A Blockbuster Idea

I believe SAAS is many things (new technology, new type of commercial relationship, recalibration of people's thinking about what really matters in software) but above all else, SAAS is a new business model. The product itself is different - but so is the way it is sold, who is prepared to buy it, what kinds of firms are in the supply chain and how they interact, the risk / reward balance between the players and so on. This goes way beyond "software".

When a new business model emerges, most people either (a) try to understand it by analogy to the other business model, or (b) freak out and try not to think about the new business model at all. You can see both behaviors in the software industry today. I believe the right approach is (c) understand the new model and how you can best play in it, without getting too hung up on the other model. But that's easier said than done - if you grow up in a certain industry / business model, you eventually become an Old Dog and will find it hard to learn New Tricks.

So maybe one way to crack the ice is with an example from another industry that we can all understand without our software-industry mental filters turned on. One great example is a revolution that happened in the video rental business around 10 years ago.

The established model for doing business worked like this:

• The retailer bought videocassettes from the movie studio for around $70
• The retailer rented tapes for around $3 and kept all the rental revenue
• If a tape didn't rent, that was the retailer's problem (held all the downside risk)
  
• If a tape rented many many times, the movie studio missed out on the upside
  

This created a bad situation for all parties. The retailer would not buy a tape unless they felt certain it could be rented at least 20-30 times and could cover its own cost, so they bought relatively few tapes. If you were the retailer and were sure you could rent 5 tapes but not sure about the 6th, you would only buy 5 (and certainly not 10 or 100). You had potentially many customers who might rent the tape if given the opportunity; but no way to predict that demand. Customers were unhappy because they would go to the video store and not find the movie they wanted (happened to me many times). Studios were unhappy because they could potentially have sold more tapes. Retailers were unhappy because they often aimed too low, missed out on potential rental revenue, and their customers were not happy with them. Overall, a pretty dysfunctional market.

All this changed due to a new idea driven by some visionaries (people and companies) in the video rental industry. A new business model was established that changed all the rules. In the new game:

• The retailer bought videocassettes from the movie studio at cost, around $5
  
• The retailer rented tapes for around $3.50 and split this 50/50 with the studio
• When a tape stopped renting, the retailer would sell it and split that 50/50 as well

This was truly a new business model for the video rental business. Now the retailer could buy a vast number of tapes and not worry too much - if a tape rented only 2-3 times it would cover its cost. As a result, retailers bought MANY more tapes (I remember walking into Blockbuster and seeing hundreds of copies of a new release). As a result, customers were more likely to come to the video store since they expected to find what they wanted. This created a boom for the movie studios and the rental stores, and fueled the growth of the industry - for example, Blockbuster experienced 30% growth in number of retail outlets, and 50% growth in revenue in the 3-year period following this change. Revenue for the movie studios also boomed. Retailers who did not switch to this model lost share in the growing market.

Apply this lesson to software -

1. A new business model might be a great thing for you
2. Trying to get all your money up front may actually hurt you

Asking $70 per tape up front (that's a perpetual license) makes the customer less willing to buy from you, because their expense is certain but their return is uncertain. You will do some business that way, and it feels good to get your money up front, but your customers is not stupid - they will tailor their buying behavior to the risk / reward economics of the situation. If you create a way to share the upside and the downside with them - you will make more money.

SAAS is a great way to share risk and reward with your customers, because you don't ask for money up front, and if you don't perform your customers can move on. This is nearly heresy for an industry that has always focused on large financial commitments up front and ways to "lock in" customers to your solution. But if you want to experience "Blockbuster" results you may have to move to a different risk / reward model. SAAS is a great way to do that.