Monday, 3 October 2011

The Cloud Business Model - Practical Advice vs. Hot Air

It doesn't help that we are in tough economic times and that the attrition of Resellers is at an eight year high (figures according to Graydon but Resellers considering selling in the Cloud need to understand the impact of the Cloud business model on their profitability and cash-flow.

Vendors and Distributors talk glibly of how they can advise Resellers on how to modify sales incentives and to tell them of the impact of Cloud sales on their business but few people within these companies either have the experience of running Cloud business models or have the ability to eat their own 'dogfood' by actually adopting the model themselves.

Most salespeople from these companies will struggle to recognise a Cloud based version of their own products - believe me I have seen that at firsthand with one of the largest vendors in the world - and they most certainly will not be paid on the kinds of models they try to tell you about. So how on earth are they qualified to 'advise' resellers on how to change their business?

The answer is simple: they read it off the slides so well prepared for them.

The Rule of 78s

I have blogged on, and much is made of, the Rule of 78 which is a method of budgeting for and creating targets for monthly billable sales. It came out of the telecom industry where such methodology is tried and tested as the basic sku of a telecom sale is a unit of time consumed on a telephone line. This mapped well to a SaaS based consumption model I used at Genesys Conferencing where audio conference minutes were a base unit at premium price to include the proportionate web minutes consumed. And once a conference service was provisioned, it got used to a greater or lessor extent.

Rule of 78s tells you that in a 12 month period, assuming your base monthly selling unit is one, then in month one you will bill one unit corresponding to the acquisition of a customer billing one unit. In month two you will bill a new customer one unit plus the one you will bill again from month one. Track this through the year and you have a rapid stepwise accumulation on monthly sales units that if all are added over the year, equals 78. You can substitute your one for any other number.

You can apply this easily to a customer base by assuming the monthly billing rate from the previous 12 months as being a base level required, then adding some growth number you are aiming at for the total year and divide that by 12 and then add it to the monthly average (i.e. you want to pay for growth not status quo). that becomes your monthly expected unit of sale. 

There are some obvious things that come out of Rule of 78. Firstly, you will pay commissions at a disproportionally high rate in the first six months when the graph is very shallow as opposed to the last six months when the graph gets very steep. So you need to plan your cash to accommodate this.

But more importantly, if you apply this model to a brand new monthly billing model then you have no baseline to work from, so every increment is pure growth. If your sales cycle is less than 28 days, it is no problem. But that is very rare. What typically happens is that there is a lag.

So after around 3 months, it is very often in a new product sales situation that very little or even no sales have occurred. The trouble with Rule of 78 is that it doesn't forgive and a salesperson in that environment with no baseline sales to keep them going very often loses heart between month 3 and 6 because they can see no sales arriving and no commission rolling in - and it will only get worse even if their luck changes beyond month 6. 

Rule of 78 is really not very good when applied solely to new business as if the dispirited salesperson leaves then you have to start the graph again but you have lost 6 month's selling on the budget.

Ideally, Rule of 78 has to be implemented with a robust CRM package like and keen KPI measures need to be set in terms of baselines of acceptable numbers of calls, demos, sales visits etc . A close scrutiny is required on the pipeline and funnel of future and forecasted sales  - these need to be reviewed and questioned. Rule of 78 rapidly becomes a pressure cooker for salespeople.

In the telecom environment this tends to wash itself out over time as if a phone line is sold it is almost guaranteed to bill and the billings may actually vary from customer to customer dependent on usage. Software and services sales don't work like that - you either get them or you don't.

Churn is a problem in telecoms because they are charging for actual line usage, but again statistics favour the salesperson. In software, churn is direct licence annuity lost and so it needs to be as low as possible which means 'adoption or roll out' is key in SaaS based sales to prevent churn.

Annuity Sales

Rule of 78 then is better for established businesses with a monthly billing model. A harder model on the business but a greater incentive to salespeople is annuity style commissions. Effectively, this is similar to insurance sales where a sales commission on the whole value of the contract is paid on booking rather than the billing. This can mean an even greater call on cash but experience shows this evens out quickly. 

Why? Because the astute SaaS biller may be booking revenue and profit to the accounts monthly in 12 equal instalments but they may be collecting the whole cash value as one upfront subscription. In my case at PlaceWare, we would offer a small discount for two years worth of subscription paid upfront but equal to 24 months of billings.

The salesperson can quickly see that sales accumulate very rapidly. Also, there is a natural benefit toward the end of the year, when salespeople typically look to next year's goals. In a Rule of 78 model, each month's P&L billing drives the commission so a sales in month 12 is worth the same as in month one for that month's commission. But in annuity, the sale in month 12 is worth a full 12 month's worth. At this point, spikes in bookings can be dramatically increased with the clever use of accelerators.

At PlaceWare, by using annuity over Rule of 78, we drove booked sales incredibly rapidly throughout the year while we also had a positive effect on cash-flow by offering cash deals for annual payments ahead. The potential danger is salespeople leaving after sales so just make sure there are tight rules around scheme payments and clawbacks.

The other issue on Rule of 78 is that it works best if the underlying profitability of each unit sales washes itself cleanly. In reality, vendors and telecom companies are operating at 40 to 80% gross margins in billing services and software. At best, resellers are facing SaaS based gross margins of as high as 20% - and sometimes as pass through commissions only where they do not have the direct relationship with the customers to 'deal' on the cash side and so cannot recognise full revenue and enjoy the cash-flow.

Resellers Get proper Advice

The term 'Transformation' is the new vogue amongst the Cloud Intelligentia - mostly from people with little experience of what they are talking about, least of all actually living the SaaS transformed business model. So please be wary on whose advice you act as a Reseller.

It really pays to get some advice.

The reality for most resellers is that the simple issue of billing recurring monthly bookings is actually very hard. Most accounting or ERP systems don't cater for this feel, requiring things like new monthly orders or POs etc. Most companies end up with some kind of manual work around.

Imagine the difficulty of dealing with multiple Cloud vendors such as software companies, distributors and co-hosting companies offering a variety of bills for services and products - some of which, like hardware, might be on regular 30 days, full billing terms. How do you amalgamate all these and then create bills for clients each month but also track the existing ones and bill them? And then book the revenue and profit.

Usually, the clever distributors who claim to 'advise' on transformation really have no solution and the vendors just look after themselves. This is because most of these companies, with the exception of true Service providers, haven't actually solved the problem themselves. Distributors receive spreadsheets from their suppliers and they then create invoices for their customers once they have fathomed out who needs to be billed what this month and last.

Few, if any, distributors have invested in a true Billings Aggregation platforms even though they talk about the concept all the time. Rather than advise on things they are not experienced in, it would be better if suppliers invested their money in devising practical solutions for resellers which take away the need for resellers to invest in expensive systems for billings of their own.

One or two distributors are making this investment but it is not a simple process as most have ERP systems which are based around physical logistics and 'sell and forget' models. Do not expect much beyond manual processes until some time in the new year.

For those companies wishing to understand these issues in greater detail, I would be delighted to get involved.

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