Complexity of Building a SaaS Software Channel Program

Complexity of SaaS Pricing

Complexity of SaaS PricingIn my previous blog entry, I discussed about the complexity of channel development and channel alignment. I recommended for SaaS software vendors to use Business Model Canvas to compare the business model with the assumed business model of its prospective channel partner.

During the past few months I have spent time building a SaaS channel development educational program, a program that I wanted to be not only actionable, but providing information of all of the needed drivers that SaaS software vendors should be thinking about when building its channel strategy.  Call me old fashioned, but my  philosophy is to educate people of things that I have personal experience in. There are lots of consultants that “help” their clients doing things such as channel development, consultants that have never sold anything, but have read about it in books.  My strategy is to build something that is concrete and actionable (not academic) that my audience can use when thinking about their SaaS channels.

The way I initiated the development of the channel development alignment educational program in http://www.tellusacademy.com was to reflect on my own channel development experience (both as channel builder as well as reseller) and list the main things that I felt were crucial in getting channel partners to become excited. The way I started working on it was not from a traditional channel perspective. I asked myself a simple question: how is the channel partner going to make money? Once we identify this, we can worry about the software vendor (ISV) as without a profitable business model for the channel partner, there is no need to invest time and energy to plan something that will not work anyway.

If the financial success of the channel partner should be the foundation for the software vendor to evaluate the channel strategy, it is easy to assume that it is important for both the software vendor and the channel partner to understand how SaaS financial will change the business model and what kind of drivers each party needs to be thinking about. Therefore, I believe that every person working in the SaaS world needs to have a good and solid understanding in how the financial and operational model will change when running a SaaS business. I am sure that the CFO of the ISV and channel partner appreciates this.

I spent considerable time in reviewing the topics that both ISVs and channel partners should be thinking about. Besides having a solid understanding in SaaS financials, any vendor in today’s world has to be thinking about business model innovation and topics around that. How do we stay relevant today, tomorrow and next year? What is happening in our marketplace and what kind of actions do I have to take to ensure that my services or solutions are also appealing in the future? You would not believe how many organizations ignore this….it is amazing.

Another important factor to think about is to understand the expectations from the channel and ISV perspective. What can the ISV expect from the channel and what should the channel expect from the ISV? This is a also something that has changed in the last couple of years as channel partners have a tough time to adjust to the recurring revenue model from the traditional “one big lump sum model”. Besides this, traditional channel partners are not very good at account management and this is a huge issue for SaaS vendors as upselling and ensuring retention is a top priority to any SaaS vendor. The ones that have negative churn can say that they have been successful at least in the upsell to existing clients.

Channel roles and responsibilities is a topic that seems to be very unclear to both software vendors and channel partners. Basic questions such as “who is going to provision the cloud instance” is not clear and questions such as billing is also a question that many struggle with. Should the software vendor manage the billing or should it be the channel partner? What if the end customer does not pay the bills, should the software vendor still bill the channel partner and even take them to court for unpaid balances? In the traditional channel world we can argue that most of these types of questions could be easily sorted out due to known practices, but the SaaS/app world is still a bit unclear who does what.

Part of the channel profitability discussion should be a discussion of channel margins. In my course, I will give examples of a typical channel partner scenario where we will model one sales rep and his/her targets and what it means to the channel partner. This type of exercise is extremely health for any software vendor to see the reality of a channel partner and their desire to build a solid business. If you are a software vendor, have you modeled the channel partner business and how your solution might play in that space?

And finally, any software vendor will either become successful or fail and it is going to be based on the channel program that the organization is going to build and maintain. During my SaaS channel development course, I will also address the main drivers of channel management and key issues that an ISV need to be thinking about.

It was fun to create this course as everything is based on experience either from my own work or the teams that I have worked with for more than 20 years. As said, I do not believe in education of best practices if the person does not have any personal experience. This type of experience comes with blood, sweat and tears.

 

 

 

 

photo by: Sean MacEntee

The App Economy – How should we view app monetization?

The blogosphere is all about apps and how different ecosystems compete for the eyeballs of these and the money of course. You might still remember the the news when a far app pulled as much as $10,000/day in revenue but since then there is tens of similar applications on the marketplace. This started a trend where people left their well-paid jobs to chase their dream of creating apps and living a life without pressures. The growth of app economy is one of the most promising trends, but people/organizations that want to make real money of it, need to include some risk management into it as well. The app industry has become similar to film industry where relatively few people make money and the ones that make, are hugely successful like Angry Birds phenomenon from Finland.

One might of course ask oneself is whether this is a shift in our society and how work is performed. according to Erik Brynjolfsson (director of the M.I.T. Center of digital business), “technology is always destroying jobs and always creating jobs, but in recent years the destruction has been happening faster than the creation”. There is no question that technology is creating new jobs and apps can be part of this opportunity as can be seen in many of the reports that have studied this trend towards “app economy”.

What I have not seen many discussions around is how the app economy is linked with the enterprise software business. I have researched around this and identified the “dimensions” that are typically linked to the app business, but not that much is said how established software vendors should view this space and how these vendors can make a entry to the app space in a way that makes sense and where there is also a sustainable economical model.

So, the question that we should ask ourselves is how much of the app business is truly geared towards the consumer business and how much of this will gradually move into enterprise business? Should software vendors keep the app business in their plans when building enterprise solutions specifically using the cloud? If they should keep this in mind, what kind of pricing should the ISV use? Maybe free as the real money comes from the enterprise solution and not the app that accesses it? As you can see, it is not that clear and my own experience when working with both small and large enterprises, the app business hardly ever comes up in discussions. I am convinced that this will change and it will change very quickly. One of the drivers will be Windows 8 and Windows Phone 8 developers that will create solutions that will be based on app technology and not on traditional desktop app architectural model even if these will be able to run in Windows 8 Pro environment.

