Software as a Service: Implications for Investment in Software Development Vidyanand Choudhary The Paul Merage School of Business University of California, Irvine Irvine, CA 92697 veecee@uci.edu Abstract Software as a Service (SaaS) is a rapidly growing model of software licensing. In contrast to traditional software where users buy a perpetual-use license, SaaS users buy a subscription from the publisher. Whereas traditional software publishers typically release new product features as part of new versions of software once in a few years, publishers using SaaS have an incentive to release new features as soon as they are completed. We show that this property of the SaaS licensing model leads to greater investment in product development under most conditions. This increased investment leads to higher software quality in equilibrium under SaaS compared to perpetual licensing. The software publisher earns greater profits under SaaS while social welfare is also higher. 1. Introduction ���Something momentous is happening in the software business. Bill Gates of Microsoft calls it ���the next sea change���. Analysts call it a ���tectonic shift��� in the industry. Trade publications hail it as ���the next big thing������ [20]. There is excitement in the software industry surrounding the rise of ���Software as a Service��� (SaaS). SaaS is seen as a possible replacement to traditional software where the buyer obtains a perpetual license and installs and maintains all necessary hardware, software and other technical infrastructure. Under SaaS, the software publisher (seller) runs and maintains all necessary hardware and software and buyers obtain access using the Internet. For example Salesforce.com with annual revenues of over $300M, offers On-Demand Customer Relationship Management software solutions built on its own infrastructure and delivered directly to users over the Internet. Salesforce.com does not sell perpetual licenses instead it charges a monthly subscription fee starting at $65/user/month. The Economist [20] estimates that the market for SaaS is growing at 50% each year. Other trade publications are equally enthusiastic about SaaS, for example the title of a recent International Data Corp. (IDC) white paper on SaaS [13] reads ���The future of software licensing: Software Licensing under siege���. Credit Suisse First Boston has released an index to track this sector and their analyst John Maynard claims that ���Traditional software is already dead��� [20]. Although these articles in trade publications communicate the view that SaaS represents a dramatic change from traditional software, few substantive differences between SaaS and traditional software have been documented. Trade journals point out that SaaS does not require large upfront investments and thus there is an impact on cash flows of both buyer and seller with small, stable cash flows under SaaS rather than large periodic payments. Data security is another issue since users��� data is stored on the vendors��� hardware and systems. The University of Florida lists predictable costs, increased bargaining power, ability to switch across providers and up to date software as the key benefits based on a one year experiment with SaaS [8]. In this paper, we focus on the last of these reported benefits, i.e. users��� access to the latest and most current version of the software. SaaS and perpetual use licenses are different licensing schemes and thus typically considered to be marketing decisions that follow product development. In contrast we show that these licensing decisions influence the firm���s incentive to invest in product development. In particular, we focus on how software publishers��� incentive to invest in product development differs between traditional software development and SaaS. The difference in incentives arises due to SaaS vendor���s incentive to make available the most current features in their software solutions. Proceedings of the 40th Hawaii International Conference on System Sciences - 2007 1 ��2007 1530-1605/07 $20.00 IEEE Proceedings of the 40th Annual Hawaii International Conference on System Sciences (HICSS'07) 0-7695-2755-8/07 $20.00 �� 2007