The Cloud. It's where cool tech ideas get funded by eager venture capitalists and mega fortunes are made when the next big thing goes viral. For all of the excitement and hype surrounding the Cloud, there are some sobering realities that tend to get swept under the rug: namely the fact that, on the whole, the cloud business model is not a profitable one. Surprised?
Yes, cloud companies (such as software-as-a-service and technology-as-a-service, just to name a few) are all the rage, and rightly so, for they are the future of tech. They regularly enjoy double- or triple-digit growth rates and garner enviable media coverage and razzle-dazzle headlines. But the mostly unspoken truth is that they are underpinned by unproven financial fundamentals that, frankly, wouldn't be allowed to persist in any other industry.
So, why can't we turn a profit in the Cloud? In large part, it's due to the allure of high revenue multipliers that have been awarded to cloud company stock prices—the otherworldly returns that mesmerize investors. In spite of the fact that cloud companies, in aggregate, regularly produce negative operating income, the venture capitalist community is happy to pour funding into these cash-starved ventures because they can gain more ownership, which will translate to huge gains when they exit. To investors it's a brilliant scenario, but others may call this a new form of irrational exuberance. Either way, it's not a sustainable model, and eventually the Street will cease rewarding this behavior and demand profitability.
The good news is, it doesn't need to be this way! If you're leading a cloud company and aspire to generate profits that would earn Warren Buffet's stamp of approval, keep reading. Many of the leading cloud company CEOs are already talking about becoming more focused on profitability. How can you prosper in the Cloud and still make money?
#1: Understand The 3 Phases of Cloud Success
Cloud businesses must journey through 3 distinct phases on the road to profitability, as seen in Figure 1. As the leader, it's important to understand how to navigate the unique dynamics of each one and to ensure your team knows how to think and act differently in each phase.
The first, and most prevalent, cloud business profile is the Future Value Aggregator (FVA). This is where virtually all born-in-the-cloud companies start. An FVA's primary goal is market fit and viral growth, so everything you do is focused on eliminating friction to get new users and logos on your platform. This usually shows up in your offer and pricing strategies with tactics such as freemium offers and bundling in services for free. At this stage, you are not focused on profitability, but as you'll discover in the next section, you can't ignore it completely. In fact, quite the opposite.
The next profile is the Mid-Term Wedge. Here, you're starting to think about proving your financial model, typically targeting to achieve it within a 2- to 4-year horizon. With this goal in mind, you're starting to diversify your revenue streams, monetizing more of your offers, and adding in new high-margin services, reaching for your “wedge moment” when you cross over the line to profitability.
The last profile is the Current Profit Maximizer (CPM). Here, you are working every possible lever to ensure that you consistently produce profits today. A CPM is likely to have a very robust portfolio of offers and is not afraid to charge profitable prices. It may still offer a low-cost or free entry point onto its “platform,” but it's rapidly upselling each customer onto offers that results in positive customer “unit economics.”
#2: Organize to Grow Customers
The beauty of the cloud model is how easy it is to get customers onto your new platform. However, this is also its Achilles heel, as it's just as easy for customers to off-board from cloud solutions, which is why cloud companies are obsessed with avoiding churn. (Tweet this!)
While cloud models make it easy to get customers onto your new platform, it's just as easy for them to off-board. - Tweet this!
How do you do this? By organizing your team to ensure your customers are growing the business value from your solution every single day. From the moment you close the sale, the mantra of your company must be about adoption, a motion typically run by a “customer success” team.
However, adoption is only the beginning. The real home run is creating an organization that is purpose-built to deliver business outcomes for your customers, which must be a key anchoring principle for your organization. This capability establishes the conditions for selling your portfolio of value-enhancing services—the ones that form barriers to entry for competitors, create stickiness with your customers, and allow you to monetize new profit-generating revenue streams. A useful construct to think about here is the LAER customer engagement model (pronounced “layer”), described below:
- Land: On this team, you have sales resources dedicated to landing new logos and large expansion deals within existing accounts. That's all they should do—don't distract them from their mission!