Another valid question that we need to ask ourselves is whether app economy should be see purely from mobile app development perspective or should we view it from a perspective where the device is just the means to get to what you want and the backend (typically the cloud) is the one that provides the services and brokers the interaction between different services. Shouldn’t we in fact be talking about services economy instead where organizations build apps to consume and combine information from different sources using different SOA interfaces that organizations/developers have exposed to the world. Isn’t this what we have always dreamt about?

NokiaExpressI downloaded today a Windows Phone 8 app (Nokia Xpress) to my shiny Nokia Lumia 920 and this app really demonstrates where things are going. After having installed the app, it asked me whether it can use location information (which most apps want to use), but what really made me to think about the future of apps is that developers really have to think “outside the box” on when developing apps. The thing with this Nokia Xpress app is that it enables users to store and read articles on your phone (locally) so when you travel, you do not have to use expensive data roaming. I know.. there are many of these apps from before, but what this app has specifically thought of is to really monitory and minimize data usage and provide a combination of technology such as Microsoft SkyDrive technology to store videos and images without having to use the data plan. Why is this relevant to me? Just this week, my son’s data plan was going over the limit and I found out that it was all about video streaming and 2 gig data plan does not cope well with this.

The topic of “app economy” is very interesting to me as researcher, but also as practitioner. A recent paper written by Dr. Michael Mandel and Judith Scherer (commission by CTIA (The Wireless Association) and Application Developers Alliance provides an interesting view on the app economy. According to Mandel, the entire “App Economy” was coming to use in early 2009 and was popularized by a cover story run by BusinessWeek in November 2009.

The way that Dr. Michael Mandel describes App Economy in his February 2012 report resonates well with what I have educated my customers in respect to ecosystems:

“ App Economy is a collection of interlocking innovative ecosystems”. Each ecosystem consists of a core company, which creates and maintains a platform and an app marketplace, plus a small and large companies that produce apps and/or mobile devices  for that platform. Businesses can belong to multiple ecosystems and usually do”.

There is no question in my mind that this topic is relevant to anybody that works in the software industry and it is fascinating to see how this evolves with time and what kind of new companies will rise to take advantage of this.

If you work in the Microsoft ecosystem, I highly encourage you to read the article “Microsoft’s cloud vision: Why Azure is the linchpin of the firm’s new devices and services strategy”. Another great article from Information-Management.com that predicts Enterprise Apps to go mobile big time and that money apps will move to the cloud. The article lists quite a few things that are very interesting and I encourage you to read that article as well.

Stay tuned for more, there will be more to come on my research on different topics and this app economy being one of them!

ISV wakeup call: Cloud and mobility will surge in 2012 according to IDC

I run a seminar in Finland at Microsoft Finland office 23rd of November for Microsoft ISVs about the transition to the cloud and what it means for software vendors overall. One of the key things in my messaging for ISVs is that they have to look at the cloud together with mobility going forward. This morning I run into an article in Information Management web-site where IDC predicts that mobility and cloud will surge in 2012.

It is easy to agree to this based on what we have seen in our work and research specifically in the US continent. IDC predictions are based on 1000 IDC analysts and according to this study, cloud spending will top $36 billion next year which is four-times the overall IT industry rate of growth.

Another interesting statement from IDC chief analyst Frank Gens is that there will be a “generational shift in the tech platform adoption and innovation” which could according to him lead to a worldwide IT spending of $5 trillion by 2020 and all of this based on mobile tech and the cloud.

Based on hundreds of discussions with independent software vendors (ISVs) around the world we have seen a clear shift in the urgency of many ISVs to ensure that they are on the right bandwagon concerning the cloud. My colleague, Juha Harkonen has been analyzing the trends for quite a while and the observations that he has made are very interesting. You might want to check some of his observations from his excellent blog.

 

 

 

SaaS companies are better valued when compared with traditional software companies according to latest research

Now it is in the open. According to a recent article from Gigaom.com and research from Martin Wolf M&A Advisors, SaaS companies are getting much higher valuation when compared with legacy software vendors. The chart from Wolf M&A Advisors tells it all:

I knew we would get to this sooner or later as the move is definitely towards the cloud and ISVs that are resisting this move, will eventually run into issues if they do not re-architect their legacy solution as clients will require a true SaaS solution and not a solution that is “running in the cloud” but without really taking advantage of things such as scalability etc.

The Gigacom.com article concludes that it is not a surprise that enterprise vendors acquire smaller SaaS players such as the acquisition of RightNow Technologies by Oracle (1.5 billion). I work with ISVs around the world and I have seen many different types of organizations, some of them being start-ups and some making the transition from legacy business to SaaS business. One very popular way for traditional ISVs to make inroads to SaaS game is to build some type of an extension to the legacy solution to get experience what it is to build for the cloud and this also gives a more evolutionary way of creating something that can be sold to existing customers as add-on service.

