Financing a Services Business: The Valley of Death

It is a late afternoon ritual for me to read the Meritage Minute, a daily briefing on key news events published by my colleague Heidi Longaberger. If you would like to receive The Minute, email Heidi at: Yesterday’s briefing included an AlwaysOn piece titled “In Ten Years Will All Apps Be in the Cloud?” I’m not here to debate the merit of the piece; “all” is a strong word despite the fact that directionally, movement toward the cloud is inevitable. The article lists a series of challenges of moving into the cloud, most of which are the same FUD often touted by those that don’t quite understand. And of course there is the compulsory Twitter data breach mention. Despite that, the last paragraph contains an important nugget of wisdom; a challenge all services businesses (including those in the cloud) face which has nothing to do with technology, scalability, security or compliance. Here it is:

Return on Investment. From a VC standpoint, it takes a long time to run a subscription business past the Valley of Death.  Time to revenue for a cloud business is very long, because revenue comes in a stream, not a lump. Driving sales has to be very swift and very focused.

This is essentially a financing challenge. It is all too often overlooked by entrepreneurs. Services businesses can be capital efficient, but are not necessarily so. To understand this fully, we have to look at both the cost and revenue-sides of the business.

Build it Before They Come

In the services business, you have to build the service before you serve the first customer; not just the product, the entire service. The product analogy is the R&D that goes into hardware/equipment design or into software development in the software business. But in the services business, the stakes are higher, you also have to create a customer service infrastructure, billing and operating support systems, and service delivery infrastructure to wrap around your offering. These costs are ongoing, they are not one-time and sunk. Worse yet, all that infrastructure has to be supported by staff. Early in the businesses’ development, the services operator is by definition operating at well less than minimum efficient scale, so these up-front investments can consume significant amounts of capital and look highly inefficient on paper. Simply “outsourcing” these functions is not the solution. You are still running at sub-scale so whoever you outsource to is going to charge you rates that reflect your scale.

The point is that the services business has a significant minimum cost structure that is required to deliver on a minimum required level of customer support, quality of service, uptime, sla management, etc. Relative to other businesses, the cost structure is high fixed operating cost, low marginal cost per incremental customer. Now lets look at the revenue side of the equation.

Delayed Revenue

One of the appealing elements of the service delivery model for customers is that they get to swap up-front CapEx (think hardware and software purchases) for a delayed, consumption-based payment stream. This is well and good for the customer, but has some significant implications for the services operator. The first and most obvious issue is that the receipt of cash is delayed; that is challenge enough.

But what happens when you miss your bookings of incremental monthly recurring revenue (MRR)?

The Rule of 78s

Those of us who have been around services business have internalized a concept called the rule of 78s. Lets say you project your company will book $50k of new MRR during your first twelve months of revenue generation. The rule of 78s say that the company will generate a total of $3.9 million ($50k * 78) of revenue over that year. [Note: 78 is simply the total of the revenue months during the year; 12+11+10+…+1] But what happens if the company does only $25k of MRR bookings. Now the first year revenue is only $1.95 million. The company just missed its revenue number by$1 million and that miss is probably all incremental burn because of the high fixed cost, low marginal cost of operating the business. I’ve taken a bit of a liberty (albeit a small one) on the cost structure assumptions here, but you get the point.

Run-Rate Matters

Now lets look at where the company stands at the end of that first year of revenue generation. If the business hits the $50k MRR bookings number, the end of year run-rate revenue is $600k. But if the Company does only half of the projection, the end-of-year run-rate revenue also drops by half; to $300k. Again, the difference, in this case $300k per month, is probably all incremental burn, because of the cost structure of the business. So not only has the company burned $1 million more than anticipated in the first year, but the business is also burning $300k per month more than projected at the end of year. If your fixed operating costs are $600k per month, the business is 2 months away from covering fixed operating expenses under the $50k MRR bookings scenario, but 12 months away under the $25k MRR bookings scenario; assuming no churn. This gap between fixed costs and recurring revenues is the Valley of Death referenced by the AlwaysOn author. Further delays in revenue acquisition are going to exacerbate this problem, particularly if your fixed operating costs are higher than $600k. MRR bookings misses don’t just impact the month of the miss, but reverberate though every subsequent month.

Skeptical not Cynical

You can understand why investors are weary of investing in services-delivery model businesses early in their life-cycle. And so far, we’ve only addressed the costs and revenue economics of the business at an income statement level. We haven’t even begun to address the uncertainties around customer profitability, including the lifetime value of a customer, which makes investors really queasy. Profitless prosperity (think Vonage), is a scary concept to investors and without operating history to prove out metrics around customer acquisition costs, ARPU, churn, renewal rates, costs to serve, there is a bunch of guesswork to be done, educated as it may be. I’ll address some of the issues around customer lifetime value in future posts.

Don’t fret, all is not lost. Some of this, particularly on the cost side can be managed. Better yet, there are actually investors who prefer the services model (I happen to be one of them) and understand how to build services businesses. Having uncovered some of the services businesses flaws, I’ll talk about why I prefer it in future posts.

Financing a Services Business: The Valley of Death