Consumers used to have to visit a retail store to buy software. That all started to change in the early 2000s when (NYSE:CRM) launched the first software-as-a-service business.

In this episode of The Motley Fool's Industry Focus: Technology, host Dylan Lewis is joined by Motley Fool contributor Brian Feroldi to discuss the benefits of switching to a software-as-a-service business model and why it can be so lucrative for investors.

A full transcript follows the video.

This video was recorded on July 6, 2018.

Dylan Lewis: Why don't we start with what software used to look like, and make our way to the present?

Brian Feroldi: Sure. Rewind the clock 15 or 20 years. The way that software was distributed to users was primarily at retail stores. If you wanted a certain program, you would walk into, say, a Best Buy or Radio Shack and you would pick it out off the shelf, you would buy a physical CD ROM, and you would purchase it. That kind of model was, the user paid a one-time, large, upfront fee to essentially own that software, and they would install it on their computer and they would use it, essentially, as much as they wanted, forever.

The downside to doing this is, one, it was pretty expensive upfront; and two, whenever updates came out to the software, they had to be manually made. And whenever there was a major release of a software, the customer would have to go back to the store and purchase a new version of it in order to keep up with the most recent date.

While this worked pretty well if you were just an individual home with just one PC, the real big problem with this model was when it came to implementing it at a large company. You can imagine having to maintain 50 or 100 or even 1,000 computers like this. Just the physical process of installing the software on each of them would be a huge burden.

Lewis: Yeah, that sounds like a headache for any tech department. Thankfully for folks that work in tech, in the late 90s, comes around, and they change the way that enterprises interact with software.

Feroldi: They were the first to push the idea of what we now call cloud computing to consumers.'s resolution was, they would take the software, and instead of distributing it on CDs, they would actually host it in servers. Their idea was that users would connect to this software through the internet. They would go on their browser, log into a website with a username and password, and they would have access to this software through the internet. They called that through the cloud. Instead of selling the software up front, you're almost renting time to use this software. That model is called software-as-a-service, or SaaS.

Lewis: This delivery mechanism really removes a lot of the issues that we see with the old CD ROM system. You are able to access software from anywhere. You're always working on an up-to-date version with this delivery mechanism. It seems to eliminate a lot of the friction that we'd see normally.

Feroldi: There are a lot of benefits to the SaaS model. You touched on a couple of them. If you, again, go back to the enterprise model, it's extremely easy to deploy this across 50, 100, 1,000 users, because all you're doing is giving them a website, buying a username for them and time on it, and then everybody can access this software instantaneously. It's also a lot lower cost upfront for the user. Instead of paying a large bolus of money upfront, you're just paying a low monthly or annual fee.

A couple of other benefits are that, depending on the software, some of these programs can be very intensive on your processing power. But when you host it in the cloud, all of that processing, that heavy lifting, is done by servers that are stored elsewhere. So, you don't necessarily need to have the most up-to-date, latest version of a computer to run some of these programs.

Lewis: You mentioned the low upfront cost. Something that you'll see a lot with SaaS providers is this idea of a virtuous cycle. You start out small, and it's something that an individual entrepreneur can use. As they grow their business, their use case grows with it, they add more licensed users, maybe they build out the functionality. This is a benefit for consumers. It's also a great benefit for these businesses because they grow, and they share in the successes of the people that are using their software.

Feroldi: That's absolutely correct. There are a lot of benefits for consumers to switch to this model. Having said that, there are some downsides, too. Adopting a SaaS model can be a lot costly in the long-term. While you're paying smaller monthly fees, those fees do add up over time to typically be a bigger number than the initial bolus that you would pay upfront for the old model when you were purchasing the software.

You also need to always have an internet connection to access it. And, the data that you're actually using at your company is also stored on a server that resides at another company. That can create some problems if you're working with really sensitive information. But, overall, the switch makes a lot of sense for consumers.

Lewis: Let's look at SaaS from an investing perspective here. Lewis asked this question, and I think it's probably prompted by looking at a decade-plus of returns from SaaS companies and realizing that this has been a great place for investors to park cash. I think one of the biggest benefits to these types of models is the fact that, instead of having a one-time sale, you now have predictable, recurring subscription revenue.

