China enterprise software: PaaS vs SaaS

As enterprise services buck the downward trend in Chinese private equity investment – there were 54 deals in the first quarter, more than any other sector, according to the China Academy of Information and Communications Technology (CAICT) – there appears to be a growing consensus as to where the smart money should go. Forget software-as-a-service (SaaS). Platform-as-a-service (PaaS) is the new goldmine.

Alibaba Group, Tencent Holdings, and Huawei Technologies have all launched middle platform solutions – which enable customers to collect and manage data，and also run business applications from outsourced cloud-based systems. Meanwhile, investors are pouring money into PaaS start-ups such as MiningLamp Technology and 4Paradigm. The latter achieved a valuation of $2 billion in its most recent funding round.

Some industry participants are keeping their distance, however. Wayne Shiong, a partner at China Growth Capital (CGC), started investing in SaaS as early as 2014 but has yet to participate in the middle platform frenzy. “Many SaaS or PaaS companies offer customized solutions instead of standardized projects, so margins are low. The business models cannot back up these companies’ sky-high valuations,” he tells AVCJ.

Shiong’s withering assessment is that Chinese venture capital investors raised on consumer internet plays have caught the enterprise bug. Valuations are being driven up because a consumer internet business logic is being applied to enterprise services. 

The SaaS business model is simple and attractive, not unlike a landlord collecting rent on a property. Customers pay an annual fee for as long as they use the product. For start-ups in the space, it is infinitely preferable to the traditional model of a one-off payment for a perpetual license – although updates and quality service are key to customer retention.

“Say a customer pays me RMB100,000 ($14,200) this year and the same again every year. It’s possible that I can cover all my costs in that first year, so the net profit margin rises in each subsequent year,” explains Changzheng Zhang, chairman and CEO of Huilianyi, a cost-management SaaS player that recently raised a RMB300 million ($42 million) extended Series C led by China Renaissance.

Those margins are maintained because there is no customization. “Every company has different requirements, if you customize for each one, you’ll hit a dead end,” Zhang adds.

Monetization issues

Not all investors are convinced by the SaaS narrative. Erhai Liu, founder of Joy Capital, previously told AVCJ that the segment could die out completely because Chinese companies are unwilling to pay for software. There is a widely-held view among investors that small and medium-sized enterprises (SMEs) cannot be persuaded to pay for a service based on efficiency gains alone – there must be some angle to help boost top-line revenue.

This has led to a degree of business model innovation. Linctex Digital, for example, is a design cooperation SaaS start-up that targets the fashion industry. According to James Wang, partner at Vision Plus Capital, which is an investor in the company, Linctex does not sell software. Rather, the company enables garment manufacturers to adopt modern design processes and thereby secure more orders from fashion brands using the same systems.

Even if start-ups are able to construct a value proposition that brings SMEs in niche markets to standardized products, large businesses represent a hugely different challenge. Put simply, everything must be customized. “None of our government customers use SaaS,” says Ping Jiang, co-founder of MiningLamp, adding that the commercial demands placed on large corporates are sufficiently complex that SaaS is not a good fit for them.

This leaves the industry in a difficult situation: large corporates prefer customized products, so no high-quality standardized solution has been developed; and because there is no high-quality standardized solution, large corporates stick to customization.

With this in mind, Kyle Liu, a principal at Redpoint China Ventures, argues that PaaS represents a superior opportunity to SaaS. While front-end delivery must be tailored to meet the needs of individual users, the middle platform can become more of a standardized layer. A PaaS player can therefore rely on upstream and downstream partners to deliver customized products.

This nuance is recognizable in the strategies of China’s technology giants. Zhifeng Li, head of WeChat Work, Tencent’s enterprise coordinating tool, compares his product to a house that comes equipped with basic utilities such as water and electricity. The “fine decoration” is carried out by partners who offer SaaS applications and smart hardware that integrate with WeChat Work.

Collaboration-enabling platforms like Alibaba’s Dingding, Huawei’s WeLink, and ByteDance Technology’s Lark take a similar approach: they want to bring together different SaaS providers that offer functions from video conferencing to marketing campaigns.

However, the PaaS or middle platform concept amounts to much more than integration. It was first put forward and executed by Alibaba in 2015 as internal fix. The company found that each business unit generated and managed its own data, which was held in silos and couldn’t be easily shared. The middle platform brought all these data together, allowing Alibaba deeper insights into how its businesses might operate with greater efficiency.

