ISVs transitioning to a SaaS business model should have three key considerations: 1) to avoid infrastructure, 2) which platform and 3) how to fund working capital.

1. 1
ISVs in the Cloud
considerations for a successful transition
By Reinout Schotman & Nick Fryars
Draw a circle of 5 kilometers in
a metropolitan area and imagine
how many independent software
vendors (ISVs) are in that area.
More likely many than none.
How many of these ISVs have
built their business based on on-
premise software? Probably
most. How many will survive
without adopting cloud
computing theory and
technology? Most likely, none.
The paradigm shift of cloud
computing is not only
transforming IT for end-users,
it is also reshaping the supply
side of software. It is a threat to
ISVs with on-premise products
and delivery models that do not
adapt to the cloud environment
in a timely manner. ISVs that do
change mostly virtualize their
infrastructure and offer software
as a service in their transition to
the cloud. As a result most of
such ISVs find themselves with
decreased margins and eroded
revenues.
Outperforming ISVs are using
cloud computing to a greater
benefit. They deal better with
three key considerations:
1. Avoid owning infrastructure
2. Select a cloud based on
commercial opportunity
3. Financially leverage your
sales
Avoid owning Infrastructure
To understand why owning
(cloud) infrastructure should be
avoided by ISVs it is important
to understand the drivers for
value creation. Customers
choose one ISV over another
because it delivers a product
that is it better fulfills their
functional needs. The customers
delivers as a cloud service will
not even be aware of the
underlying infrastructure or
technology. Infrastructure (such
as hardware, network, operating
system) has been commoditized.
The key economic driver for
infrastructure is scale and the
required scale to be efficient is
huge. Microsoft, Google, IBM,
Amazon, Apple and limited
other providers all operate
infrastructures of hundreds of
thousands of servers. It is a
market dominated by very large
IT companies with deep pockets.
Even a new entrant like
Salesforce.com with a modest
ISVs transitioning to
a SaaS business
model should have
three key
considerations: to
avoid infrastructure,
which platform and
how to fund working
capital.
January2012

2. 2
scale infrastructure publicly stated
that it had invested $100m in
infrastructure before it was ready to
do business and offer service. Even if
this is overstated it signals that the
investments in infrastructure are
significant for new entrants offering
Infrastructure-as-a-Service (IaaS).
Many data centers and even telecom
providers are struggling to compete
in a market that they regarded as
their home turf. (see: Experience
Curves for Clouds).
The cost of renting
infrastructure capacity through IaaS
is not necessarily lower, but that may
not be the most important benefit of
renting. The key consideration for
an ISV is whether outsourcing to an
IaaS provider allows it to focus on
its true added value: functional
product innovation. The question an
ISV should ask itself is: can we build
and operate an infrastructure meets
our quality requirements more
economically than a top-tier IaaS
provider? It is a market anomaly
that many ISVs overestimate the
value they earn from their
infrastructure. This suggests that
they will have an increasingly tough
time demonstrating their value to
customers. Owning infrastructure
absorbs precious management
attention and resources and limits
the growth potential of an ISV.
Which Infrastructure
Mostly ISVs choose an
infrastructure based on technical
compatibility, cost and
(organizational) stability. Such
criteria miss a crucial strategic
opportunity: the opportunity to
leverage the infrastructure provider
commercially.
Cloud infrastructure is driven
by scale and therefor the biggest
providers have a strategic advantage.
Such top-tier IaaS providers have
established relations with large
customer bases and they realize that
they need small ISVs to provide
innovative services on their
infrastructures to make them
relevant. There is a catch for ISVs,
however. By choosing one IaaS
provider, the ISV is often denied
access to the customer base of a
competing IaaS provider. Choosing
an IaaS provider is therefor a
significant commercial
consideration. The IaaS provider
with the biggest relevant customer
base for an ISV is possibly
commercially more attractive than a
IaaS provider with a superior
capabilities and reputation, but with
a less attractive customer base.
The ISV might catch the
biggest fish, but it is the biggest fish
of a small pond. Instead it could find
itself fishing in rich oceans.
An Example
Okta is a provider of identity
and access management (IAM) for
the cloud. Within the IAM market
they gained quite some attention and
significant funding. However, so far
its commercial performance has been
disappointing. So, what opportunity
did Okta miss?
Okta is based on the force.com
platform of Salesforce.com. Highly
capable and stable, force.com is a
proven technical platform of an
industry leader. So piggy-backing on
this platform seemed a good choice.
However successful
salesforce.com is, their installed base
is ~ 2 million seats, less than 1% of
world-wide seats in the enterprise
market. This means that Okta gains
entry to 1% of their addressable
market by partnering with
salesforce.com.
Had they chosen Microsoft
instead, they could have gained a
partner with an installed base of
over 265 million seats in the
enterprise market and a yearly R&D
budget of US$ 8.6 billion to convert
this base onto the cloud, a partner
that has access to nearly every
imaginable customer world-wide and
an extensive eco-system of System
Integrators (SI’s) to drive sales.
Instead Microsoft bought BHold
Company (see note).
Funding
ISVs transitioning from on-
premise to a SaaS based business
model face a funding challenge. SaaS
businesses always have a
subscription model for their core
offering. This means that revenues
are delayed compared to a classic
Figure 1: Funding analysis with and without collateralized loans of a SaaS
ISV that is expecting high revenues growth in the future.
RequiredFunding
Time
Customers
Customers Funding w/o loan Funding with loan
note: BHold Company is a client of Outdoor Connect
© 2012 Outdoor Connect

