Why cloud business models differ from on-premise software

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Jul. 23 2014, Updated 5:00 p.m. ET

A new business model

With traditional software companies like Oracle (ORCL) or SAP (SAP), customers pay for software licenses up front and then typically pay a recurring annual maintenance fee. This fee is about 15%–20% of the original license fee. Here, all the license fees go directly to revenue and the associated costs are reflected as well. So the timing of revenue and expenses is completely aligned.

The chart above shows how the economics of cloud adoption differ for on-premise versus SaaS (software-as-a-service) customers.

The SaaS business model

In SaaS, services like access to online software applications, with training and technical support, sell on a subscription basis. This means traditional accounting guidance for software revenue recognition doesn’t apply to SaaS.

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But, instead of a customer signing a contract—let’s say for 12 to 24 months—the company doesn’t get to recognize the revenue immediately. The organization recognizes revenue only as the software service is delivered. So, for a 12-month contract, revenue is recognized each month at one-twelfth of the complete contract value. Expenses—like sales and marketing, developing and maintaining the software, and hosting infrastructure—are incurred up front. So with SaaS, the timing of revenue and expenses are misaligned.

Relatively young SaaS companies usually incur high sales and marketing expenses as a percent of revenue. Workday (WDAY) spends approximately 42% of its revenue on sales and marketing. Splunk (SPLK) spends 70% of its revenue on marketing. Salesforce.com (CRM) spends more than half of its revenue on sales and marketing.

The timing of the cash flow is also out of sync, as the customer often only pays for the service one month or year at a time but the software business has to pay its full expenses immediately.

Late realization of profits

In the beginning, a company incurs all costs related to customer acquisition. Nearly all incoming cash flow from customers after deducting customer acquisition costs are profits. So for SaaS, profits come in at a later stage.

In the growing SaaS environment marked by cloud companies, revenues and cash flows don’t state the true financial performance of a business.

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