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It doesn’t happen often, every 10 to 15 years or so, but we are in the throes of the reordering of the $4 trillion corporate IT market. And depending on which side of that transformation you sit, this is either the best time to be an enterprise technology company (see: renaissance in enterprise computing), or reason to start looking for a new line of work.

I certainly sit among the group that sees this as a huge opportunity, and it’s far from finished. If the first phase was to build replacement technologies for every part of the IT stack, the next phase—and the next golden opportunity—is to re-imagine the business side of the equation and change how buyers and vendors come together. That is where this SaaS Manifesto comes in. Think of it as a three-part field guide to the new way enterprise computing will be bought and sold.

Part 1: Navigating the Departmentalization of IT

In the enterprise IT world, companies like Oracle, Microsoft and SAP are established giants, so entrenched that every new company has had to either peacefully co-exist with them or else face getting steamrolled into oblivion. But that strength comes with a weakness: These companies are slow adapting new practices and evolving to new models. In fact, both SAP and Oracle recently attributed their missed earnings targets to “the cloud.”

And there is a major change occurring in the enterprise: Beyond the technical and architectural innovation we see in new products, there are fundamental opportunities appearing on the distribution and customer side that simply never existed in the past. In past technological shifts (e.g. from mainframe to client server, or from client server to PC) purchasing was always done through a centralized CIO organization, no matter the product. Large vendors could rely on the depth of their existing sales channel and the reluctance of customers to move outside their respective fiefdoms to successfully enter newer areas. Sure, vendors would be left behind in each shift, but it was largely due to lack of new technology, as opposed to a lack of changes in the go-to-market landscape.

Today, the new buyer is the operating department—HR, sales, development, marketing—and the decisions of which technologies to procure are no longer solely centralized through the CIO. In fact, nearly 50% of all IT purchasing decisions are now being influenced and/or made by an operating department, says an August 2013 study by Enterprise Strategy Group, as these departments look for purpose-built applications. This change creates one of the most meaningful differences in the new world of enterprise computing: Not only do the large players have to create or buy new technology, but they must also adapt their offerings and sales models to appeal to this new buyer.

Here’s why this shift is difficult for established players:

Perpetual vs. subscription licensing. Many current operating plans and sales organizations at the largest technology companies are built on the perpetual license model, where a customer pays one large sum up front and the vendor immediately recognizes nearly 100% of that payment as revenue. This perpetual license gives customers the “privilege” of paying an annual maintenance fee regardless of whether or not they take advantage of future upgrades. With subscription licensing, however, revenue is recognized over the life of the contract, making this an extremely difficult economic and organizational shift for an existing vendor.

Product cycle and software development methodology. For packaged software, new features are delivered (in the best case) twice a year. Often these feature releases are never deployed due to the complexity of field upgrades, resulting in users working with software that is years old. With SaaS, development is near continuous, allowing for rapid feature innovation and instant deployment of new features to all users.

Ease of adoption and trial-use. In the pre-SaaS, on-premise world, software purchases were made through a central CIO organization, which was equipped to deploy infrastructure and then test, certify and validate every new application. This highly concerted—not to mention, costly—effort required salespeople and systems engineers to run pilots, alphas and internal rollouts. The process would often take months, and by the time the software was ready to be deployed, there was no clear indication as to whether the product was really useful to the company.

However, with the advent of cloud and SaaS, the end user/department can easily try new software without an on-premise install, often at no cost. Developers and startups have found a replicable, reliable way to circumvent the iron grip of the industry’s major players and innovate, rather than iterate, on solutions to complex business problems. It’s a meritocracy of applications, where the best wins.

Inside sales leverage. With easy adoption and trial-use, a typical SaaS customer will have used a product and know its capability. This makes selling an upgrade or enterprise-wide deployment much easier and more economical.

Because of SaaS, the inside sales function is growing at 15 times the pace of direct sales. For existing companies that have large direct sales groups, moving to an inside sale model requires a complete re-tooling of the sales organization. This is a difficult transition and provides an opportunity for new companies to prevail.

Customer relationships. Customer lock-in has long been the hallmark of incumbent companies. Selling on-premise software directly to the CIO resulted in a tight relationship between the CIO buyer and the incumbent vendor. No matter how slow the rollout or buggy the end result, the fact that any new product had a receptive, locked-in customer, made it incredibly difficult for a new company to wedge its way in.

