SaaS: Financial, Legal & Negotiation Issues

By Marcia Gulesian

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A cross-functional team with representatives from IT, Finance, and Legal should be involved in the acquisition of mission-critical software as a service (SaaS) applications.

SaaS is a software distribution model in which applications are hosted by a vendor or service provider and made available to customers over a network, typically the Internet or VPN. Better use of Web standards, and the emerging use of AJAX, has enabled Web-based interfaces that rival those of locally installed GUIs.

SaaS can offer customers lower costs that are aligned with usage, minimal up front expense, rapid implementation and time to value, plus reduced risk. In individual cases, however, the CIO must decide whether SaaS is good for his or her IT operation, while the CFO must decide whether SaaS is good for the economy of the firm as a whole.

Microsoft and other industry-leading software vendors have indicated that future product releases will often have both a traditional and SaaS version, which is recognition that customers can now choose to deploy software in their own infrastructures in combination with solutions delivered through SaaS.

There are two types of SaaS providers. With the first type of provider, a licensing fee and a monthly fee are separate and are paid to the maker of the software and to the hoster of the software. With the second type of provider, there is no division between licensing and hosting fees.

The SaaS provider hopes to achieve better economies of scale than its clients could when operating the application themselves. By applying economies of scale to the operation of applications, a service provider can sometimes offer cheaper and more reliable applications than companies can themselves.


Leasing vs. buying is a generalization of SaaS vs. hosting software in-house. So, to the CFO, the latter decision is similar to the lease versus buy decision he or she makes when acquiring a car or real estate property for the firm.

Leasing is one form of financing. Companies can buy assets using excess available cash, using cash borrowed from a bank or other lending institution, or using cash from equity or debt offerings, to name some general sources of cash.

Once managers have compared all sources of financing they could employ to own an asset and decide to borrow money from a lending institution at 'X' percent, this rate becomes the relevant “buy” alternative to be compared with the cost of leasing.

The only costs that managers need to compare in making the decision to lease or to buy (and borrow in this case) are those that determine the incremental cash flows of each alternative. Still, in order to make this comparison, they must consider a number of factors.

If a firm owns an asset, it can depreciate the asset and reap the tax shield from the depreciation. In this case, the company is liable for any and all costs of the asset, including the expenses of operation and maintenance. Any interest that is incurred to purchase the asset is deductible but principal payments are not deductible for taxes.

You can set up two tables showing cash flows for owning (hosting software in-house) and cash flows for leasing software (SaaS). You can then discount the cash flows from both options at the opportunity cost for owning (e.g., the return from or opportunity cost of investing excess cash rather than using it to purchase an asset).

If the present value of the cost of owning is less than the present value of leasing, then the effective interest rate in the lease is higher than the opportunity cost of funds from owning. That is, you will add more to your company’s bottom line if you own (host the application yourself).

You can also find the interest rate that forces the cost of owning to exactly equal the cost of leasing. This is the effective interest rate of the lease.

This analysis may sound simple to some readers but is best handled by an experienced accountant because there are often countless details that need to be considered before the cash flows can be estimated. For example, the usual host-it-yourself software license does not include maintenance or support fees, but most SaaS fees do.

Readers wanting a basic description of cash flow, depreciation, taxes, opportunity costs, and present value used in the previous paragraphs, as these terms relate to IT decision making, can refer to an earlier series of articles starting at developer.com.

The Contract

There are some inherent disadvantages in adopting SaaS, including but by no means limited to:

  • Integration with your non-SaaS systems may be problematic.
  • Loss of control of your corporate data.
  • Dependence on the service provider for security.

    These three points are of concern to IT. The first is an in-house technical matter, but the second and third need to be addressed in the contractual relationship between the firm and its SaaS provider.

    Setting up an escrow account becomes critical when using SaaS, since loss of support by the SaaS provider means not only the loss of the application functionality but access to all of the proprietary data along with it.

    Escrow generally refers to the placing of property which is the subject of a commercial transaction (money, title deeds, software source code, etc.,) into the hands of a trusted third party for safekeeping until some specified event occurs which will trigger the release of the property to one party to the initial transaction.

    You are at risk of loss of SaaS support whether you’re dealing with solid industry leaders or fragile start up companies. For example, many users of Research In Motion's BlackBerry product and service faced the very real threat of seeing their addictive devices become useless earlier this year.

    There was nothing wrong with the products in question, and RIM. was financially healthy. However, a patent trial judge nearly ordered an injunction that would have shut down this potentially patent-violating product.

    So, make sure that your SAAS vendor offers a code-escrow deal so you have the option of running the application internally if the service were to be shut down. This model can work, but, caveat emptor, it might be weeks or months until you have the application running satisfactorily in-house.

    At some point, you might want to migrate away from a SaaS application to another solution, so it's important that you are able to take your existing data out of the application and move it to another one. Ask your prospective SaaS provider about any data-migration strategies and procedures it uses, including any provisions for data escrow.

    Escrow agreements including verification should be set up with your SaaS provider. Your provider should be able to guide you through the process, but independent, third-party legal advice should be sought if you don’t have in-house expertise in these maters.

    Continue to evolve the level of your protection by managing escrow accounts online and updating coverage levels as necessary.


    You probably won’t be able to negotiate the massive discounts common in the traditional packaged-software industry, in which list price is generally something of a joke. With this hosted model, you’ve got to keep in mind that deep discounts won’t be there. Volume is your most fruitful negotiation point; to lower your cost per seat, add more seats.

    The SaaS has your data, so you need to have an exit strategy. Be sure to negotiate transition support: How long it will take the provider to return or hand off your data, what notice is required on both sides, and so on?

    Cover all the bases. Get service level agreements (SLAs) on availability, response times, and notifications of outages and how soon after a failure you must be notified. Other issues you must address: regulatory compliance, data integrity, data privacy, frequency of backup, support and disaster recovery. Budget for surprises. Even when you think your bases are covered, you may run into nasty surprises.

    SOA, Web Services, etc.

    Most SaaS applications are specifically designed as web-based applications. As such, they are accessible from virtually any location with an Internet connection, enabling remote access, as well as providing excellent support for businesses with multiple geographic offices or locations.

    A variety of enabling technologies, such as service-oriented architecture (SOA) and web services, permit SaaS to be more easily provisioned and metered based on actual usage levels. This means companies no longer have to pay for excess capacity.

    The bottom line? Lower total cost of ownership and quicker time-to-value are the promise of SaaS. But, before proceeding to sign a contract for software services from an outside provider, the CIO needs chat with his or her CFO and Legal Department, particularly when large amounts of money or mission-critical data are involved.

    Marcia Gulesian has served as software developer, project manager, CTO, and CIO. She is author of well more than 100 feature articles on IT, its economics and its management, many of which appear on CIO Update.