Feroldi: Yeah. The markets love certainty, the markets love predictability. Going from a single software sale that occurred, say, every two or three years, turning that into a monthly, predictable, recurring revenue is highly attractive.

There's other benefits for the companies, too. Back in the early 2000s, there were a lot of issues with piracy. People were taking software and trading it over the internet for free. When you convert to a SaaS model, it basically eliminates the piracy issue.

Software companies, when they were distributing them at retail stores, would also have to split the revenue with their retail partners. But, if you're distributing it over the cloud, the company gets to keep all that money for itself.

One of the things that you touched upon was what's known as the "land and expand" model. That's when the SaaS company essentially gets their foot in the door with a customer and then upsells them with more licenses, more products, more ways to create revenue over time. That's a very low-risk way to have growth from your existing customer base.

Lewis: You'll see different SaaS models approach this differently. Some of them low price their baseline product very cheaply so that entrepreneurs and very early stage start-ups can afford to use them. Some of them will go with the freemium model and say, "We're going to make ourselves available for free to individual users." The hope there is that they then become evangelists at their company when it comes to making software decisions.

Feroldi: Yeah. Both models definitely work.

Lewis: One other thing that I think is really important for investors looking at this space, and why it's so appealing, is that these businesses tend to have very high margins. Just as a case in point, we've talked about Salesforce a couple of times, they post gross margins of over 70%. That speaks to how profitable these types of businesses can be once you hit a critical mass of users.

Feroldi: Gross margins tend to be very high for these SaaS companies. Having said that, some of these SaaS businesses employ a couple of different models. Some of them have a service component to it, where they're selling a subscription, but they're also providing actual, physical human services to it, which can be a lower-margin business. Some of them sell subscriptions, but users can also pay one-time fees for access to higher-value services. Those can have different gross margins in them.

When you're comparing SaaS companies, you can't just look at the gross margin, you have to understand how it's made. But, to your point, the subscription portion of the SaaS business model does tend to be very high margin.

Lewis: Another strength that we see with this model, too, is the idea that switching costs become high once you become installed. This is the case whether you're delivering it in the old school method of software or SaaS. The switching costs are high because you trained people to use a certain type of software and you build out service functionality as they become more and more comfortable with it. To retrain an entire group of employees to use something else, it's going to be disruptive for a business, so these tend to be very sticky businesses.

Feroldi: Absolutely. From my own personal experience, the company that I worked for prior to coming to The Fool was a customer. We used that software for customer support, marketing, selling, for financials. If, by chance, was offline for a day, our business would grind to a halt. We were 100% dependent on for day-to-day operations. That just shows you how much power some of these SaaS companies can have over the customers.

Lewis: There are some drawbacks, though, for investors in this space, and some things that I think people need to be aware of when they're looking at SaaS companies. We talked about how we're building out these nice, stable, consistent cash flows with the subscription model. What that does mean is that there's going to be less cash on hand when the first purchase is made.

Feroldi: Yeah, that's absolutely the case. You can imagine, say, a company was selling a CD ROM for $100. Under the SaaS model, they're selling it for, say, $8 a month. From a revenue perspective, when they sold one user under the old model, they got that $100 upfront. Under the new model, they can only go up $8 in revenue per month. It does make their financial statements a little bit harder to decipher, because the way that the accounting works is, it masks a lot of the true profitability that these companies have just because of the timing of the revenue.

Another major risk for investors to watch is churn. You can imagine, if somebody bought a product ten or 20 years ago, they used it once and then they abandoned it, well, the software company still kept all that money upfront. Under the SaaS model, if somebody abandons the product after a month or two, then that company spent a lot of money acquiring the customer and they didn't even come close to recouping their cost back.

Lewis: Yeah. Much of the SaaS model is built into the expectation that once you acquire a customer, you keep this customer; and not only do you keep them at the current level that they're at for their subscription, you actually grow whatever their account value is. That might be through added users, or through new services being added to the suite of products that they're using. But it's not something that stays flat in the eyes of most of these management companies.

Feroldi: Yeah. For SaaS investors, one of the most critical metrics to look at is churn. You want, obviously, churn to be as low as possible.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.