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:
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.
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.