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A transformative shift is unfolding in the realm of enterprise software, propelled by the rapid advancements of generative artificial intelligence (AI). A recent study published on Monday by consulting firm AlixPartners reveals that the emergence of reasoning models and AI agents is challenging the long-standing assumptions that have underpinned the software-as-a-service (SaaS) business model for decades.

According to AlixPartners, this paradigm shift is impacting over 100 midmarket software companies, which find themselves ensnared in what the firm describes as a "big squeeze." These companies are caught between two formidable pressures: on one side, agile AI-native startups that can replicate software applications at significantly lower costs, and on the other, colossal technology corporations, such as Microsoft and Salesforce, which are investing billions of dollars into the AI arms race.

AlixPartners warns that many mid-tier enterprise software companies could face existential threats within the next two years. However, in light of the sensitive nature of their findings, the firm refrained from naming specific companies that may be affected.

AI: The New Foundation, Not Just a Feature

The study highlights that while some of the most advanced applications of AI in enterprise software include coding copilots like GitHub Copilot from Microsoft and support chatbots, such as Zendesk's Answer Bot, these instances might merely represent the beginning of a larger trend. Generative AI is evolving from its initial narrow applications to now impacting the broader "logic and presentation layers" of softwarethe very foundation on which traditional SaaS tools are built, according to AlixPartners.

This indicates that AI agents are transitioning from being mere assistants within applications to becoming the applications themselves. These intelligent agents are now capable of performing complex tasks, including scheduling meetings, analyzing reports, and writing code, often with minimal reliance on graphical interfaces or strictly structured workflows. Moreover, since they can operate across various data formats without requiring extensive data normalization, there is a distinct possibility that some traditional SaaS layers could become obsolete.

AlixPartners stated, "This shift could eliminate the need for many enterprise software companies that thrived in the traditional SaaS architecture," highlighting the profound implications of this evolution.

A New Threat from Both Sides

The emergence of generative AI tools poses a significant challenge to midsize SaaS vendors, the report elaborates. AlixPartners conducted an analysis of 122 publicly listed enterprise software companies, all generating annual revenues below $10 billion. Results from this analysis indicated a concerning slowdown in sales growth for these firms. For instance, the percentage of companies classified as high-growth dropped sharply from 57% in 2023 to only 39% in 2024. Analysts predict further declines, estimating that a mere 27% of companies will maintain their high-growth status this year.

Additionally, AlixPartners revealed that customers in the software sector are shifting their allegiances more frequently than ever before. The median net dollar retention rate for enterprise software companies plummeted from 120% in 2021 to just 108% by the third quarter of 2024, according to data sourced from Bank of America. Net dollar retention (NDR) is a widely used metric to assess customer loyalty and revenue growth, where a figure above 100% indicates increasing revenue from existing customers, while a figure below signifies a downturn.

The pressure on these midmarket firms is exacerbated by AI-powered competitors who can offer services at lower costs and deliver innovations at an accelerated pace. Simultaneously, tech giants are integrating AI into their broader service platforms, providing bundled functionalities at reduced price points, thus leveraging economies of scale.

A noteworthy example of this trend is Klarna's recent decision to abandon Salesforce and Workday in favor of smaller, AI-powered vendors and in-house solutions, demonstrating a potential shift in customer preferences.

The SaaS Model: Ripe for Reinvention

The traditional SaaS model relies heavily on user interfaces, structured data workflows, and seat-based pricing strategies. However, the emergence of AI agentscapable of operating independently from dashboards and rigid data hierarchiescalls into question the viability of the SaaS model as it currently exists, according to AlixPartners.

Recognizing this shift, companies are beginning to adapt. Industry leaders such as Salesforce and ServiceNow have initiated experiments with outcome-based pricing for AI agents, where fees are determined by the results delivered rather than the number of users.

In AlixPartners' analysis, half of the mid-sized software companies surveyed expressed expectations of significant changes to their business models within the next year.

Additionally, the computational costs associated with deploying AI agents can often exceed those of traditional SaaS tools, raising concerns about profit margin compression. As such, software providers may be compelled to rethink their infrastructure strategies and transition to more efficient inference architectures, as noted by industry experts.

Amidst higher interest rates and tightening capital markets, the focus on profitability rather than mere growth has intensified for software companies. In response, many firms are undertaking cost-cutting measures, optimizing their portfolios, and reassessing their pricing strategies.

The AlixPartners report indicates that over 60% of executives are now prioritizing AI as a critical driver of growth. However, realizing this growth will necessitate more than superficial product adjustments; it will require a comprehensive transformation across operational processes, market strategies, and customer engagement approaches, as suggested by the consulting firm.

How to Survive: A New Playbook

So, what does the future hold? The report outlines several strategic imperatives that companies should consider for survival and growth in this evolving landscape:

• Build AI agents: Develop these as core products rather than just supplemental features.
• Transform the business model: Shift from a traditional seat-based fee structure to one that is based on usage or outcomes.
• Streamline and focus: Discontinue low-growth products and reallocate research and development resources toward AI innovation.
• Lean into mergers and acquisitions: For some companies, consolidation or acquisition may be the optimal path forward.

In a landscape where generative AI tools can effectively create or replicate software, the differentiation must stem from speed, relevance, and efficiency rather than the design of user interfaces or outdated feature sets.

While the era of traditional software may not be coming to an end, the SaaS landscape, as we have known it, is undoubtedly undergoing a significant evolution. The next generation of enterprise tools may not necessarily be traditional applications; they could very well be intelligent agents. According to AlixPartners, only the most adaptable companies are likely to successfully navigate this transformative journey.