3. 3
one-time license model, and that
funding R&D and customer
acquisition can be problematic. As
Bessemer Venture Partners explains
(see “Bessemer Cloud Computing
Law #9: Mind the GAAP!”) it is
important to match revenues and
costs to consumption. This is
especially challenging for ISVs that
anticipate significant growth. They
can run out of liquidity or miss
capturing market share by not being
able to ramp up sales due to budget
constraints.
This is a classic and
fundamental challenge for SaaS-
based ISVs. In fact, the low net
income margin of Salesforce.com is
mostly because Salesforce.com is
using its revenues to fund future
growth while not capitalizing its
sales expenses. Corrected for the
cost of growth, its profits are up to
about 50% of revenues. This implies
a Price/Earnings of about 10 (like
Microsoft) rather than the stellar
current P/E of 5.000.
The ISV needs to choose
whether to fund working capital
through debt or equity. The
incentive for existing shareholders is
growth without the cost of diluting
shares. Debt on the other hand
requires some form of tangible asset
as collateral. ISVs are typically light
on tangible assets (or they are not
funded efficiently), but, unlike on-
premise ISVs, do have relatively
strong, tangible assets that provides
a steady and predictable cash flow:
sales contracts.
Under certain conditions ISVs
can leverage existing sales contracts
to attract collateralized debt to fund
future growth.
As the example in figure 1
demonstrates, the amount of equity
funding can be significantly reduced
as well as equity becoming “in the
money” sooner.
Once existing revenues generate
enough cash flow to pay-off the
loans, debt can be easily reduced and
the ISV can grow autonomously or
use the cash flow to explore new
markets.
Call for action
For ISVs to survive the cloud
computing paradigm shift, they
should consider carefully whether
they walk-the-walk and outsource
their own infrastructure into the
cloud. Successful ISVs use the
transition to cloud to build powerful
commercial alliances that provide
them new go-to-market strategies.
And finally ISVs should consider the
financial challenges of growth in a
SaaS business model. Collateralizing
on sales contracts could be a
solution.
History has many powerful
reminders of failures to adopt to a
new reality. Music publishers
underestimated the power of digital
distribution of media and the impact
on their value chain. It nearly cost
them their market.

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Copyright © 2012 Outdoor Connect
All rights reserved.
Outdoor Connect and its logo are
trademarks of Outdoor Connect B.V.
About Outdoor Connect
Outdoor Connect is a
management consulting firm and a
leading advisor on cloud computing
strategy for enterprises. Outdoor
Connect partners with clients in all
sectors and identifies their highest-
value opportunities, addresses their
most critical challenges, and
transforms their businesses.
Outdoor Connect advises clients
in technology engagements in phases
preceding implementation and helps
them manage the delivery of cloud
computing value thru program
management. Clients are both end-
user organizations as well as service
providers that deliver cloud services
to end-users.
Its home page is
www.outdoorconnect.nl
About the Authors
Reinout Schotman is a senior
management consultant and leader in
the field of cloud computing. Prior to
joining Outdoor Connect in 2010
Reinout was practice lead of the SaaS/
CRM practice within Accenture
Netherlands. Furthermore Reinout has
experience in Telecoms and he holds a
MSc in applied physics of Delft
University of Technology.
Nick Fryars works with
international business leaders to drive
new ventures and strategic change. He
recently set up Sales Operations for the
HR cloud company Lumesse. Nick was a
founder member of PA Consulting
Group's Strategy practice. He holds an
MBA from Twente University and a
BSc in Computer Science &
Mathematics from London University.
For more information on how Outdoor
Connect helps organizations to benefit
from the cloud, please contact:
Reinout Schotman
reinout.schotman@outdoorconnect.nl
+31 6 11 14 19 16
Nick Fryars
nick.fryars@outdoorconnect.nl
+31 6 54 38 85 49