But with departmentalization, individual operational units have more autonomy to purchase technology. This gives the newcomer a real opportunity to establish relationships that the incumbent may not have. In fact, several large, incumbent companies are now making an effort to get to know the departmental buyer and get ahead of this trend.

The cloud and SaaS are stripping the complexity of IT to the point where any given operational department now has the confidence to purchase the tools they need directly from the vendor, circumventing a large part of the traditional IT procurement process. Moreover, the new buyers are not encumbered by risk-averse, IT decision-makers who operate under the belief that “nobody gets fired for buying IBM.”

By targeting this departmental user, Goliath topples almost before he sees David coming.

Up next: The Saas Manifesto: Part 2 – Building a sales organization that caters to the department, but recognizes the critical aspects to enterprise-wide requirements, and the changing role of the CIO.

Note: Part 1 of “The SaaS Manifesto” first ran in The Wall Street Journal‘s CIO Journal.

In addition to the Freemium + upsell model that SpiderNet has implemented, you have also decided to pursue a strategic partnering/OEM model. You’ve brought on a world-class Business Development executive with the objective of getting major ecosystem players to adopt your free, base software into their distribution and enable them to upsell above that base. The model will enable additional deployments of your free software, providing additional opportunity to monetize the user base.

The new BD executive has been active for several months, targeting large players with massive distribution capabilities and $100+ billion market caps. A deal with any one of the “elephants” would be a game changer for SpiderNet.

Recently, one of the “elephants” finishes their evaluation of the SpiderNet product and wants to do a deal. After several rounds of negotiation, the terms they offer are:

  • 50/50 net revenue split on all products upsold from the integrated free base;
  • Pay SpiderNet $5 million in up-front cash;
  • Five-year contract length;
  • All current and future products;
  • Exclusive distribution rights;
  • First right of refusal if SpiderNet gets an offer to be purchased;
  • Rights to source code if SpiderNet gets acquired by a competitor

You realize that some of these terms are not very favorable to SpiderNet, but this deal has the ability to fundamentally change the future for you. Having one of the largest ecosystem vendors in the market bundle and upsell SpiderNet products will be a huge win. Do you agree to these terms and quickly move to lock down a deal, or do you negotiate further, possibly losing the deal to a competitor? And if you do negotiate further, what would you propose to change?

What Now?

For a small company, the allure and perceived value of a large strategic deal often results in a deal where the relationship is heavily skewed to the benefit of the larger company. Because these deals often create a “halo” effect by blocking competitive companies and providing a high degree of credibility, the temptation to accept a collection of unfavorable terms is quite natural. In the beginning, the smaller company will likely “need” the big company more than the big company “needs” the small company. The larger organization often recognizes this asymmetric condition and will rightfully apply their leverage in the negotiation. It is not right or wrong. It just is.

While a smaller company may need to accept a set of unfavorable terms, the question becomes “how unfavorable”? At what point does a collection of terms effectively result in a “box car” acquisition of your company?

The Box Car Acquisition

In the case of SpiderNet, the above terms proposed by the larger company are interesting in that the first few terms make the deal seem quite appealing. SpiderNet will split all revenue with the larger company, get paid $5 million up-front and have this condition exist for five years. However, the next set of terms, when combined, result in the effective acquisition of SipderNet by the larger company—my definition of a “box car acquisition”.

Let’s take a look at the terms and understand some guidelines for how to avoid some of the pitfalls with each term.

50/50 revenue split. While on paper this looks like a great term, the gotcha is how much net revenue the larger company will generate. Suppose the large company gives away the SpiderNet product for free or charges much less for the upgrade than SpiderNet plans? In such a case, the net revenue might be very low and splitting would be quite disappointing to SpiderNet.

Advice to SpiderNet: Propose a minimum floor payment (yearly or per unit) that the larger company must pay, such that SpiderNet is always guaranteed an acceptable payment.

$5 million up-front. Up-front payments are certainly beneficial from a cash flow standpoint.  However, it is often the case that the larger company will only propose an up-front payment to get better terms elsewhere in the agreement.  In this particular example, is it possible that the $5M has been used as a trade for the other (bad) terms in the deal?  Has the larger company not just purchased SpiderNet for $5M?

Advice to SpiderNet: Construct a deal that represents a stable arrangement, without a pre-payment option. Then, possibly apply a pre-payment, such that SpiderNet understands exactly what they are getting in exchange for the up-front cash.