I think each and every software executive should contemplate on the message from Gigaom and Martin Wolf especially if the company is in the game of getting sold in the future. The times of high license revenue with maintenance and support is gone and will be sooner or later replaced by monthly/quarterly recurring revenue where the software vendor has to create a solution that is not only used but loved by its users. Gone are the times where a software was sold that was both unfriendly to use but as the software vendor got its money, there was no incentive (other than getting the annual maintenance and support fee paid after first year) to ensure that the software was something that the buyer really liked. In the old-fashioned model, the company paid a large lump sum for the software and this was almost always a lock-in from the software vendor as the end user organization is always fully invested in the solution and is almost forced to pay the maintenance fee in the end. I do remember vividly when I was CEO for a business intelligence company when I was always worried whether our largest clients would pay the support/maintenance fee in the beginning of each year.

 

Cloud ISV: Are you managing your Customer Churn and what tools are you using to control it?

How do you make sure that your SaaS application is relevant and the end users are happy with the solution? In the past, you were able to charge for the solution in one big payment, but with the new subscription-based licensing model, you will have to retain the customer happy throughout the contract period and if the person is not happy, they will not continue using the software.

I have stated before in my blog posts that a net new client and the associated Customer Acquisition Costs (CAC) will have to be absorbed in a year or less, but the reality is something else. Therefore, if the customer quits using the solution after the first contract term (typically one year), the ISV will not even recoup the costs that were accumulated to get it in the first place.  If you look at the included picture from Joel York (2010), you will see that the ISV will cover the overall customer acquisition costs by signing up new customer and eventually the ISV will make a profit as it will cover the CAC costs when the Churn is also considered.  I explained this in more detail in my blog entry “ISV transitioning to the Cloud, Cloud Financials and Operational Metrics”

Churn and CMRRAs developers and engineers, we typically fall in love with what we do and we expect the end users to do the same thing. Wrong. Won’t happen and have been there, done that. What we need to be doing is to building employee software as the Bessemer Top 10 Cloud Computing Law states (#Law5) and I described this in my previous blog entries. If we do not use the software ourselves within the company and act as real customers, why would we expect customers be the ones where we test the usability. You would be surprised how many times we have seen solutions entering the market without any testing. The question now becomes how the solution can be tested prior of delivery and also in scenarios where the SaaS ISV enables a trial version of the software. How can the ISV make sure that most of these trials are converted to real customers? How can we monitor the application usage and also identify possible use cases that lead to an unsatisfied customer/user?

Luckily, there are some innovative companies thinking about this and one of these is Totango that has recently announced a beta version of a solution that helps SaaS vendors to be more effective in retaining customers and also converting trials and freemium licenses to fully paid clients. According to CIO.com article, many SaaS vendors have adopted a freemium pricing model, which is an evolution of the traditional 30/day free trial model according to CIO.com. The freemium model enables users to use the software in perpetuity, but the freemium model is usually missing some key components/elements that the user organization needs and will there want to upgrade to.

Totango  provides an “instrumentation layer” that tracks relevant business events that enables the ISV to really understand the application usage. The funny thing is that I used to build this kind of functionality into business intelligence solutions, specifically executive briefing books so we could evaluate if a report/graph was necessary and what had to go away. Back then, we wanted to make sure that the decision support group did not build charts/reports that were useless as this would be waste of time and money. Today a SaaS application that does not appeal a user will lead to churn and churn and low growth means slow death to the SaaS ISV. It is as simple as that.

What is needed for traditional Independent Software Vendors (ISVs) to move to the cloud?

If you have not heard enough of the cloud and its importance, you have probably been sleeping or being ignorant of what is happing in the IT industry. I have to say that I am unbelievably excited of having the opportunity to be part of this change and there are many reasons for this. The first and foremost is that the cloud has brought the software industry something new and exciting and a reason to re-learn a few things that keeps the innovation happening in our industry. I have lived three different IT industry eras: the minicomputer, client/server and dot.com era. The latest and very much transformational will create a new generation of solutions/applications that we all will somehow benefit from.

I still hear from many ISVs that “this is nothing new as we have had managed services for years” demonstrates that these naysayers do not really have the understanding what the cloud will bring to the table such as “pay as you use”, scalability etc. The cloud platform will give new opportunities for innovation, opportunities that traditional hosting can’t provide. If you are one of the naysayers, you can keep doing that but I will remind you in a year or two about this and let’s see where we are at that point in time.

If you are an ISV and have not looked at the cloud possibilities, you could be soon overtaken by a competitor that you would never have expected. There are hungry entrepreneurs that want to take over established vendors that might not be any longer as agile as a small startup can be. To become agile again, we have to think outside the box and forget about our old routines and thinking and accept that the change is here and that people will be consuming software in a different way that we are used to. I still think it will be a hybrid model where some of the apps will have to live on the device due to usability factors, but most of the data and logic will stay in the cloud. The cloud era has been here for a while and the early adoptors have accumulated experiences that the rest of the IT industry can benefit from. Some best practices can be found from CIO.com and an example of this is an article “Which Apps Should You Move to the Cloud? 5 Guidelines”. My recommendation is to do your homework (=planning) before you go to the execution phase. The cloud is different and requires different skillsets from people involved with it.

What if you are a traditional software vendor with a legacy application that relies heavily on a traditional business model? What are the actions that you need to take when taking the steps forward? I like the advice from Ben Kepes blog where he lists six different things that he feels that are important to understand. He also emphasizes that it is not that much of a technological change, but more of a cultural change that has to happen for Independent Software Vendors (ISVs). I fully agree what Ben is saying. My typical comment to ISVs is that it is a change in the DNA when an ISV moves to cloud architectures and some people will never get it and I expect there will be some turnover within the ISV community. A good example is the change in sales model where the commission structure has to change for the sales rep whereby the traditional commission plan with one-time deals is gone that made some successful sales reps to really make big money in short-term if successful in closing large deals during a financial year. Let’s view on what Ben Kepes views as the six culture changes are:

1)      Accept that disruption is going to occur and identify that it’s better to disrupt from within than without

2)      Accept that for disruption to occur, control needs to be given up.

