In the summer of 2000, a security problem shut down the IT help desk software at the University of Memphis in Tennessee and left students bewildered. The application,Ask Tom, had become an indispensable source of information for students, telling them where to pay fees and how to open a university email account.

School administrators decided that it would be safer to move Ask Tom from an internally administered system to one hosted by a software provider on its own server and accessed via the Internet. RightNow Technologies, a fast-growing provider of hosted applications based in Bozeman, Montana, came to the rescue. “Hosting relieves us of all the headaches associated with scaling up capacity and doing software upgrades,” says Steve Terry, director of IT client services at the university.

The school is of one of many businesses and organizations that have turned to web-based software instead of packaged software that can cost millions of dollars and take months to implement. Essentially, they are making a major shift to renting instead of buying.

“Software as a service” is the catchphrase for applications delivered over the Internet. Also known as on-demand or online software, this approach took off in the late 1990s and has begun to pose a significant threat to the traditional providers of enterprise software, which is used to manage business functions like manufacturing, inventory, accounts, and sales and customer data. With on-demand applications, a vendor provides access for a monthly subscription fee and frees the customer from maintaining and operating the product.

This isn’t necessarily good news for the enterprise software sector, whose growth fell from double digits in the 1990s to an estimated 4.9 percent in 2005, according to research firm IDC. Traditional packaged or licensed software still captures more than 90 percent of revenue, but the on-demand segment is clearly the fastest-growing. Although it accounted for just 1.5 percent of the $72 billioninglobal software sales in 2004, IDC expects that share to more than double to 3.8 percent by 2009.

But does that mean it’s the end of the road for SAP, Oracle, and BEA? Hardly. “Software as a service has the potential to reinvigorate the overall software industry, which has been a little stagnant lately,” says Erin Traudt, a research analyst at IDC.

Software buyers are interested. “[Software as a service] is the biggest item being discussed by software companies and by the customers,” says M.R. Rangaswami, managing director of The Sand Hill Group, a software consultancy based in San Francisco. “The attention, the mindshare, and the buzz it is getting is phenomenal.”

The hosted software business is growing at a 21 percent compound annual growth rate, according to IDC estimates. The total market for hosted software was $4.2 billion in 2004 and could reach $10.7 billion in 2009.

On-demand software has made its biggest inroads in managing information about customers, so-called customer relationship management (CRM). While the revenue share of traditional licensed CRM applications dropped to 91 percent from 95 percent in 2004, revenue for on-demand CRM rose from 5 to 9 percent of the total $4.8-billion CRM market, according to AMR Research. The big enterprise software players are well aware of the shift. Oracle has launched an on-demand product, and SAP plans to. Microsoft offers both a traditional package and an online version.

Others have failed to adjust to the shift, and suffered as a result. Siebel Systems of San Mateo, California practically invented the CRM category. However, despite introducing an online version of its own product, Siebel’s licensing revenue declined by 55 percent to $487 million in 2004, from more than $1 billion in 2001. Siebel’s stock price peaked at more than $100 during the 2000 tech boom and now hovers around $8.

“Software-as-a-service vendors are getting much bigger traction and they have been able to grow at the expense of traditional software companies,” says IDC analyst Albert Pang. “This is really going to transform the enterprise software industry for years to come, and we have seen just the tip of the iceberg.”

On-Demand in Demand

Until about five years ago, companies seeking heavy-duty software had one choice: complex products that often took months to implement and that came with hefty licensing fees. And buyers were often disappointed with the results. In 2004, 53 percent of enterprise software projects were either late, over budget, or were delivered without required features and functions, according to research by the Standish Group, an IT investment evaluation firm in West Yarmouth, Massachusetts. These problems will cost businesses $84 billion in capital investment in 2005.

To avoid the recurring failures, businesses started switching to hosted solutions from companies such as Salesforce.com, which made its name with on-demand CRM. The San Francisco-based company, founded by flamboyant former Oracle executive Marc Benioff, has grown its revenue 245 percent to $176 million in 2004. Its subscriber base has grown to 308,000 users at the end of July from 41,000 three years ago.