Five-year contract length. It may seem that longer contracts are better, but remember that the contract length locks in the asymmetric condition for the length of the agreement. In my experience, shorter contract lengths (two years) are far more advantageous to the smaller organization since the dependency shifts.

SpderNet advice: The shorter the term, the more quickly SpiderNet can re-negotiate key points in the agreement. By the way, the larger company also realizes this and they will want a long contract period.  (Two- to three-year contracts are standard outcomes). Do not agree to a five-year term.

All current and future products. Giving all future products away makes no sense. Who knows if the new products are even applicable to the larger company? If the larger company is unsuccessful with the initial products, why offer future ones, especially under the same terms as the initial products?

Advice to SpiderNet: NFW. Show stopper. Do not agree to all future products. Limit agreement to existing product line. Full stop.

Exclusive distribution rights. Very often the larger organization will want to “help build” the small company’s distribution capability by proposing that they become the exclusive channel. While this may seem appealing, the downside is that the large organization maintains full account and customer control, effectively cutting the small organization out of the distribution loop. This is a very dangerous situation, as that smaller organization will be 100% dependent on the larger organization for generating users and revenue.

Advice to SpiderNet: Another show stopper. Do not agree to exclusivity. If necessary, allow the larger company a period of exclusivity (six months) to get started, but reduce the distribution concentration as quickly as possible.

First Right of Refusal. Giving a first right to the larger company means that they can always trump any offer that might come in. Agreeing to a first right effectively prevents other offers from coming in since no other company will want to spend the time or energy on giving a term sheet with this condition in place.

Advice to SpiderNet: If SpiderNet needs to agree to something, then agree to notify that an offer has been received but without having to name any of the terms of the offer. Give the larger company 24 hours to respond.

Rights to source code on change of control (CoC). In all software companies, source code is the key intellectual property. Giving this to the larger company on CoC materially changes the strategic value of the smaller company to any acquirer, especially if the larger company and the acquirer are competitors. Why would another company pay full value for the smaller company if their key competitor gets the IP for free?

Advice for SpiderNet: This is another show stopper. Upon CoC, allow the larger company to terminate the agreement and execute a reasonable wind-down, but never give away the source code.

Summary

As can be seen, the terms being proposed to SpiderNet are not acceptable to proceed without negotiation. If you lose the deal to a competitor, and they have agreed to such terms, then it will be a problem for them over time. Getting key terms structured correctly will avoid a dangerous and crippling “box car” acquisition.

In last week’s decision, the management at SpiderNet decided to pursue a freemium model, where the company would give away a free product and then upsell a $99 added value feature set.  As part of this go-to-market model, SpiderNet must now decide on how to allocate and budget for sales resources.

In order to promote and sell the added-value features, the company decides to use an inside sales model for generating revenue.  This approach has worked well for other companies delivering a freemium product and avoids the costs of a direct/outside sales approach.  The inside sales team at SpiderNet will be responsible for following up on leads, generating demand for the for-fee upsell, and ultimately closing business.

As CEO of SpiderNet, you must now decide on the operational plans for growing this inside sales capability.  Right now the company has no salespeople, but with the product coming out this next quarter, you feel it is the right time to start bringing on sales talent to generate revenue.

While everyone agrees that hiring sales is important, the internal debate centers on how many and when.  Most people in the company, including engineering, wants to hire as many sales people as can realistically be hired, such that the company can quickly capitalize on the opportunity and grow quickly right out of the gate.  This group also wants to make sure that the sales force can cover all opportunities and be well trained ahead of the demand.  A few people suggest waiting until the freemium model is proven and suggest hiring just a few sales people initially.

You expect the demand for your freemium product to be huge, that the upsell will be in high demand, and that you’ll need capacity from the sales organization to field in-bound requests.  Hiring too few sales people might cause SpiderNet to miss out on a golden opportunity.   Given this, do you rapidly ramp up sales capacity or hire less aggressively?

What Now?

Every company that is about to release a new product is always optimistic about the future of the product.  The expectation is that the product will offer great value and, in turn, create an amazing following of users and revenue.   However, it often takes time and iteration to get the formula correct and the tendency for most companies is to over-hire sales capacity before the product-to-sales fit has been fully worked out.   The consequence of over-hiring in sales without knowing whether the company can repeatedly sell the product can be severe.  Therefore, a prudent balance must be established between capitalizing on the opportunity and hiring the appropriate number and type of sales people at the outset of a product’s market entry.