3)      Dedicate resource – people, money and time – to building a development team charged solely with finding the “golden disrupter”

4)      Accept that disruption will hurt short and medium term revenues, but will ensure long term survival

5)      Once the product is there, don’t try and subvert it to suit the current status quo

6)   Don’t even think about having the same sales personnel or strategies selling the traditional and the disrupting offering – it won’t work

The first statement is what I always try to bring up in my workshops. You have to face the reality now and not delay the decision to innovate using the cloud. If you do not, you might have the same fate what Nokia had with Symbian platform.

The second statement is also important to understand. You cannot control the change, but you have to try to live with it and make the best out of it.

The third one is what ISVs usually fail with. If you try to push the “cloud transformation” to the same team that is taking care of your traditional software application/solution, you will not only burn these people; you will also fail in your cloud attempt. Software development using cloud architectures is not the same as developing for the traditional software architectures due to many reasons such as multi-tenancy, latency and also how the application is consumed using different mobile devices. Ensure that the people that are assigned to work on the cloud solution will have the means to do it including sufficient investment and realistic expectations.

The forth statement is in line what I have been blogging about for months, where the ISV has to plan how to manage the financial impact on the ISV business with a strong transitioning plan that takes into account the change from perpetual licensing model to subscription-based model where the payments are divided into the contract period. Based on our research and discussions with lots of different ISVs, three years or 36 months seems to be the magic number where the organization should start to see the real benefits of an ongoing subscription-based revenue model.

Statement five and six has to do with the change of ISV DNA that I explained earlier in this blog.

Remember also that traditional geographical boundaries that you thought kept you secure are also gone with the cloud. End users will test-and-try solutions regardless of location and there is nothing that the IT department can do about it. We have seen it so many times that it is not even funny anymore.

Is there a Magic Number for a SaaS business?

We have a tendency to find a magic formula for everything and this applies also to SaaS companies. In my research in this topic, I have found a few resources that give some direction of how to evaluate the healthiness of a SaaS business. It is easy to conclude that Monthly Recurring Revenue (MRR) or Average Recurring Revenue (ARR) is the driver for everything and this number is combined with Customer Acquisition Costs (CAC) we will eventually see whether the company will make money or not. If we add Average Recurring Cost per Customer (ACS) we have the main elements to figure out what the break-even point by using following formula:

BE=CAC/[ARR-ACS]

If we view the formula, it is easy for us to agree that if BE is greater or equal to 1; the company will never be profitable. In other words, Average Recurring Revenue (ARR) less Average Recurring Cost per Customer (ACS) will never be higher than Customer Aquistion Cost and that is not a good position to be in. Therefore, the ACC has to be able to cover the CAC for the company to be profitable. That is a very easy conclusion to come to. I demonstrated this in my previous blog entry where the sixth client finally was able to cover the overall CAC cost and the SaaS ISV started generating profit.

The fourth major driver is Customer Churn and this is specifically important with a SaaS business as nobody uses bad software and this will be very obvious when the customer does not want to sign up for a new contract term.  It was easier in the past when a perpetual software license was sold and the ISV got the money for it. The only thing that the ISV could lose is the annual maintenance and support fee of 15-25%. Today, an unsatisfied customer will never become profitable if walking away the first year (in typical scenarios).

A key number that seems to be a driving “Magic Number” and represent the health of a SaaS business is based on MRR growth when taking into consideration Sales and Marketing spend. The idea is that as long as the company is growing and the “Magic Number” is demonstrating that the sales and marketing spend is generating results, the company should continue on this path. The blogosphere includes a few sources in this topic and Lars Leckie was then one that came up with his blog entry that many others seem to be referring to. His Magic Formula is as follows:

QRev[X] = Quarterly Recurring Revenue for period X

QRev[X-1] = Quarterly Recurring Revenue for the period preceding X

ExpSM[X-1] = Total Sales and Marketing Expense for the period preceding X

The SaaS Magic Number = (QRev[X] – Qrev[X-1])*4/ExpSM[X-1]

Let view this formula with real numbers so we can get a feel what it means with some numbers:

 

Q1 Q2 Q3 Q4
Revenue $1.0M $1.2M $1.5M $1.6M
Sales and Marketing spend $800k $900k $1.2M
SaaS Magic Number 1.00 1.33 0.33

 

So what happens in the calculation is that the current quarter’s sales is subtracted from previous quarters sales and this is then multiplied with four (to annualize it) and then finally divided with previous months sales and marketing costs.

In the case above, the Magic Number seems to be going smoothly until Q4 when the number goes down dramatically with sales plummeting even with increased Sales and Marketing spend. According to Leckie, as long as the company maintains a ratio above 0.75 it should increase its sales and marketing spend, but if it is less than that, it should review its business as something might have changed the market condition.

Joel York takes this number a bit further by including Average Cost of Service (ACS) into the formula with the conclusion that the cost of service should be covered when calculating the Average Customer Rate of Return for the SaaS business. According to York, the Customer Rate of Return is the most powerful metric that a SaaS business can be measured on as it really shows whether the SaaS business will be a business or not. Therefore, York concludes this number (J) to be calculated in following way:

 

 

 

York also includes churn in his discussion where the growth added with churn should always be less than the average Customer Rate of Return (J). This is very logical if you think about it. The contribution from the client needs to recover the Customer Acquisition Costs, Average Cost of Service (ACS) and possible churn to achieve a situation where the customer becomes profitable for the ISV.

