The future is in services

Last week, I attended GigaOm’s Structure ’09 Conference: Put Cloud Computing to Work. It was worthwhile to attend and I intend to return next year. It was exciting to see how the services business model is being rapidly adopted by the technology-delivery value-chain.

In a talk titled The Cloud in Context, Russ Daniels, VP and CTO of Cloud Services Strategy at HP put it most succinctly, describing HP’s vision as:

“Everything is a Service”.

Full video of Daniels’ talk here. While the “everything is a service” mantra is almost certainly overreaching, it drives home an undeniable point; the action is in services. To make it fully, I think you have to start with the view from the customer’s perspective. What the customer wants is functionality that helps them achieve a business objective delivered at a total cost of ownership that is less than the value they can extract from the functionality. Issues of security and control aside for a moment, the customer is mercenary about this and will adopt the delivery method that gives them the functionality they want with the best ROI. Said another way, customers are becoming delivery-model agnostic.

It is no wonder then that the operating model through which value is delivered to customers (whether enterprise, smb or consumer) is turning away from products and toward services. It is well documented that in many cases, the services model has an ROI advantage over the product model. At a macro level, I tend to frame the transformation technology markets are undergoing as one where products are turning into services.

Products turning into services

Consider the transformation taking place in each of the following areas:

Value PropositionProduct Delivery ModelServices Delivery Model
Application level functionalityShrink-wrapped SoftwareSoftware as a Service
Data storageHardwareStorage as a Service
Computing power/ProcessingWeb ServersComputing as a Service

In each case, the value proposition – once delivered to the customer in the form of a one-time sale/license product – can now be accessed by the customer through a CapEx light service. Customers are dropping the CapEx and OpEx associated with managing IT infrastructure for pure OpEx in the form of services.

An Investors View

While technology plays a key role in enabling the trend toward services, the trend itself is not fundamentally about technology. Rather, the opportunity offered by the cloud is a more efficient operating model; the service operating model. This creates a new layer to the technology value chain; the services layer. Any time a new layer is added to a value chain, new investment opportunities are created and pre-existing layers of the value chain are at risk. From a venture investor’s point of view, this forces a rethinking of investment approaches.

An ecosystem play

The new investment opportunities in the cloud go way beyond the traditional IaaS, PaaS, and SaaS layers of the stack, although there are opportunities within each of those categories. Each of these layers will require its own support ecosystem to achieve its full potential. These are often referred to as enablers. Enablers are interesting investment opportunities, because they enable the investor to play the momentum of a category. For example, an investment in a SaaS enabler that provides billing, operating support and other capabilities to SaaS developers is a play on the success of SaaS as a category as opposed to any one SaaS operator. If the category you “enable” fails, like the mobile virtual network operator category, your enabler will fail, like the mobile virtual network enablers failed. But if the category you are enabling is successful, the rising tide is likely to lift your boat too, so long as you have a valuable service.

Existing value chain is threatened

The emergence of the service layer is facilitated by massive improvements in networking, computing, storage and software, including virtualization. What is ironic is that the emergence of the services layer threatens the very same product vendors that have facilitated its development. In the product oriented technology value chain, product vendors (software, storage, computing) sold to end users; enterprises, small businesses and consumers. In a services oriented value chain, these same product vendors sell to the service providers (IaaS, PaaS, and SaaS). For an investor there are two implications. The first is that those product companies just lost access to the end customer, replaced by the relationship between the service provider and the customer. The second implication is less obvious, but more threatening. The services business is a business of economies of scale. It requires a significant up-front investment in service delivery infrastructure, but has very low margin costs for each new customer added. The result is that sub-scale service operators can’t compete; and the big get bigger. This tends to restult in a concentrated service provider market, consolidating buying power, which squeezes margins of  the suppliers to the service providers. Those of us who have roots in the services sectors understand this phenomenon quite well. We have a saying at Meritage about the communications equipment space that I’ve grown fond of; “there are too many vendors and not enough customers”. This is one of the many reasons we don’t invest in communications equipment, but we love the communications services landscape.

The point is, if I were a product company focused on selling software, storage, or computing, I’d be frightened right now because my sales model is going to change dramatically over the coming ten years and not in my favor. The “On the Shoulders of Giants” panel at Structure really drove this message home. The panel, moderated by Jonathan Heiliger of Facebook, included ops leaders from Microsoft, MySpace, Google, Yahoo! And LinkedIn. These guys push their vendors hard. Heck, Google designs its own hardware and considers it a competitive advantage. Product vendors can expect more of the same treatment with the emergence of big cloud services operators like Amazon, Salesforce.com and others.

It is no wonder then that every major product vendor, from SAP to EMC is stuck in a seemingly bipolar tug of war between their legacy product businesses and their emerging attempts to run services platforms. Unfortunately, the key success factors for running a product-oriented company don’t translate well into a services environment.

Implications for Venture Capital

Participants in the technology supply chain aren’t the only ones struggling with the implications of the cloud’s emergence. The venture community is as well. It turns out that investing in services businesses demands a different skillset and philosophy than investing in product companies.

Because most services businesses go to market with a recurring revenue business model, the economics of the business are much harder to evaluate and the profitability is back-end loaded. In a prior post, I wrote about The economics of on-demand services, which includes an evaluation of unit factors like ARPU, churn, service delivery costs, etc. This is sufficiently more complicated than the economics of hardware; sell a unit, collect the revenue and lock in your gross margin on the sale.

The net result is that services businesses can be quite capital intensive, even if the market responds well to the service. It is more capital efficient than was the case when you had to build your own network to deliver a service (think cable), but still more capital intensive than product investing. As a result, investing in services is not for the faint of heart. Early indicators of success that are so prevalent in the product world are harder to come identify, except with an expert eye. It takes a tremendous amount of patience and in some cases stubborn conviction to be successful in services investing.

The opportunity for investors in the cloud is real, but only for those with an appropriate long-term company building philosophy and a level of comfort with the services business model.

Derek Pilling is a Managing Director at Meritage Funds, a growth equity firm. Derek invests in technology-enabled services businesses in the Internet Infrastructure, Cloud Computing, Digital Media and SaaS sectors.Derek lives in Denver with his wife and his three children. In his spare time, Derek enjoys coaching youth soccer, skiing, hiking, spinning and hopping on his rowing machine in the morning.

Tagged with: , , , , , ,
Posted in Cloud, Conferences, Themes, Venture Capital
Derek Pilling

About Derek

I'm a Managing Director with Meritage Funds, a growth equity investment firm based in Denver, CO. I've been working with growth stage businesses my entire career. When I'm not working, I ski, spin, coach youth sports and spend time with my beautiful wife and three kids.

I blog because the process helps me crystalize how I frame the world. I want to hear what you think. Please comment.

Twitter feed

Colorado - Entrepreneurial by Nature

Categories