If you’re the CFO of a hardware, software, or IT-services firm, you’re watching your customers and the market react to the growing proliferation of cloud-based services. If you’re a new entrant in the space, you’re faced with a unique opportunity to unseat traditional leaders. If you’re a legacy provider, you’re going to have to work hard to defend your market position.
Adding to the buzz, investors and financial markets are now rewarding cloud services disproportionately. Software-as-a-service companies’ total enterprise value over revenue multiples were 1.5–2 times those of traditional software companies in 2011, and the enormous sums paid for SaaS companies such as SuccessFactors (acquired by SAP last year for $3.4 billion) and Taleo (bought by Oracle for almost $2 billion early this year) continue to reinforce the trend. Wherever you are currently positioned in the market, there’s increasing pressure from customers, shareholders, and competitors to design and implement a cloud strategy.
The question is how.
The operating model and the economics of a cloud-based offering are fundamentally different from those of a traditional, on-premise technology product. We’ve found that operating margins at SaaS companies run about 10–15 points lower than those of traditional software companies. This gap stems in large measure from the investments SaaS companies need to make in customer acquisition; that is, sales and marketing, upon which traditional software companies, with their perpetual licenses, are less dependent. Other differences that contribute to lower margins include dollars spent to combat customer churn; the need to sustain renewal rates and, if you’re new to the space, the necessity of re-focusing your sales people and opening new channels.
With this in mind, it’s important for technology-company CFOs to focus on the following five critical areas when their business begins offering its products in the cloud:
Pressure-test your strategy. Because of all the buzz, there is no shortage of ideas within technology companies about how to invest in the cloud. As the CFO, the burden will be on you to discriminate between the good and bad ideas. The key question to ask is what new or unmet customer need is being fulfilled.
There are many ways to get on the cloud trend. Some companies choose to supplement their core product with added hosting and management services (either buying or renting servers). This provides opportunities for add-on recurring revenue within the existing base, and also allows for the targeting of new customer segments, such as small-to-midsize businesses. However, gross margins here tend to be lower than traditional, on-premise products. Other companies choose to bolt-on cloud-based services to existing offers, as Adobe has done by adding cloud storage and collaboration to its Creative Cloud Suite. This approach extends the value proposition of the core offering, and in the case of Adobe creates a level of stickiness by integrating storage and collaboration. Still other companies might choose to redesign their product completely to become more cloudcentric. Market dynamics might dictate this shift; however, this will involve an expensive, multiyear commitment and it doesn’t address the near-term need to have a credible cloud solution to bring to market.
While all these are financially viable, each results in a fundamentally different set of operating-model requirements and economic implications. As CFO, you should pressure-test the assumptions that underpin your company’s cloud strategy. Be wary of investing in the cloud for the sake of the cloud.
- Drive innovation in pricing. Subscription-based pricing is the status quo for cloud offerings, and prices are generally set with a planned three- or five-year return on traditional license and maintenance revenue. However, given that cloud-based service providers host their customers’ applications and store their data, they can recover significant insights about how customers use their offering and on where value is being derived. These insights include knowledge of which users are accessing the services most where the services are being accessed from (e.g., iPad versus desktop), what features are used most, how much and what type of data is being stored, when and how often the services are being used, what the user complaints are, and so on. The opportunity is to mine these insights and use them to maximize revenue by taking a more targeted approach toward packaging and pricing. You could up-charge for valued features and higher service levels, for example, or design promotions to penetrate favored user segments. It’s possible to offer dynamic time-based promotions with the knowledge you’ve retrieved about usage patterns. As CFO, you need to guide the organization to price these offerings in a more strategic way than has been traditionally adopted.
- Manage your sales costs. Asking your existing sales channels to sell cloud services in addition to their traditional portfolio is not always going to work. It often becomes necessary to add specialists in cloud selling. Also, because high-renewal rates are critical to your success, investing in customer satisfaction is a must. All of this will inevitably increase the cost of sale, at least in the short term. Making the channel self-sufficient, using automation and analytics to capture deep insight into customer usage, and balancing incentives to reward new sales with renewals, along with up-selling, are all important to managing sales and marketing costs.
- Start thinking about your infrastructure. As the CFO of a company that makes and sells software or hardware products, you probably haven’t spent much time thinking about managing data centers, servers, storage, networks, and firewalls. You know, infrastructure. All that changes with the cloud, as infrastructure-based concerns like system up-time, latency, security, and redundancy are now your problem, not your customer’s. Whether you choose to outsource infrastructure management to a third party or bring the capability in-house, it is a cost (or investment) that CFOs must understand and manage effectively to ensure long-term margin growth.
- Redefine your services portfolio. Just as introducing a cloud offering requires significant changes to your product portfolio, marketing strategy, and sales channels, it also demands significant changes to your services portfolio. Customers have been trained to buy maintenance and support as an add-on in the traditional on-premise model. In the cloud model, they expect it to come along with the product, and the cost needs to be included as part of the monthly or annual subscription fee. But there are add-on services that customers are willing to pay for, such as extended support, data management, and analytics. Redefining the services model to deliver basic services efficiently is critical to managing margins, while building out a portfolio of value-added services can contribute to revenue growth, and to customer satisfaction and retention.
As your technology business executes a cloud strategy, success will be driven by the effective design of the key operating elements unique to the cloud. CFOs have a critical role to play in ensuring that operating-model decisions for this service are made with a view toward sustaining margins.
Dhaval Moogimane and Ken Ewell are partners at Waterstone Management Group, a boutique strategy consulting firm focused on serving investors and management teams of technology companies.