw uses for its technology that extended far beyond Government, into retail for inspections, “line busting,” and other store-based applications. Companies wanted to buy their software in small bites, testing it across a small number of stores before expanding across an entire geography or chain. In short, a SaaS sale. So the company made the tough decision not to sell any more enterprise licenses and to bet its future on SaaS. Revenues initially fell. Cash flow fell, too, as software needed to be re-tooled to function as a SaaS platform. But what resulted was a stream of consistently rising CMRR resulting from a great product, a low-cost initial sale and myriad up-sell opportunities within existing accounts. Eventually, the company caught the eye of VeriFone who purchased Global Bay in Q4 2011. It was a happy ending, but one that took a ton of work, wrecked the financials for 18 months and thankfully happened away from the peering eyes of the public markets. 

How enterprise software companies manage this competitive imperative will be fascinating to behold. But rest assured, this transition, be it going private or trying to make this shift in the public arena, will provide fodder for many case studies for years to come.

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This article originally appeared at Information Arbitrage. Copyright 2014.