The company charges around $65 per month per user for subscription. Salesforce’s stock, which debuted on the New York Stock Exchange in June 2004 at $11 per share, was up 80 percent to around $20 at the end of August.

RightNow Technologies, founded in 1997, also successfully completed an IPO in August 2004. The company’s revenue increased 130 percentto $62 million in 2004 from $27 million in 2002.

Other companies have expanded the on-demand model beyond CRM. NetSuite, based in San Mateo, offers an enterprise resource planning (ERP) product online as well as CRM to SMBs. The private company has seen its revenue grow 250 percent per year in each of the last three years, according to Mei Li, vice president of corporate communications.

VCs Jump In

Some venture capitalists decided that hosted software was so hot that they created a VC firm just to nurture innovation in the area. Gordon Ritter, Brian Jacobs, and Jason Green came together to create Emergence Capital Partners in the nuclear winter of 2002. It took the San Mateo, California-based firm nearly two years to raise a $120-million fund from institutional investors.

“We started this firm because we see a structural, tectonic shift” that will be easier for smaller companies to make, says Mr. Ritter. “The differences are so great there are very few companies that may be able to switch over, and the bigger you are—like SAP and Oracle—the harder it is,” adds Mr. Jacobs.

Also, startup service companies don’t require a great deal of upfront capital like software companies. Since the late 1990s, a slew of software-as-a-service startups have sprung up in the industry. They include Vettro, Rearden Commerce, and Five9.

What Are the Bigwigs Doing?

Salesforce’s Mr. Benioff may revel in proclaiming the end of business software, but most analysts expect the market to evolve into a blend of traditional and on-demand software, with on-demand products gradually taking a bigger share.

Large companies like SAP, Oracle, Microsoft, and Siebel already say that their on-demand products are their fastest-growing offerings. “Thanks to on-demand, we’re opening up whole new markets that we weren’t in before,” says Keith Raffel, vice president of Siebel CRM OnDemand.

The hybrid model is embedded in Microsoft’s CRM strategy. “I think the market is looking for a balance between an option for on-premise and software as a service,” says Brad Wilson, general manager for Microsoft CRM.

Concerns remain about the potential limits of on-demand products, however. Some customers worry about security because their data is stored on someone else’s servers; they also fret about the real cost of customization, and whether these products can scale up to the number of users on full-fledged packaged products.

Making the transition to an Internet delivery can pose a technical challenge for software makers accustomed to a client/server model. It requires major changes in the underlying software architecture and in sales and marketing strategies, as well as alterations in the accounting practices to accommodate differing revenue streams. Perhaps most vexing, it may also require cultural change within the company, says Rick McGee, IBM’s vice president for Software as Services.

The complexity of on-demand software can increase with the involvement of partners and systems integrators and the size of the deal. Salesforce made unwelcome news in July for a delayed deployment of its applications at Cisco Systems. According to a report by JMP Securities, user resistance and integration challenges caused the delay. Mr. Benioff denies any problems at Cisco, calling it “a very successful deployment.”

Oracle, the world’s second-largest enterprise software company, has invested in about 600 research and development engineers to better deliver software as a service, says Juergen Rottler, executive vice president of Oracle On Demand.

“We’re interested in transforming the way our company does business and at some point in time we expect on-demand will be a standard way customers will do our business,” says Mr. Rottler.

He expects Oracle’s on-demand model to overtake the traditional on-premise model in terms of revenue in the next five years. But that doesn’t mean that the company will abandon traditional software.

Moving to the on-demand model will also affect the finances of enterprise software companies. Companies with the on-premise model are accustomed to recording millions of dollars in revenue every quarter while signing deals, but revenue will be spread over a period of time for hosted products.

SAP doesn’t appear troubled by this. “It’s good news—having ongoing revenue is better than betting our life on upfront revenue every quarter,” says Pascal Brosset, SAP’s senior vice president for market strategy. Nevertheless, “it will take a lot of explanation to The Street,” he says.

Contrary to the battle cries of some, the on-demand model won’t kill enterprise software—if anything, it has breathed some life back into the slow-moving market. New business models, new revenue streams, and the challenge of balancing onsite software with the new Internet delivery model will keep managers on their toes for some time yet. Confronted by a plethora of choices, customers can’t seem to lose.