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.