ISVs in the Cloud, considerations for a successful transition
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Independent software vendors (ISVs) must transition to cloud computing to survive, as reliance on on-premise software is increasingly untenable. Successful ISVs focus on strategic considerations such as avoiding ownership of infrastructure, choosing cloud providers based on commercial opportunities, and leveraging sales for funding. A failure to adapt to this shift can limit an ISV's growth potential and market relevance.
ISVs in the Cloud, considerations for a successful transition
- 1. 1 ISVs in the Cloud considerations for a successful transition By Reinout Schotman & Nick Fryars Draw a circle of 5 kilometers in a metropolitan area and imagine how many independent software vendors (ISVs) are in that area. More likely many than none. How many of these ISVs have built their business based on on- premise software? Probably most. How many will survive without adopting cloud computing theory and technology? Most likely, none. The paradigm shift of cloud computing is not only transforming IT for end-users, it is also reshaping the supply side of software. It is a threat to ISVs with on-premise products and delivery models that do not adapt to the cloud environment in a timely manner. ISVs that do change mostly virtualize their infrastructure and offer software as a service in their transition to the cloud. As a result most of such ISVs find themselves with decreased margins and eroded revenues. Outperforming ISVs are using cloud computing to a greater benefit. They deal better with three key considerations: 1. Avoid owning infrastructure 2. Select a cloud based on commercial opportunity 3. Financially leverage your sales Avoid owning Infrastructure To understand why owning (cloud) infrastructure should be avoided by ISVs it is important to understand the drivers for value creation. Customers choose one ISV over another because it delivers a product that is it better fulfills their functional needs. The customers delivers as a cloud service will not even be aware of the underlying infrastructure or technology. Infrastructure (such as hardware, network, operating system) has been commoditized. The key economic driver for infrastructure is scale and the required scale to be efficient is huge. Microsoft, Google, IBM, Amazon, Apple and limited other providers all operate infrastructures of hundreds of thousands of servers. It is a market dominated by very large IT companies with deep pockets. Even a new entrant like Salesforce.com with a modest ISVs transitioning to a SaaS business model should have three key considerations: to avoid infrastructure, which platform and how to fund working capital. January2012
- 2. 2 scale infrastructure publicly stated that it had invested $100m in infrastructure before it was ready to do business and offer service. Even if this is overstated it signals that the investments in infrastructure are significant for new entrants offering Infrastructure-as-a-Service (IaaS). Many data centers and even telecom providers are struggling to compete in a market that they regarded as their home turf. (see: Experience Curves for Clouds). The cost of renting infrastructure capacity through IaaS is not necessarily lower, but that may not be the most important benefit of renting. The key consideration for an ISV is whether outsourcing to an IaaS provider allows it to focus on its true added value: functional product innovation. The question an ISV should ask itself is: can we build and operate an infrastructure meets our quality requirements more economically than a top-tier IaaS provider? It is a market anomaly that many ISVs overestimate the value they earn from their infrastructure. This suggests that they will have an increasingly tough time demonstrating their value to customers. Owning infrastructure absorbs precious management attention and resources and limits the growth potential of an ISV. Which Infrastructure Mostly ISVs choose an infrastructure based on technical compatibility, cost and (organizational) stability. Such criteria miss a crucial strategic opportunity: the opportunity to leverage the infrastructure provider commercially. Cloud infrastructure is driven by scale and therefor the biggest providers have a strategic advantage. Such top-tier IaaS providers have established relations with large customer bases and they realize that they need small ISVs to provide innovative services on their infrastructures to make them relevant. There is a catch for ISVs, however. By choosing one IaaS provider, the ISV is often denied access to the customer base of a competing IaaS provider. Choosing an IaaS provider is therefor a significant commercial consideration. The IaaS provider with the biggest relevant customer base for an ISV is possibly commercially more attractive than a IaaS provider with a superior capabilities and reputation, but with a less attractive customer base. The ISV might catch the biggest fish, but it is the biggest fish of a small pond. Instead it could find itself fishing in rich oceans. An Example Okta is a provider of identity and access management (IAM) for the cloud. Within the IAM market they gained quite some attention and significant funding. However, so far its commercial performance has been disappointing. So, what opportunity did Okta miss? Okta is based on the force.com platform of Salesforce.com. Highly capable and