The common expectation is that CAC costs should be recovered in a year or so but York has put this additional requirement that the ACS costs have to be paid as well. I think this makes a lot of sense as the ACS could in some cases be considerable whereby the ISV should pay attention to them.

If we assume that the SaaS ISV has a contribution margin of 50% (Revenue less variable expenses), Joel’s Magic Number would be as follows:

When Contribution Margin = 50%

Joel’s SaaS Magic Number = The SaaS Magic Number /2

York takes a more conservative approach in his numbers where he concludes that The SaaS Magic Number of 0.75 just is not enough to “step on the gas” as the needed growth requires aggressive spending which then moves the SaaS ISV further down in time to profit scale. If we furthermore assume that the contribution margin (CM) is anything less than 50%, the time to profit is much longer specifically in start-up phases. York wants to see a Magic Number that is more or equal to 1 with the added requirement that ARR is > 2 x ACS whereby the ISV can quickly recover its acquisition costs.

We can conclude from this blog entry that the SaaS world does have some metrics to measure the health of the operation, and there are many perspectives how each analyst sees it: some view it from more conservative perspective and some have their venture capitalist perspective. The latter is very prevalent in the blogosphere and many of the SaaS authorities are from this domain. It is easy to say that they might not always represent the view of the entrepreneur, but more from an investor perspective and we all know what that means. It will be interesting to see if more entrepreneurs will provide guidance in this field like Josh James, CEO of Omniture gave at a conference and this generated the blog entries from both Leckie and York. Interestingly, Omniture was sold to Adobe and left the company soon thereafter.

Once we get enough people sharing their experiences in different aspects of the cloud business, we will eventually achieve a situation where we can provide guidance in metrics for different types of SaaS vendors.

ISV transitioning to the Cloud, Cloud Financials and Operational Metrics

I divided in my previous blog post how a cloud transition will impact an ISV. The first blog entry was about the change in business model and this blog entry is about the impact in financial model. However, it is important to recognize that the financial side has lots of different drivers and I will only portray a few of these in this entry, and deal with some others such as sales related metrics later.

Independent software vendors (ISVs) have the concern of profitability when running a cloud business. Mature software vendors with ongoing annual maintenance and support revenue are wondering how to make a transition to avoid future cash flow issues. The most typical question that I get from ISV management team members is: “how do we transition to the cloud without jeopardizing our current business?” Unfortunately there is not one and simple answer to this and what nobody wants to hear as an answer is: “it depends”. There are many different variables to consider and some of them are ISV specific and cannot be generalized. It is like comparing two different cars that have a different purpose: one that is used for racing and the other for transportation of heavy equipment. How does one compare these two and what is the comparison metrics?

I can still remember my early career when we did a bunch of comparisons between publicly traded companies in my business school using metrics that was regarded as “industry norm”. We had to learn in our accounting class each ratio that could be calculated concerning income statement and balance sheet. When we added cash flow statement to the equation, we were sometimes completely lost… me included. Once I understood the connection between income statement and balance sheet, life become so much easier. I would argue that ISV management has to do the same thing to really get to understand where a cloud business is taking them. I am sure that the ISV CFO and controller are on the right page, but I am not that convinced that the management team members all understand the impact of the change. That is just my observation from both research and talking to a bunch of entrepreneurs.

It is obvious that accounting metrics has not changed but was has changed is how we measure our operational activities that eventually leads into the financial accounting metrics that we track and our auditors are interested of.  If we change our model from classic perpetual software licensing model to subscription-based model and keep our operational metrics in the prior, I will guarantee that the company will run into a wall pretty soon and one of the things that would be recognizable is that there is no cash in the coffers.  Do we really know how to recognize revenue in a way that tax authorities are OK with it? Do we know how to recognize service revenue with a software sale from revenue recognition perspective? You do not want to find this out later on when an audit is taking place or when you are during due diligence when selling your company.

The ISV management has many questions to answer. Is your current business and software solution built in such way that it is easy for the current client to move to pure SaaS environment? What is the current complexity of your solution and does it require lots of human interaction to get delivered? Does your solution have lots of integration points to other operational applications? Does your current software solution support a migration to a pure SaaS environment? If it does not, what is the alternative? I am sure you are getting my point here. Running a solution from the cloud is not just to “port” the solution, but it is to have it run natively and I do recognize that this is not easy for many legacy ISVs.

What about the financials? The number one term that you need to familiarize yourself with is CMRR (Contracted or Committed Monthly Recurring Revenue), Churn and Cash. Other key metrics are Customer Acquisition Costs (CAC), Customer LifeTime Value (CLTV) and there is a bunch of others that are related to different operational functions such as sales, marketing etc.

Fortunately there are lots of good resources in the Internet that I have found very helpful in doing my own research. Many of these examples come with lots of use cases and practical advice so my recommendation to any ISV is not to try to figure these out on their own, but to really learn from what is already known.

Some of these resources such as David Skolp that maintains a blog for entrepreneurs with a specific focus on SaaS business as well as Joel York that brings lots of financial mathematics to the game. He also addresses something that I have not seen anybody else do which is the concept of Net Present Value (NPV) in the calculations.

What many ISVs forget is to keep their Customer Acquisition Costs (CAC) down as much as possible as many ISVs are still used to the old model where the prospect/lead needs lots of human interaction before the deal is closed. This is no longer possible in scenarios where the price is on a level that the ISV can never achieve break-even with providing too much support in the deal closing. If you look at the Customer LifeTime Value (LTV) and Customer Acquisition Cost (CAC) figure below, the trend needs to be according to the following picture.

