Tag Archives: Services

A Tale of Two Companies: The Professional Services Paradox

Quick:  which company do you like better?

Yes, assume they’re similar size, growing at similar rates, and both at scale. Pick A or B.  Thelonious can’t help because there’s no third option.

C’mon.  You know you want to pick A.

  • Company A has a leaner services business at 10% of revenue, where company B’s is kind of hefty at 25%.
  • Both companies have barely profitable services businesses (2% gross margin), but at least company A’s is relatively smaller so that services boat anchor does relatively less damage.
  • Company A has much higher gross margins – by 13 percentage points – at 81% vs. 68%.  Additionally, that 81% is above the public company median of 76%.
  • Company A has somewhat higher operating expenses, but in the end they both produce the same 3% operating margin.

It seems clear that Company A is superior.  And not just by a little — look at the gross margins.  Think of the impact on CAC Payback Period.

Here’s the trick, though.  Company B is company A with one, single difference:  $100M additional services revenue.  Here’s a deeper look showing both dollars and percentages.

Company B has $100M more in total revenue, $2M more in gross profit, and $2M more in operating profit.  Every other figure (not derived from those differences) is the same.  For example:

  • The same subscription revenue of $450M
  • The same subscription COGS of $45M
  • The same S&M spend at $180M
  • The same R&D spend at $140M
  • The same G&A spend at $70M

What’s jamming our radar here?  What’s making them look so different?  Percent of sales analysis.  Normally our friend, but here it’s working against us.

While Company B looks less efficient at gross margin level, it looks more efficient at an opex level because we’re dividing by $600M, not $500M.  That 13% less efficient gross margin is exactly offset by 13% more efficient total opex.  But we didn’t really notice that.  Why?  Because we were stuck on gross margin. Think:  Company A’s clearly the better business – look at those gross margins – so it’s fine to spend a bit more to build it.

Through a purely financial lens, I might still like Company A better than Company B.  Yes, B has $2M extra in operating income, but it’s having to take on the hassle of managing a $100M larger services business.  Is it worth all that for an extra $2M in operating profit?  Maybe not.

This is how investors tend to think.  With 2% margins, it’s a crappy services business anyway, so why not let someone else do it?  Heck, they can probably do it more profitably than us, anyway.  I sometimes call this the Mikey likes it argument, referring to the ancient TV commercial where two brothers force their little brother to try a new cereal.  Think:  we don’t want to do our services ourselves, but I’m sure we can find partners who will just love doing them.  Maybe Mikey will like it, just like the commercial.

This argument overlooks a few key points:

  • The nature of the services business.  If it’s a bunch of $20K deployments, the odds are that partners won’t be too excited.  If it’s $1M transformations that consume consultants by the busload, they’ll probably like it a lot.
  • The training and certification process.  If you want to outsource all of your associated services, then who is going to build curriculum, train, and certify your services partners?  It’s hard to train people on best practices you don’t know and have never developed.
  • Customers who insist on a single point of accountability (fka, one throat to choke).  Some customers, especially in big deals with complex deployments, will want the software vendor to commit to their success.  It’s impossible to promise “no fingerpointing” when there are two parties involved.
  • Competitors who exploit your weakness.  Once your competition determines that you don’t provide services, they will likely sell deployment and adoption FUD relentlessly, find and tell your customer horror stories, and emphasize the importance of vendor-provided services to customers.
  • Customer success as a driver of renewal.  Successful deployment avoids inception churn.  Success adoption drives renewal and expansion.  Reducing customer success to avoid the hassle of managing a breakeven services business is myopic.
  • Services as the saves team.  When a customer fails in deployment and is up for renewal in 6 months, do you think a partner is going to provide free services to save the renewal?  Like relief pitchers in baseball, your services team is in the business of saves.

The biggest problem — one I think of as the services paradox — is when vendors want to transition to selling solutions, not just software.  This strategic upleveling is a common request from sales teams and boards alike.  It’s an important part of category creation and/or 3+1 repositioning strategies.

Here’s the catch — while  boards generally love to hear that you’re selling solutions, they don’t want to hear that you’re building a services business to actually deliver those solutions.  They want you to sell solutions, but deliver software.  In the absence of real, committed partners, that message is going to ring hollow with customers.

