So many innovations have emerged from computer technology that a new business model based on the Web is scarcely surprising.

In 1999, Marc Benioff founded Salesforce.com with the idea that software could be delivered through the Internet rather than loaded onto a computer through a disc. Over the next nine years, the business model became known as Software as a Service, or SaaS (pronounced “sass”), and even Wall Street is starting to pay attention to companies on this field.

“The reason SaaS is exploding is because of the small/medium businesses,” says Richard Hanks, chairman and president of Mindshare Technologies, a Salt Lake City-based firm that provides customer feedback management products. “Once you take some piece of software application that used to cost millions and you open it up on pennies on the dollar and you rent it, you’ve gone way down into the hierarchy of companies that can afford it.”

SaaS Defined
Saas companies typically set subscriptions to their products; subscribers access the application through the Internet. This saves the customer from purchasing what is typically extremely expensive software, and removes the hassle of software updates. The vendor simply updates the Web version and then all the subscribers are automatically updated as well.

From a client’s perspective, the immediate advantage of the SaaS model is that the vendor takes care of all software maintenance and the equipment data centers, Hanks says. “There’s another benefit, particularly for small and medium businesses-you only have to pay for what you use,” he says. “You also get regular updates to the software, and no one has to come to your businesses to do the update. At Mindshare, we update our software three or four times a year, and that’s included in the subscription.”

There are three types of SaaS models, says Sendside CEO Willaim Borghetti: pure, hybrid and dual.

With the pure SaaS model, Borghetti says, “you can easily sign up, engage whatever functionality may exist on that particular Website, and derive some benefit from that.”

This typically is done with a monthly fee but is not generally a long-term commitment. This means support can sometimes carry an extra charge.

The dual Saas model offers open source software, with a subscription available if the user needs support, documentation or other services, he says.

With the hybrid model, of which the Salt Lake City-based Sendside offers, “you have the ability to deliver software as a pure SaaS play, or have a bit more of a conventional software component to it,” Borghetti says.

For example, Sendside allows users to use the Web application alone, without any clientside software. However, for clients with more complex needs, there’s a professional services module, sold on a one-time fee basis that integrates with the client’s network.

Sendside’s products allow Web-based messages to be sent, tracked, recalled, updated and protected from unauthorized forwarding or downloading, all in a secure environment. Many of the company’s clients are in the financial field, where businesses often have several back office software systems that keep track of information such as account balances. To integrate with these systems, Sendside offers a secure connection that isn’t included in its basic service.

“That connection can be sold as an integration touch point that obviously offers a lot of value to the client organization because they don’t have to send all that manually,” Borghetti says. “So there’s a huge programmatic efficiency in doing that.”

The Finances
Tracking the finances of a business following the SaaS model is very different from a traditional company.

“In the SaaS model, you’re selling something you may or not get the cash for upfront,” says Steve Smith, CEO of Draper-based Finicity, which provides money management services. “Typically you sell it on a subscription basis. You recognize the revenue over the terms of the contract, so it’s quite a bit different from an accounting perspective.”

Traditional general accounting principles don’t apply to SaaS companies because revenue comes weeks or sometimes months after a contract is signed. This can pose problems for executives accustomed to the GAP way of doing things.

“The biggest issue we find is that the CEO and the CFO have to really become one with the financial model,” says John Mellor, executive vice president of Omniture, an Orem-based Web analytics firm.

Mellor says the CEO and the CFO of a company following the SaaS model “have to have the discipline and the guts to make expenses ahead of revenue. Not necessarily ahead of customer commitment, but ahead of being able to recognize revenue. It’s very tough. It’s a leap of faith that a lot of people just can’t make.”

SaaS companies have to frontload hardware and the services they supply, so “the faster that a SaaS company grows, the poorer some of the standard GAP metrics make you look,” Mellor says, adding that because traditional metrics don’t apply to the SaaS model, Omniture executives came up with their own method to determine when they should invest in sales and marketing efforts. Subtracting the revenue of the preceding quarter from the revenue of the existing quarter and multiplying by four to obtain the annualized revenue increase between the two quarters derive that “magic number.” Then the sales and marketing statistics from the previous quarter are divided into annualized incremental revenue.

“That gives a 30,000-foot measurement gauge on how saturated or competitive your market is, how effective your sales force is and what your marketing expenses are and your ability to retain customers and up sell and cross sell into your customer base,” Mellor says. If the number is above .75, “you should absolutely be spending as much money as you can on sales and marketing because it tells you that your sales and marketing expenses are extremely efficient, meaning that there’s room to grow.”