LTV and CACIf the ISV did not control the CAC, it would very soon run into a situation where LTV and CAC are getting closer to each other and the ISV would be bleeding money.

Following picture from Joel York gives an even more interesting view how Customer Acquisition Costs (CAC) combined with Churn will impact an ISV and how each customer adds to the accumulated CMRR until it covers the accumulated CAC cost. In the picture the sixth client creates a situation where company becomes profitable. The picture also shows how churn will impact the overall MRR with time.

Churn and CMRRThe picture gives us an idea how CAC and Churn plays a central role in SaaS financials, but there are many other financial measures that an ISV should think of and also measure. Skok provides an interesting breakdown in how key SaaS goals can be divided into different components: Profitability, Cash, Growth, Other (like Market Share) and each one of these components can be divided into smaller components.

If we further divide the profitability into components, this is how it can be seen:

Profitablity in ComponentsWhen you view the picture in more detail, you can see how Customer Acquisition Costs (CAC) and LifeTime Value (LTV) drives the customer profitability, Monthly Recurring Revenue (MRR) and Services Revenue drives the overall revenue and when you add expenses and COGS to the formula, you will have the regular accounting related profitability. Measuring your employees can be done from many perspectives and I will address sales measurement separately in a later blog entry.

As we can see, there foundation for an ISV is still the same, to generate ROI for the investment and dividends for the shareholders. What has to change is how and ISV measures the operational activities when running a SaaS business. ISVs that have not made the move towards the Cloud might really have issues with their competitiveness going forward. My recommendation to mature ISVs is to start looking what can be done in the cloud world and get the development team focused on the changes that a pure Cloud solution will require to be truly multi-tenant so the ISV can achieve the scalability benefits of a PaaS platform such as Windows Azure. Stay tuned for more about metrics and changes in operational models for an ISV.

 

An Independent Software Vendor (ISV) moving to the cloud – what are the financial implications of this?

I have to say that I am living in a nirvana from a researcher perspective (even if I am an entrepreneur on daily basis working with practical execution). Nobody of us will have the chance to experience too many profound transformations in our lifetime. I was asked to write a report on ISV transformation from traditional software business to cloud business from financial perspective and I loved the nights and weekends that I spent on the Internet doing research. Coffee, music in the background, two large screens side-by-side and the feel of really learning and assembling pieces of information together is a feel that is hard to explain. No wonder I like to write books, dissertations, and reports…

My personal background is that I came from school when minicomputers such as HP3000, VAX/VMS and later UNIX computers where the ones that software was built to. The next era was the move towards client/server architectures where I really made my personal career in product development. Then we all remember the short period of web-enabling solutions and the huge investments in hosting facilities which many have now disappeared. This new cloud/SaaS era is much more than just making your solution web-enabled. It will change not only the way you build software, but it will change the way you run your business. Let me explain how by reviewing the picture:

The Cloud ImpactI will start with the business model in this blog entry and continue with the others in later blog entries. The change from perpetual software license model to subscription-based model will change the way the ISV sells its solution and it will change the way the ISV structures its partner channel. It will also change the way the ISV markets its solution. The main driver for this is that the ISV will not be able to sustain its cash flow with a traditional sales model as the sales team needs to keep much higher pace in sales when moving to the cloud environment. The sales model for an ISV has to be either fully automated with customer self-service or it can be highly transactional where you can have some human elements but the amount of transactions will cover the cost of maintaining people to close the deal. The ISV has to be able to control the Customer Acquisition Costs (CAC) as that is one of the key drivers to be able to achieve break-even point and start generating pure profit. This does not typically happen in less than a year, whereby the ISV has to maintain a happy client so they sign up for a new contract period assuming that the contract period is 12 months. I will analyze the metrics in my later blog entries. This just gave you an example of the operational changes that an ISV will experience.

How does an ISV manage to plan appropriate scenarios that it can take when moving to the cloud? Obviously, the assumption is that the Board of Directors have made a decision that the ISV has to make the move to survive in the new global competition where anybody from anywhere in the world can enter the competitive field. There are no geographical borders that will keep the ISV from competition. If you are an ISV from Italy, you can expect to get somebody to enter your territory from France, Germany, Brazil or Bolivia. Once the strategy has been set, you will have to use a model to operationalize your strategy and I am used and thrilled about Dr. Osterwalder’s Business Model Canvas that provides all of the needed elements to analyze and “paint the picture” on a high level. I have witnessed several experienced senior management team members to become enlightened of the power of the canvas and it really has become our number one tool when working with ISVs. The Business Model Canvas consists of nine building blocks: Value Proposition, Customer Segmentation, Revenue Streams, Cost Structure Key Resources, Key Activities, Channels, Customer Relationships and Key Partnerships.

Business Model CanvasThe power of a business model framework such as Business Model Canvas is that the management is compelled to take a position on each of the nine building blocks on a Business Model Canvas. Each building block can also have its own key metrics and these can become the foundation for a dashboard that the management team tracks on the monthly basis.

Besides the question whether the ISV has the right core competence to move towards a cloud business, the key question that any ISV has is how this change is going to impact the financial model and the canvas above shows how the Revenue Stream building block has to be in balance with the Cost Structure block. In the perpetual software business model the metrics on the cost structure and Revenue Streams are completely different.

