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Wall Street Shifting to On-Demand Model

April 23, 2004

By: Ron Miller and Erin Joyce

“On-Demand” has been a buzzword in the software industry for a couple of years now, a catch-all phrase to describe the shift to pay-as-you-go computing services and software.

Among investors, however, these providers used to be called “Application Service Providers” before the tech bubble burst and buyers’ ASP interest fizzled.

But now Wall Street is gearing up for a second round, with the pending IPO of On-Demand CRM provider Salesforce.com offering a test case for how On-Demand software companies will be received — and valued.

Merrill Lynch, for one, has also just launched a new On-Demand Index that is designed to help the newfangled ASPs to test the markets again.

The “MLODI,” though not an investable or tradable index, “is designed to help investors better track, measure, and understand the transformation of the software industry to the On-Demand model. Very simply put, On-Demand practices will change the way customers buy, vendors sell, and investors invest.”

The index is another sign that investors, and the software industry as a whole, are realizing that software revenues are increasingly being recognized in bits and pieces, utility-style — rather than as up-front lump payments typical under traditional licensing models.

Under traditional licensing models, companies purchased a perpetual license usually involving more software than they needed, with yearly renewal and maintenance fees tacked on. This often devolved into a feast-or-famine existence for companies that enjoyed a big up-front payment, and a big drop in revenues when signings slowed.

“With a perpetual license, the buyer must account for both future growth and maximum capacity, frequently overbuying to take advantage of attractive vendor discounts,” Merrill Lynch said. “The customer owns these licenses whether or not they ultimately grow into them.”

Added Mike Doyle, chairman and CEO of On-Demand CRM software provider Salesnet, “What you’re seeing [instead] is a change in the way that even investors and institutions and their analysts are looking at the value of what a dollar of ASP revenue is versus a dollar of license revenue.

“The beauty of an ASP revenue dollar is that it’s a recurring dollar,” he said. “And we believe that, as a result of what Salefsorce.com will have [with its upcoming public offering], investors like that kind of certainty” in how revenue is recognized.

Doyle, who helped launch Boston-based Salesnet in 1997, said On-Demand software providers are building up an annuity revenue stream over time. “We think there’s a large premium that investors are going to pay for that.”

But Merrill has caution for investors. When they decide how to value the stocks of public software companies offering pay-as-you-go models, the bank recommends investors shift from merely examining companies’ income statement, and rather pay careful attention to the entire financial statement — with a careful eye toward deferred revenue and cash flow.

Indeed, Salesforce.com has already had to adjust how it recognizes its own revenues. The San Francisco-based CRM vendor recently re-filed its S1 registration statement after federal regulators reportedly ordered the company to change the way it accounts for sales commissions. According to the San Francisco Chronicle, Salesforce.com’s software-by-subscription model apparently ran into some snags about how the company recognizes revenue.

“Some investors are unsure how to measure near-term growth, now that the license line of the income statement is a smaller part of the story,” Merrill Lynch said. “The answer is on the balance sheet–specifically the increase or decrease in deferred revenue is the near-term indicator of growth.”

In addition, Merrill Lynch warned investors to watch renewal rates very carefully.

“For vendors, the longer-term viability of the model is predicated on strong annualized contract value renewal rates,” the Merrill Lynch note said. “This is very important because, without a strong renewal rate, the On-Demand model simply masks a longer-term slowdown in bookings.”

Doyle agreed that renewals are key, and claimed that Salesnet has the lowest attrition rate in the CRM software sector.

“Basically, we take a very conservative approach in recognizing revenue,” he said. “We only recognize it when the service is delivered. Traditionally, in a software licensing model, the customer paid up-front and the revenues were recognized up-front. We don’t recognize [revenue] till the month that [the service] is delivered.”

This is where traditional metrics for software companies are changing.

“And what’s happening is that companies are now getting powerful applications with a fraction of the costs” that they used to incur on software,” he added.

Merrill’s index breaks the software market down into sub-segments for applications, infrastructure, and management. The firm looks at how software is licensed and how it is deployed to determine its final MLODI score. Index scores range from 0 to 100, with 100 indicating a model that is 100 percent On Demand.

“This new model is the wave of the future,” Doyle said. “We have to earn our customers’ business every month … We think it’s an exciting time.”

Exciting indeed. Doyle said investment bankers have already begun knocking on Salesnet’s door, asking if, after the expected IPO of Salesforce.com, it would like to be next.

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