But partners are generally unwilling to make strategic come-bets on your category creation strategy.  Once you’ve created a massive market, they’ll be happy to come along and suck up services.  But taking strategic risk to do that?  Building a services practice on the come?  No thanks.  Services firms are unapologetic opportunists.

That means there are times when only you can deliver the services needed to execute a transformation strategy.  Qualtrics had to do this as part of their strategic transformation from survey software to customer experience management (CXM) to experience management (XM) platform.  And they provided plenty of services along the way, running in that uncomfortable 25% of revenues range (and perhaps higher in the earlier days, but I don’t have the numbers).

So, all that considered, which company do I like better?  I need to know the answer to two more questions.  Are they executing a strategic transformation from software to solutions?  Are they upleveling their message and creating a new, broader category (i.e., Playing Bigger)?

  • If no, I like A better for all the standard reasons.
  • If yes, I like B better and I’m fine with the “excessively large” services business

Peace out.

The Role of Professional Services in a SaaS Business

I love to create reductionist mission statements for various departments in a company.  These are designed to be ultra-compact and potentially provocative.  My two favorite examples thus far:

I like to make them based on real-life situations, e.g., when someone running a department seems confused about the real purpose of their team.

For example, some police-oriented HR departments seem to think their mission is protect employees from management.  Think: “Freeze, you can’t send an email like that; put your hands in the air and step away from the keyboard!”

I think otherwise. If the HR team conceptualizes itself as “helping managers manage,” it will be more positively focused, help deliver better results, and be a better business partner — all while protecting employees from bad managers (after all, mistreating employees is bad management).

Over the past year, I’ve developed one of these pithy mission statements for professional services, also known as consulting, the (typically billable) experts employed by a software company who work with customers on implementations after the sale:

Professional services exists to maximize ARR while not losing money.

Maximizing ARR surprises some people.  Why say that in the context of professional services?  Sales brings in new ARR.  Customer Success (or Customers for Life) is reponsible for the maintenance and expansion of existing ARR.  Where does professional services fit in?  Shouldn’t they exist to drive successful implementations or to achieve services revenue targets?  Yes, but that’s actually secondary to the primary mission.

The point of a SaaS business is to maxmize enterprise value and that value is a function of ARR.  If you could maximize ARR without a professional services team then you wouldn’t have one at all (and some SaaS firms don’t).  But if you’re going to have a professional services team, then they — like everybody else — should be there to maximize ARR.  How does professional services help maximize ARR?  They:

  • Help drive new ARR by supporting sales — for example, working with sales to draft a statement of work and by building confidence that the company can solve the customer’s problem.  If you remember that customers buy “holes, not bits” you’ll know that a SaaS subscription, by itself, doesn’t solve any business problem.  The importance of the consultants who do the solution mapping is paramount.
  • Help preserve/expand existing ARR by supporting the Customer Success (aka, the Customers for Life) team, either by repairing blown implementations or by doing new or expanded implementations at existing customers.  This could entail anything from a “save” to a simple expansion, but either way, professional services is there maximizing ARR.
  • Help do both by enabling the partner ecosystem.  Professional services is key to enabling partners who can both provide quality implementation services for customers and who can extend the vendor’s reach through go-to-market partnering.

Or, as our SVP of Services says, “our role is to make happy customers.”

I prefer to say “maximize ARR without losing money” but we’re very much on the same page.  Let’s finish with the “not losing money” part.  In my opinion,

  • A typical on-premises software vendor drove 25% to 30% gross margins on professional services.  Those were the days of one big one-shot license fees and huge multi-million dollar implementations.  In those days, customers weren’t necessarily too happy but the services team had a strong “make money” aspect to its mission.
  • A typical SaaS vendor has negative 10% to 20% gross margins on services (and sometimes a lot more negative than that).  That’s because some vendors subsidize their ARR with free or heavily discounted services because ARR recurs whereas services do not.

I believe that professional services has real value (e.g., I’ve worked with several amazing services teams) and that if you’re driving 0% to 5% gross margins with such a team that you are already supporting the ARR pool with discounted services (you could be running 25% to 30% margins).  Whether you make 0% or 10% doesn’t much matter — because it won’t to someone valuing your company — but I think it’s a mistake to shoot for the 30% margins of yore as well as a mistake to tolerate -50% margins and completely de-value your services.