To summarize, the ISV and its management has many different questions to answer in its journey to the cloud. The first is to make sure that the owners, the management team and the Board of Directors have a common understanding where to go with the strategy. The role of the Business Model Canvas is to help the ISV to lay out a few possible operational scenarios that it can take in its cloud transformation. In my next blog entries I will explain in more detail the financial impact on an ISV when moving from traditional perpetual software license business to subscription-based business model. Stay tuned for more.

 

 

 

 

 

Will Independent Software Vendors (ISVs) without a cloud strategy have a slow but certain death?

Independent software vendors (ISVs) and system integrators (SIs) will have a wakeup call very soon unless they spend some time contemplating how the cloud will change their strategy. What I am seeing around the world is that innovative ISVs and SIs are eating the lunch of traditional and more established vendors and I expect this trend to continue. This is not just a change from client/server era to cloud architectures; the change will have a tremendous impact on how we consume software and what end user organizations expect ISVs and SIs to deliver. My company is getting requests from very traditional end user organizations to move their solutions to the cloud and this is happening in an ever increasing pace. The most logical move is to move email and document collaboration to the cloud to be followed by accounting if you are in the SMB space.

My professional career started when the mini computers were the hot platform for software development. Mainframes were still very much the main platform for large organizations, but mini computers with HP 3000, Digital VAX/VMS and UNIX grew in market share. It did not take long until client/server architectures grew in popularity and this is the era where I led product development of more than 20 software products in the business intelligence/data warehousing and forecasting/planning domain. 

Jumping forward to the cloud era (ignoring some trends such as PC etc.), I have heard many people referring that it is the same thing as mainframe era. In some respect it is, but there are considerable differences as well. These differences have to do with how we innovate and how we build software to be consumed by the outside world. The mainframe era was more contained to services inside the corporation and any outside connection was controlled via physical machines or in some cases pre-determined integration mechanisms. Cloud era will not change this, but it will change the way organizations interact from within the organization to the outside world and how they consume services provided by software vendors.

The cloud era is completely different to any prior era when you view it from software development perspective. The software world (Internet at large) includes a massive amount of services providers that expose services that can be consumed by third-party software development organizations. A good example of this is Microsoft Azure platform and the new services Dallas (codename as of now) that allows developers and information workers to easily discover, purchase, and manage premium data subscriptions. In this case it will be more about data, but it could be anything, anything at all that software vendors are melding into their solution and building a composite application. Gone are the times were small ISVs were focusing on building infrastructure elements/components. I can still remember the times when software vendors were developing infrastructure to enable applications development. I have also been forced to spend money on building proprietary communication protocols based on SNA and TCP/IP as it gave our solutions a competitive edge. This is history and will never come back again.

Is consumer buying behavior also changing how corporations will buy software in the future?

I am tempted to claim that consumers are driving buying behavior in corporate world as well. Executives are now exposed to software solutions on the net and are forcing corporate IT to view the cloud world with applications that are consumed based on use. Executives download apps to their smart phones and get exposed by younger generation how apps are used from the net. The question that many executives might have is why some of the internal applications that are used in the corporation are so clumsy to use and any change to the system takes weeks/months to accomplish. You have probably read in business papers and magazines that sales of traditional enterprise solutions are not growing anymore the way they used to. It could be market saturation, but I also believe that there is a fundamental change in adding solutions that take care of the issue and not try to solve all of the problems in the world. This could be very smart for many smaller vendors that sell high quality packages to enterprises with a price point that is very low. It is about easy buying and I know that large enterprise deals are hard to get in today’s economic environment.

There are still enterprise solutions that will not work in the cloud due to many reasons. It could be due to regulatory issues but I am convinced that with time, regulators and lawmakers will have a wakeup call where any country’s competitiveness is founded on openness and not on closing the borders.  With the buying behavior changing, some less complex areas are already making huge progress like an interesting software vendor in the security play called Spectorsoft. The company sells and develops Internet monitoring software for home uses, business, education, and government. Most of the sales happen over the Internet and the software is assumed to be easy to install and to use. This will be the most typical scenario when it comes to software purchase.

Software buying can happen in 30 thousand feet

When you review your own shopping behavior, you will also understand how most solutions will be bought in the future. A few days ago on my flight from Seattle to Dallas on American Airlines, a gentleman sitting beside me was doing extensive search on products and made finally multiple different transactions by using his credit card. This has been made possible with innovation in wireless space where American Airlines provides wireless access for its passengers. It is fascinating to think about the new software era and compare it to the era when I started by software career. We can now sign up for CRM solutions without having to talk or consult the software vendor. We can deploy accounting packages in our company such as Intuit Quickbooks Online and we can manage our daily personal financial lives by using cloud solutions such as Mint.com. We can be sitting in 30.000 feet conducting business without really thinking about it. Another gentlemen that was on the same flight was chatting on Microsoft Office Communicator the entire flight with multiple people whereby he did not miss any working hours as we were flying towards east. He seemed to spend most of our 4 hour flight using the messenger.

My company is run in the cloud and any solution that is not SaaS-based, will not be considered

I run my business in the cloud. We have not owned or managed a single server since I started TELLUS more than five years ago. All of our operations are managed from the cloud such as accounting, email, collaboration, project management etc. I do not consider any new solutions that are not SaaS-enabled and this is the situation with many other organizations as well. The market is moving into “targeted” point solutions where we buy and consume services from the cloud. Integration of these solutions to possible onsite applications needs to happen either in the cloud or in some on-premise integration software tool. Integration still remains a factor that prohibits large organizations to move its operations to the cloud, but there are already numerous different solutions that enable integration between on- premise and off-premise (cloud) solutions. With time and new cloud solutions in the enterprise space, integration issues will become easier and new standards and interfaces for integration will emerge.

