At the Information Technology Alliance meeting in Austin last week it was clear that the mid-market value added reseller community is feeling that cloud computing momentum is now unstoppable, but many are still struggling to get their heads around the economic model behind cloud computing and how it is different from what they are used to in the old licensed software model.
The background behind this discussion is that the sales of new licenses have dramatically slowed down for the traditional mid-market ERP software companies – driven by the aging of their products, by the recession and now by the huge growth of cloud computing. This has put revenue and earnings pressure on the publishers of legacy software applications, which has caused them to reduce R&D investment, consolidate product lines and to squeeze the margins of their channel partners.
There are a couple of key insights that have made the light bulbs go off in my head around this topic that I thought I would share.
In the old on-premises software license model, the software vendor has high margins on a high dollar amount for the initial sale of their software, and very high margins on a much smaller dollar amount for recurring software maintenance fees. So the vendor’s cash in might look like $50,000 in year one and $9,000 ongoing. The vendor’s expenses might be $25,000 in year one and $2k per year recurring.
In the cloud computing / Software as a Service model, the vendor typically has zero or negative margins on a smaller dollar amount on the initial sale, and good margins on an ongoing recurring subscription fee that is 100% of the initial fee. So cash in looks like $30,000 both in the first year and ongoing and expenses might be $30,000 in the first year and $10,000 per year ongoing.
I think most people can wrap their heads around this. But this is also about the point in the discussion with the channel partner where I usually get the question – “Why would my client ever be willing to pay the same amount every year for their software when today they only pay 18 to 24% of their initial purchase price in ongoing years."
So here is the first key insight - in the old on-premises model, the vendor and channel partner economics are limited to the application software only.
In the SaaS or cloud computing model, the vendor and channel partner also participate in the revenue stream that their customers would formerly have spent on hardware, operating systems, databases, operations and IT, etc. All of these infrastructure and operating component are built into multi-tenant cloud applications – but the channel partner never considered this holistic view before because they only participated in the application software license component. From the channel partners economic model perspective, it means that in the SaaS model the channel partner is getting an ongoing revenue share on a much bigger slice of a much bigger pie.
And here is what’s really cool - In the SaaS model the customer actually pays less every year when you consider the total cost of ownership of the all in costs to operate the entire system. This is the secret sauce behind SaaS economics – it’s the disintermediation of IT infrastructure and operations – with the savings being split between the customer (who’s TCO is less per year) and higher ongoing margins to the publisher and the channel partner. The losers are the hardware and infrastructure software companies plus no value added IT tasks.
The key to SaaS margins is that the firms in the cloud computing world are vastly more efficient in infrastructure and operations that any individual customer can ever hope to be on their own – in the case of Intacct we and our channel partners gain a share of the spend that more than 5,000 CFOs would formerly have had to make on servers, copies of Oracle, IT staff, backup services, disaster recovery, etc.
If a channel partner is selling traditional ERP software, the channel partner typically participates only in the application software piece of the pie – the CFO writes separate checks to Dell, to Oracle, to their own internal IT staff, etc that the channel partner will never see or participate in.
This seems to be the hardest thing for the traditional channel to understand – they are so used to just thinking about only getting a piece of the application license fees. The cool thing about SaaS is it’s better for everyone (well everyone except the infrastructure vendors) – customers get better service and a lower total cost and the channel participates in a bigger slice of the overall pie.
This inevitably leads to the question of – ok what happens in the future when cloud computing matures – will the cloud firms squeeze channel margins like the on-premises publishers are doing today?
Here is the dynamic.
When new business dries up or slows down the legacy software vendor is in trouble because they only have the maintenance stream of their application software to rely on, and as we discussed above the dollar amounts are very small in comparison to new license sales – so small the high margins can’t make up for the overall earnings and revenue hit to the publisher. So what do they have to do – they squeeze expenses, including marketing, development and the channel.
When new business slows for a SaaS vendor, there is much less of a disruption – because the marginal impact of new sales is much lower and the ongoing stream is dominant both in terms of revenue and margin. Fast growing SaaS vendors actually get more profitable when new business slows down – the opposite of license vendors – because their mix shifts from zero or negative margin new business to solid margin stream business. So there isn’t the same pressure on SaaS companies to squeeze marketing or development or channel margins as business slows.
For fake cloud vendors – that are peddling “cloud washed” hosted versions of their old on-premises software it’s even worse – because their products are not multi-tenant, they don’t have anything close to the ongoing operating margins that the modern multi-tenant cloud vendors do – it is literally an order of magnitude more expensive to run hosted or single-tenant software that it is to run multi-tenant cloud applications.
This is why fake cloud vendors typically start out with unattractive channel margins from the get-go – they can’t afford to pay the channel due to technology economics - or inevitably will squeeze or disintermediate their channel - the hosted model is just broken economically. Witness the failure of the application service provider market in the early 2000’s – the fake cloud / hosted market is similarly doomed because the economics are not viable as compared with multi-tenant SaaS.
The last idea I'll leave you with is how positive the impact of both the business and innovation model of SaaS is to the channel partner and their client. It is not at all uncommon in the old on-premises world for channel partners to have just 10 or 20% of their customers on maintenance and support - which means most of the work they get is non-strategic and non-value added break-fix tasks and they engage with these clients very infrequently. In the SaaS world 100% of customers are on support and maintenance - it's embedded in the subscription fee and the overall delivery model and there is no way for the client to opt out - and new features come out monthly or quarterly - so the value added reseller becomes inseparable from the ongoing business processes of the client in helping them absorb change and take advantage of new functionality. Again this model works out way better for both the VAR and their client - the client gets continuous innovation and saves money, the VAR gets a constant stream of both value added work and ongoing revenue.
I hope this post helps to sort out some of the economic thinking behind why multi-tenant cloud computing is a win win win – better for the client, better for the channel partner and better for publisher too.
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