stable, force.com is a proven technical platform of an industry leader. So piggy-backing on this platform seemed a good choice. However successful salesforce.com is, their installed base is ~ 2 million seats, less than 1% of world-wide seats in the enterprise market. This means that Okta gains entry to 1% of their addressable market by partnering with salesforce.com. Had they chosen Microsoft instead, they could have gained a partner with an installed base of over 265 million seats in the enterprise market and a yearly R&D budget of US$ 8.6 billion to convert this base onto the cloud, a partner that has access to nearly every imaginable customer world-wide and an extensive eco-system of System Integrators (SI’s) to drive sales. Instead Microsoft bought BHold Company (see note). Funding ISVs transitioning from on- premise to a SaaS based business model face a funding challenge. SaaS businesses always have a subscription model for their core offering. This means that revenues are delayed compared to a classic Figure 1: Funding analysis with and without collateralized loans of a SaaS ISV that is expecting high revenues growth in the future. RequiredFunding Time Customers Customers Funding w/o loan Funding with loan note: BHold Company is a client of Outdoor Connect © 2012 Outdoor Connect
- 3. 3 one-time license model, and that funding R&D and customer acquisition can be problematic. As Bessemer Venture Partners explains (see “Bessemer Cloud Computing Law #9: Mind the GAAP!”) it is important to match revenues and costs to consumption. This is especially challenging for ISVs that anticipate significant growth. They can run out of liquidity or miss capturing market share by not being able to ramp up sales due to budget constraints. This is a classic and fundamental challenge for SaaS- based ISVs. In fact, the low net income margin of Salesforce.com is mostly because Salesforce.com is using its revenues to fund future growth while not capitalizing its sales expenses. Corrected for the cost of growth, its profits are up to about 50% of revenues. This implies a Price/Earnings of about 10 (like Microsoft) rather than the stellar current P/E of 5.000. The ISV needs to choose whether to fund working capital through debt or equity. The incentive for existing shareholders is growth without the cost of diluting shares. Debt on the other hand requires some form of tangible asset as collateral. ISVs are typically light on tangible assets (or they are not funded efficiently), but, unlike on- premise ISVs, do have relatively strong, tangible assets that provides a steady and predictable cash flow: sales contracts. Under certain conditions ISVs can leverage existing sales contracts to attract collateralized debt to fund future growth. As the example in figure 1 demonstrates, the amount of equity funding can be significantly reduced as well as equity becoming “in the money” sooner. Once existing revenues generate enough cash flow to pay-off the loans, debt can be easily reduced and the ISV can grow autonomously or use the cash flow to explore new markets. Call for action For ISVs to survive the cloud computing paradigm shift, they should consider carefully whether they walk-the-walk and outsource their own infrastructure into the cloud. Successful ISVs use the transition to cloud to build powerful commercial alliances that provide them new go-to-market strategies. And finally ISVs should consider the financial challenges of growth in a SaaS business model. Collateralizing on sales contracts could be a solution. History has many powerful reminders of failures to adopt to a new reality. Music publishers underestimated the power of digital distribution of media and the impact on their value chain. It nearly cost them their market.
- 4. 4 Copyright © 2012 Outdoor Connect All rights reserved. Outdoor Connect and its logo are trademarks of Outdoor Connect B.V. About Outdoor Connect Outdoor Connect is a management consulting firm and a leading advisor on cloud computing strategy for enterprises. Outdoor Connect partners with clients in all sectors and identifies their highest- value opportunities, addresses their most critical challenges, and transforms their businesses. Outdoor Connect advises clients in technology engagements in phases preceding implementation and helps them manage the delivery of cloud computing value thru program management. Clients are both end- user organizations as well as service providers that deliver cloud services to end-users. Its home page is www.outdoorconnect.nl About the Authors Reinout Schotman is a senior management consultant and leader in the field of cloud computing. Prior to joining Outdoor Connect in 2010 Reinout was practice lead of the SaaS/ CRM practice within Accenture Netherlands. Furthermore Reinout has experience in Telecoms and he holds a MSc in applied physics of Delft University of Technology. Nick Fryars works with international business leaders to drive new ventures and strategic change. He recently set up Sales Operations for the HR cloud company Lumesse. Nick was a founder member of PA Consulting Group's Strategy practice. He holds an MBA from Twente University and a BSc in Computer Science & Mathematics from London University. For more information on how Outdoor Connect helps organizations to benefit from the cloud, please contact: Reinout Schotman reinout.schotman@outdoorconnect.nl +31 6 11 14 19 16 Nick Fryars nick.fryars@outdoorconnect.nl +31 6 54 38 85 49