Maybe not this year or the next, but I am convinced that solutions will be based on “good enough” concept where organization buy solutions they consume on the need, and not on the “elephant” model we have been used to. A typical ERP project with customizations will probably be forgotten in the future and workflows and processes will be built in a new way that does not take down the company from both cost and labor perspective.

Large organizations with ongoing cost cutting can stifle innovation

What makes the new cloud ecosystem interesting is the innovation that can happen around it. Any software company, anywhere in the world and of any size, can bring new innovation and become something in the new cloud era. Some large organizations have been focusing on cost cutting avoiding risks instead of taking bold moves to create new market entries or new products. One of these fatalities has been Nokia as it has been reported by the press like New York Times recently.

According to the press, Nokia has had many of the ideas and prototypes built that Apple is now riding with, but management has not had the courage to make them to become true. Then on the other side of the spectrum is Apple that is known for bold moves such as iPhone that Nokia positioned to consumer with marginal importance. It reminds me of Nokia’s miss on the Motorola flip-phone market with the results of huge downfall in the US markets.  With new leadership by Stephen Elop Nokia is trying to change its course. The change has already started by two senior executives leaving the company. The first announcement was when Nokia smartphone head Anssi Vanjoki decided to leave. The second noticeable departure was last week  by Mr. Ari Jaaksi, the leader of MeeGo platform. I am sure we will hear more news in the upcoming weeks of additional changes. The incumbent Apple has also been able to put many established smart phone vendors in disarray and the rise of Android phone software platform will give additional grief to all vendors, including Apple.

Software is everywhere and software will be embedded in our daily lives.

I expect the software market to bring new innovative solutions that combine the cloud with smart devices that communicate to the cloud. This will create new opportunities for ISVs around the world and the winners will be the ones that are innovative and create new solution areas and products. Software is part of our lives already today and will continue to be even more so in the future. Embedded software will continue to rise in importance which will also create new opportunities for rising ISVs around the world.

One of the leading software development tool vendors MetaCase has been able to penetrate the embedded software space with its innovative domain-specific modeling tool that enables more effective variation of software products from a platform. This type of software product line engineering will also be of great importance to enable rapid variation of embedded software solutions and still maintaining the quality of the end product.

A couple of weeks ago I had TXU Energy install two new thermostat controllers to my house that enables me to control heating and cooling in our two story house. We have two cooling units and each of them can now be controlled from the Internet and enables us to save hundreds, if not thousands of dollars each year. The temperature in Texas is brutal in the summer so any optimization of cooling has a big impact on our electricity bill. I can create multiple profiles based on our family patterns (when we are in and out) and the system feeds information to the cloud and the cloud provides me information how to optimize my electricity consumption. This is a terrific example of intelligent use of web services, where I have much better handle of my daily/weekly/monthly electricity use.

Another example of smart devices is Fitbit device that enables me to track and control my calories burnt, steps, distance and sleep quality automatically. Whenever I am close to my laptop with the Fitbit device, it automatically loads data of my daily movement to the cloud. I can compare other people in the same age and get additional information of my health based on real data, and not on some assumed numbers that I have estimated. This is made possible by intelligent and embedded software that is becoming even more relevant in the future.

Cars are full of software devices and embedded software. My son and wife has a Ford car and both of them have Microsoft Sync that enables automated synchronization of music playlists, phone books and hands free phone use when driving. The system also provides information about vehicle health, business search, traffic alerts, 911 assist and many other things. All this is managed by GPS, wireless and Internet technology. 

Software ecosystems with cloud will change ISVs whether they want it or not.

Some software domains have been slow to move to the cloud space, but this is also changing and I will be writing another blog entry of this topic very soon. One of these domains is business intelligence/data warehousing space. There as some challenges in the BI/DW arena concerning the cloud, but many of these perceived obstacles will hopefully go away sooner or later with new innovation and solutions.

Some ISVs in smaller countries/regions have been protected from competition, but the cloud will also change this slowly but surely. There will always be new software vendors (ISVs) that are soliciting business across borders and many organizations are willing to test out new solutions even if they do not know anybody from the software company. Yet again, watch your own behavior when consuming web services/solutions. Do you really care where the solution is from? The only thing you might want to make sure is that the SaaS/Cloud vendor has an option to take backups of the data to a local environment in case the vendor disappears from the marketplace.

ISVs can’t avoid developing for the cloud anymore. I am surprised how some enterprise vendors and SMB ISVs defend their turf by concluding that cloud is not an option in their software world. Not only are these conclusions wrong, they might be lethal for the company when considering the future.  According to research, cloud adoption is accelerating specifically in the US market and if old trends are intact, rest of the world will see similar kind of growth as well.

Another clear trend that I have noticed is that organizations do not care anymore to have hugely complex applications/solutions and prefer to buy user friendly solutions that can be quickly deployed. I am convinced that the famous multi-year ERP deployment era is gone and organizations require solutions that can be easily purchased and quickly deployed. What ISV organization have to recognize is that the perception of solutions is changing whether we want or not and the price points and the usability and deployment is change forever. It will still take a few years for most organizations to move towards consumption-based software world, but it will happen as we have seen in so many cases.

If you are an ISV, you do not want to miss this window of opportunity to be innovating something new and get your footprint in the market. Does your company have a strategy for the cloud yet? If you don’t, you should take action now before your competition will eat into your market share.