At Sendside, some of the financial drawbacks of a SaaS model are offset because the hybrid approach allows the revenue from the connection points to be recognized as soon as they’re installed, Borghetti says. “In many respects it’s beneficial because you’re able to, as soon as you go live with a customer, generate revenue and recognize legally that revenue. As opposed to, say, selling a $100,000 deal into an enterprise and only being able to recognize the first month of that revenue.”

It’s a Long Slog
The general fundamentals of starting a SaaS-based company are the same as those of a traditional company: getting a good management team in place, evaluating the market and understanding the competition, the experts say. But there are differences.

The primary variance is “that you’ve got to be able to carry that company through the dark three-year period where the technology is being matured and developed, intellectual property is being secured and customers are really starting to adopt but you haven’t reached that precious break-even point,” Borghetti says.

“We always call it the three years of torture,” Hanks says, explaining that Mindshare’s founders spent $7 million to write the software, have it professionally hosted and set up the security, networks and back-up systems. “There were huge amounts of upfront costs.”

Another difference in the SaaS model is that “you typically have to make an investment in a direct sales effort early, and you can’t leverage the channel” as you can with a classic retail model, Borghetti says. “You can’t take Sendside and put it into BestBuy. It doesn’t work that way. So you have to be really careful around the first phase of your sales and in your market development because there’s a lot of direct selling that’s required. You need to be able to prove out that customers can use it, they enjoy it and they’re willing to pay for it.”

Once that occurs, then strategic partnerships may be exposed, he adds.

The payback for the long haul is that once a SaaS business passes the break-even point, it becomes extremely profitable.

“Once they break even, to add one more customer has an extremely small incremental cost,” Hanks says. “By seven years, you have this incredibly stable revenue stream. It’s highly profitable, and it’s worth substantially more than a business that has had to be selling each month.”

Finding Investors
Entrepreneurs looking to fund a SaaS-based business these days have an easier time than those who were at the forefront and whose success has helped investors take notice.

“There are VC’s that specialize in the SaaS model now. But eight years ago it was a tough sale,” Hanks says. He recalls that on 2001 he was unable to obtain funding for his first SaaS-based business even though it was beating all its metrics. Although 9/11 was a primary reason, “investors did not have longer time horizon required for a SaaS model,” he says.

In 2002, Mindshare’s founders bootstrapped the company because venture capitalists didn’t understand the SaaS model, he says. “Now we have quite a number of investors that would love to invest with us. But that’s the point-it took five years.”

Mellor has a similar story. “When Omniture started it was funded by the founders’ credit cards,” he says. “We didn’t get a lot of venture funding until about four years ago.”

Selling investors on a SaaS business’ longer profitability timeline-five to seven years rather than two or three-is key to a company’s success, Borghetti says. “You have to be very careful as a founder or an executive or a management team in a SaaS to make sure that you’re aligning the interests of the investment community with your particular venture.”

Steve Smith of Finicity acknowledges that, while many investors don’t understand the SaaS model. “There are a number of people in the venture capital and the growth equity funds that are very enamored with the SaaS model and very excited about it and have invested pretty heavily in that model. It is becoming more recognized all the time.”

Hanks agrees. “VCs who invest in SaaS models today understand it will be a longer time horizon,” he says. “But the annuity-like stream of money that is coming in is extremely valuable to companies, particularly to Wall Street.”

With Internet technology continually becoming more advanced, and with the interest from Wall Street, the SaaS model is the future for software companies, Smith says. “If you look down the road two, three, four years from now, if you’re not considering developing software and you’re not thinking software as a service, you’re going to be outside looking in.”

About Mindshare Technologies
Mindshare helps companies improve operational excellence, foster consumer satisfaction, build customer loyalty, and support employee retention. Our industry experts guide clients in building comprehensive Enterprise Feedback Management (EFM) solutions. Mindshare's proprietary survey technology captures the voice of the customer in real-time and immediately transforms it into actionable intelligence through powerful and incisive reporting. As a hosted system, Mindshare is affordable and flexible, providing automated surveys and reports tailored to each client’s specific needs. The reports are web-accessible 24/7 or by scheduled email delivery. Mindshare serves more than 25 different industries including travel, hospitality, restaurant, financial, salon, automotive, and retail. Clients range from small regional chains to large multinational corporations. For information, visit www.mshare.net.