In the first installment of my three-part series of articles about how the new subscription-based economy is affecting traditional technology companies, I talked about how product and service revenues are beginning to shrink across the industry. In this second installment, I'll be sharing what it means to embrace as-a-service offers in a tech business model and how that can lead to future profitability.
In my last article, I made the following statement:
Selling technology is becoming a low growth, low-margin endeavor.
There is data on the first article to back up this sobering statement. In addition, we reviewed the fact that born-in-the-cloud computing companies are enjoying double-digit revenue growth, but they are struggling to be profitable.
So, how do technology companies get back on the track of profitable growth? TSIA’s prescription:
Embrace as-a-service offers (this is where the revenue is going) that are anchored on business outcomes (not feature functionality, which is commoditizing) and supported by a customer engagement model that cost-effectively drives the adoption, expansion, and renewal of your offers (this is where most tech companies are failing).
In this article, I want to click into the economics of this shift to profitable subscription offers.
The Struggles of As-a-Service 1.0
Perhaps the most common rationale provided for the poor profitability of today’s cloud computing companies is the belief that market share and top-line revenue growth are the only two success metrics that matter at this point in history. “As-a-service” technology providers are heavily investing in Sales and Marketing so they can grab customers. The logic is that the platform with the most customers will ultimately be the winner. With market dominance and a large base of customers, profitability will come.
To help make this point, advocates will cite the “wedge model.” This model is often referenced by consulting firms and industry analysts commenting on the cloud business model.
The logic is simple and intuitive. A cloud provider must spend money to build a platform and acquire customers. As the install base grows, revenues will grow and eventually surpass expenses. Cloud companies are clearly growing top-line revenues. However, these companies are not becoming more profitable. In other words, they are not crossing over to the second half of the wedge model. Salesforce has been public for over a decade and has revenue exceeding $10 billion, yet they struggle to consistently be profitable.
Contrast the Salesforce trajectory to Oracle’s history. In 1986, Oracle went public with $55 million in revenue. They were profitable that year, and grew revenues to over $500 million within four years. They were profitable every quarter. The third quarter of 1990 they reported their first-ever loss (due mainly to a forced downward adjustment to revenue to correct for faulty revenue recognition policies), and then quickly corrected and continued the trajectory to increased profitability. Today, they are generating an operating profit north of 40%.
Studying the financial performance of both public and privately held technology companies, we observe several key pressure points that are presenting themselves in the current subscription-based business models:
- High percentage of revenue being spent on sales and marketing.
- High vulnerability to customer churn impacting growth and profitability.
- Difficulty in getting customers to commit to multiyear contracts without significant discounts.
- Eroding gross margins (spending more to serve the customer than initially estimated).
- Overall pricing pressure on the subscription price.
- Giving services away or heavily discounting them, creating a profit drag.
This is a daunting list of challenges, yet these challenges will be solved. Companies will decipher the profitability code for subscription-based businesses. However, companies are making a common mistake as they venture into subscription-based business models: Technology companies are providing “all in” offers supported by their legacy sales and service models. This approach is exacerbating the profitability challenges. To break through this current industry conundrum, companies must think in terms of fundamentally revised economic engines and operating capabilities.
Based on the weaknesses that are now apparent in the “as-a-service 1.0” business model, we believe there are some guiding principles that will shape the profitable subscription business model:
- Premium annuity services will need to be wrapped around the core technology subscription.
- These services will add revenue and margin to the business model.
- Consumption analytics will be a required capability.
- The product platform must provide insight on customer usage.
- These analytics will enable cost-effective tactics for customer retention and account expansion.
- Adoption services leveraging consumption analytics will be critical for account retention and expansion.
- Some of these services will be monetized, some will be provided for free.
These services will be designed to monitor and accelerate product adoption.
- Expand selling through Customer Success will be a critical capability for long-term profitability.
- Once again, this will be a more cost-effective tactic than a traditional direct sales force.
- Expand selling, with its lower cost structure, must underpin the vast majority of revenue generation.
- This means lowering barriers to entry for customers and more systematic approaches to account expansion.
- Project-based services must become profitable activities or be engineered out completely.
When these guiding design principles are pursued, profitable subscription models will have economic engines that look very different than they do today where 90% of a cloud company’s revenues are secured through an “all you need” subscription price and 10% of revenues come from other services to help the customer succeed. Profitable cloud computing companies will monetize value-added services. Table 1 provides guidance on the revenue mix ranges we believe will unfold in profitable as-a-service business models.
The margin profile of these revenue streams will also be critical to sustainable profitability. Cloud companies will most likely see competitive pricing pressure on their core technology subscription. This means subscription margins may go down in the long run. However, margin dollars from profitable annuity service, project services, and transaction services can more than offset this pressure on the core subscription.
To drive profitable growth in the Cloud, technology providers will need to diversify their economic engines, but that will not be enough. The cost structure needs to change as well. In the final article of this series, I will discuss how technology companies will need to significantly reengineer their customer engagement models.
About the Author
Thomas Lah is executive director of TSIA. Since 1996, he has used his incisive analysis, strategic thinking, and creative solutions to help some of the world's largest technology companies improve the efficiency of their daily operations. He has authored several books, including, Bridging the Services Chasm (2009), Consumption Economics (2011), B4B (2013), and Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business (2016).