The business model of software companies has gone through a monumental shift. In the old days, you had to buy an expensive CD to install software on your computer, or -- if you were an enterprise customer -- hire someone to come in and do it for you.
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Updates were available via the Internet, but not always. If the software improved markedly, you'd usually have to pay for a whole new installation -- and it wasn't cheap.
It's out with the old, and in with the new. Image source: Getty Images.
But all of that has changed now. SaaS is the new term on the tip of many investors' tongues; it stands for software-as-a-service. It is delivered via the Internet, and because you pay a much smaller monthly subscription fee, the financial barriers to purchasing it are much lower.
HR and payroll specialist Paycom Software (NYSE: PAYC), mortgage software provider Ellie Mae (NYSE: ELLI), and cloud computing king for drug companies Veeva Systems (NYSE: VEEV) are the three best software companies you could buy in 2017. They share three key traits that any investor can love: high switching costs, blazing growth rates, and founders or CEOs with lots of skin in the game.
No one wants to deal with these headaches
Imagine that you open your first bank account when you're in high school. Over time, you connect a lot of different things to this bank account: bill payments, ACH deposits, even tax refunds.
Fifteen years later, you are with a friend who needs to make a quick stop at her bank. You realize, through the experience, that the customer service you're getting at your old bank is downright terrible. It makes you mad. So, you consider switching banks.
Image source: Getty Images.
But then, you remember that your paycheck is already synced with your current account, all of the addresses and schedules to pay your bills are there as well. And -- to be honest -- you have better things to do on a Saturday afternoon. So you shrug your shoulders, decide to bite the bullet, and move on.
That is an example of high switching costs. And in this example, all we're talking about is doing a little bit of paperwork and a trip to a new bank. Imagine if switching required you to pay tons of money, retrain all of your employees, potentially lose mission-critical data, and deal with the headaches of downtime.
Paycom not only covers payroll for your employees, it also deals with other areas of HR: healthcare compliance, time off, talent management, and hiring. Ellie Mae is the one-stop shop for anyone involved in the mortgage businesses; whether you are a real-estate agent or general appraiser, Ellie Mae's Encompass platform is the easiest way to connect with customers. And Veeva has created a cloud suite through its Vault offering to handle everything from regulatory compliance to collecting data used for FDA trials.
Once customers are hooked into the ecosystems of these three software companies, the switching costs are very high.
They're winning over customers in droves
Here's the thing about having high-switching costs as your main advantage: They are also your biggest problem. That's because every customer you approach is already using someone else to provide the software that you want to sell. As such, you can only win them over if your software is markedly better.
But that's exactly what these three companies have been doing. Take a look at the sales growth rates at all three companies over the past five years.
Paycom, Ellie Mae, and Veeva have seen sales grow by 37%, 43%, and 43% per year, respectively, since 2012. And while profitability hasn't kept pace, that's because all three are aggressively reinvesting in their businesses to get market share now -- and enjoy the benefits of high switching costs later.
Founding leaders with skin in the game
Finally, I am comforted by the fact that all three companies are led -- in one capacity or another -- by their original founders. Such leaders often view their organizations as an extension of themselves and are intrinsically driven to focus on the long term rather than quick profits.
I also like it when management has its own skin in the game, too. Here's what that looks like at these three companies.
Data source: Most recent company proxy filings. Gassner owns 26.6% of voting power, partially through owning 32% of Class B shares. Veeva executives hold 46.6% of voting power, partially through owning 56% of Class B shares.
Obviously, I'd love to see even higher ownership rates at Ellie Mae, but I'm thrilled to see so much skin in the game at Paycom and Veeva. At the end of the day, I think the leaders of all three companies have a huge incentive, financial and otherwise, to maximize long-term value.
And lest you think these are empty words, its worth noting that these three companies combined form 8% of my real life holdings. I think all three are worthy of your consideration in 2017, as the SaaS model, combined with high switching costs and undeniable momentum, makes them all great stocks to own.
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Brian Stoffel owns shares of Ellie Mae, Paycom Software, and Veeva Systems. The Motley Fool owns shares of and recommends Ellie Mae, Paycom Software, and Veeva Systems. The Motley Fool has a disclosure policy.