- Adopt: These are the resources who obsess over customer usage. They on-board and handhold, and are the stewards of customer health. Importantly, they are poised to spot cross-sell and upsell opportunities. When leveraged correctly, this team can be a highly cost-effective lead-generation machine for your Expand sales team.
- Expand: This business-savvy team works with customers and your internal customer success team to identify ways to derive more revenue from customers by expanding the value from your solution. Their focus is on easy and logical cross-sell and upsell offers, such as more user licenses or premium services.
- Renew: This is the sales motion that cloud companies live and die by. It is all about securing the renewal, so you need a team that can expertly run the plays to make this happen. It's worth noting that it is possible for your Adopt team to also own this charter.
Beyond these organizational capabilities that blend service and sales competencies, you need to think about hiring people with business skills and vertical industry expertise to support your ultimate goal of delivering business outcomes.
To be clear, unlike the traditional tech-as-an-asset model, the cloud is not just about the initial sale. Rather, it's about the long journey you are on with your customers that unfolds over time and becomes increasingly more valuable to both parties.
#3: Plan to “Swallow the Fish”
Whether you're a traditional tech company making the pivot to the Cloud or a born-in-the-cloud business, there's a financial “fish" in your future that you will need to swallow.
In the case of the former, it's the fish created by the dynamic of the revenue trough you'll experience as you transition to the subscription model where revenue is realized over the life of the contract, coupled with the enormous investment you need to make to stand up your cloud business (Figure 2). Over a period of 1 to 3 years, the reduced revenue and high initial expense phases subside and your financial model starts to look solid, but that transition period is real and almost impossible to avoid.
In the case of born-in-the-cloud companies, it's a phenomenon known as the “slowdown fish” that occurs when you begin to transition from the money-losing, rapid-growth phase to a more steady-state pattern of slower (but profitable) growth (Figure 3).
Many cloud companies have been punished by investors for not seeing this day coming and setting expectations in advance. It's, unfortunately, another reality of leading a cloud company that is too often underemphasized. Hyper-growth always slows, but the question is how well management has planned the transition to a different value formula for its investors.
3 Keys to "Swallowing the Fish"
As the leader of the transition, there are some key plays you must run to swallow these fish with minimal impact.
- If you're a traditional tech company, you must model your fish carefully. This means setting a plan in which you identify the approximate timeline, revenue, and cost impact of your transition.
- Next, go public with this information. Announce that you're starting a business model transformation based on customer demand. Declare that the clock is ticking and that you're setting investor expectations by sharing milestone dates for your transition. Although this may seem counterintuitive, this strategy has been proven by companies that have made the transition using this plan, notably Adobe, Autodesk, and Intuit.
- If you're a pure-play company and need to swallow the slow-down fish, you'll need to execute a similar plan. First, model the transition, and then announce well in advance that you are entering a period where you are executing the pivot from high growth, no profit, to lower growth with a focus on profitability.
The Transition to the Cloud Can Be Difficult, but TSIA Can Help
The Cloud is where the action is, and although the “as-a-service” business model has not yet proven to be a reliably profitable one, there is a way forward for those who are willing to commit to these leadership principles. I've written a lot about this transition, such as the benefits and pitfalls from both the supplier and customer perspectives in my blog series, "The Digital Transformation Journey," which I encourage you to check out.
The concepts presented in this article are also discussed in further detail in the best-selling book, Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business, co-authored by myself and TSIA's Executive Director, Thomas Lah.
While this transformation can be difficult, there are experts that can help. At TSIA, we've made it our mission to keep our fingers on the pulse of the state of the technology industry so we can provide you with the fact-based, board-ready insight you need for profitable XaaS in a way no other company does. Please reach out to TSIA today to learn more about how we can help you and your company reach new levels of success in the Cloud Era.
Editor's Note: This post was originally published on 8/9/16 but has been updated with current information.
About the Author
J.B. Wood is president and CEO of TSIA. He is a frequent industry speaker and author of the popular books, Complexity Avalanche (2009), Consumption Economics (2011), B4B (2013), and Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business (2016), and has appeared in leading publications, such as Fortune, The New York Times, and The Wall Street Journal. He works with the world's largest technology companies on strategies to extend their innovation platform beyond the lab and into the customer experience, particularly in the age of cloud and managed services.