Logical evolution

MiningLamp is one of several start-ups with ambitions of becoming a middle platform, even though three-fifths of its business is SaaS-based. “We’re working towards PaaS because we want to do more than just simplify approvals processes or solve basic analytical problems,” says Jiang. “We want to assist in core decision-making by drawing data from different departments into a single platform and then apply our big data capabilities to that data.”

Jiang stresses that MiningLamp is not yet a PaaS company because it delivers customized rather than standardized solutions. But a customized product could be the starting point for something standardized – an evolutionary path already followed by DataCanvas.

In 2016, the company was working on customized machine-learning projects for China Bank of Communications and Shanghai Pudong Development Bank. It used these as a launching pad for standardized products aimed at a broader userbase. “What I provide is purely standardized,” explains Lei Fang, DataCanvas’ founder. “Think of it like Excel. You use Excel to create all kinds of tables. If you want to build an AI model, you need our auto-machine learning platform, which is exactly the same for any customer.”

Investors do not dispute that a project delivery model could become a PaaS solution in the future. What they dislike is valuations based on false development assumptions.

“Some middle platform companies claim to be China’s Palantir Technologies, but standardized products only account for 30-40% of their total contracted revenue. I feel like they are just telling a story,” says Liu of Redpoint, which is an investor in DataCanvas. “The ideal proportion is 70-80%. It’s even possible to achieve 100% while leveraging partners to deliver final customization.”

The reality of China’s mainstream SaaS and PaaS players is that they all still work on a project basis. These projects typically are small in size, low in margin, and the customer pays on delivery, which can lead to unreliable cash flows. CGC once backed an HR software company that wanted to pivot from project delivery to SaaS but failed because its cash was tied up in the traditional business, so there were no resources for investment.

“If the average customer order is more than RMB5 million and the gross margin is 70%, you can continue to deliver projects. After a period of exploration, you might learn how to standardize. But each project is only worth RMB500,000 to RMB1 million and your cash flow is a mess because of the long cash-collection cycle,” says CGC’s Shiong.

A consensus view has emerged that project-based start-ups should be valued based on their current business model, not what they want the business model to look like. “Investors used to bet on future profitability when a start-up achieves scale. Now this story is fading. You need to show investors that you can be profitable in any scenario, using a healthy economic model for rapid replication and expansion,” says Leo Zheng, founder of Lighthouse Capital.

Asked about realistic valuations, Shiong believes some high-quality Chinese software companies will emerge with annual revenue of at least RMB1 billion. Using a 7-13x price-to-sales ratio, the average valuation should be around RMB10 billion ($1.4 billion). “I think a bunch of existing Chinese software companies will have exit valuations of $600-700 million. If they are already valued at $500 million today, that‘s not reasonable,” he says.

Risk factors

Valuations should also consider that PaaS is inherently riskier than SaaS. MiningLamp’s Jiang describes SaaS as an ongoing endeavor, with functions added and improved here and there, delivering values in a short period for enterprise customers. PaaS represents systematic change. It is not only a digital process. It is also the transformation of the entire structure.

“IT is a tool. If you don’t have the appropriate organizational capabilities to ensure its implementation, this change will fail,” Jiang says.

Chinese media reported earlier this year that Kweichow Moutai, China’s leading baijiu maker, was unhappy with the performance of Yunxi Technology, its middle platform supplier. Yunxi, which raised a RMB350 million Series B round last October, subsequently admitted that it was unable to cover the cost of this high-profile project.

The other – inevitable – challenge for aspiring PaaS start-ups is the domestic technology giants. Alibaba, Tencent and Huawei have already expanded from infrastructure-as-a-service (IaaS) to PaaS and their next move will be into the SaaS layer, observes Yuxiang Zhou, co-founder of Blacklake Technology, a SaaS provider that specializes in smart manufacturing.

"ByteDance just released its own electronic signing software, which will impact every start-up in that space,” he adds. “As these giants are penetrating into the application layers, you need to play in a very niche market to be safe.”

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• Topics
• Greater China
• Early-stage
• Expansion
• Technology
• China
• enterprise software
• China Growth Capital
• Venture
• Redpoint China Ventures
• Lighthouse Capital