The Sales Learning Curve
The Sales Learning Curve is a concept that my good friend, mentor, and co-lecturer at Stanford, Mark Leslie, developed as a methodology for adding sales capacity following the launch of a new product.  The premise is that, in the same way a company must take the time to develop a product, a company must also take the time to develop sales knowledge and capability.   All too often, what a company thinks will work in terms of customer segmentation, sales model, and salesperson type does not end up being the optimal outcome.  Companies must learn how to sell and bring products to market in order to avoid expensive and costly mistakes based on assumption rather than quantitative evidence.

The Sales Learning Curve has three phases:

  1. Initiation.  The initiation phase begins when the product hits the market.  In this phase, few customers will typically be willing to purchase the product, so having a large sales organization with large quotas is dysfunctional.  Instead, put in place a small sales team that is focused on understanding how a customer intends to use the product.  When the small sales team generates 1x the loaded cost of an individual sales person (base+commission+expenses), the company is ready to move to the next phase.
  2. Transition. In the transition phase, the sales organization should be focused on developing a repeatable sales model, refining market positioning, and adding sales capacity, provided that each new sales person can safely generate at least 1x their loaded cost.  It is in this phase that the company moves from “renaissance” salespeople to a “coin-operated” sales organization.  A company will move out of the transition phase when each sales person is generating 2x their loaded cost.
  3. Execution.  In this phase the product has proven traction and management can predictably hire salespeople as quickly as financial constraints allow.  Specifically, there is a well-understood sales training program, the company understands exactly how much revenue each new sales person can generate and when, and the sales growth becomes a systematic process of territory allocation and expansion.  From a modeling standpoint, the sales productivity and expense should move to “industry standard” allocations, typically measured as a percentage of gross revenue.

SpiderNet

In the SpiderNet example, choosing to hire a large number of salespeople up front would assume that the company is in the execution phase of the Sales Learning Curve methodology.  However, in reality, the company has never sold a dime’s worth of product and has little quantitative evidence that their inside sales approach will even work. SpiderNet is really in the initiation phase and should hire a few renaissance sales reps who can help the company learn the proper sales cadence.  This way, SpiderNet can iterate its sales approach and avoid potentially costly mistakes as the model evolves.

The complete SLC paper can be found here.

Your company, SpiderNet, is in the final stages of defining the go-to-market model and pricing for the product. The company has spent a great deal of time debating the benefits of doing a freemium model versus paid. The product has the capability to be split along a free/paid feature set, but there are differing opinions in the company on what to do.

On the one hand, several people in the company want to charge $99 for the complete product, arguing that every installation will result in some revenue to the company. Even though the base of users will be smaller, every user is a real customer. Furthermore, if the number of users doesn’t materialize, then the company can always change to a freemium model later.

Others in the company argue that getting to a large number of users right out of the gate will help to establish the company as a leader in the space. Give the product away for free, build a large user base, and then charge $99 for additional features or capacity. They further argue that the sales and marketing costs will be much lower since the free product effectively “markets itself” through viral use. Of course, once the company gives something away for free, there’s no going back to charging for that functionality.

Both arguments make sense to you, but the company needs to decide on one model or the other. You do a quick assessment of the situation and make the determination that the proposed free product is useful to your customers, the market for your product is very large, and you have a pretty clear view of how to monetize the additional features. Given this, do you choose freemium or paid, and how do you think about the trade-offs?

What Now?
Freemium appears to be all the rage right now and my personal feeling is that companies are blindly marching into a free model without understanding key considerations. I meet with many companies who have or are proposing a freemium model. Often, when I dig into the rationale, there is no systematic thinking about why freemium makes sense or a clear view about how to generate revenue. Quite frankly, there’s a lot of hand waving going on.

There are actually some pretty simple guidelines for freemium, so let’s look at where freemium makes sense. (My thanks to my friend Uzi Shmilovici, CEO and founder of Future Simple, who has done considerable research on freemium business models and informed this post.)

The freemium model must offer…

  1. Phenomenal quality, value, and usefulness
  2. Access to a very large user base (millions of users)
  3. A logical way to make money from the free base
  4. Simple, understandable pricing and experience

Many times, one of these conditions does not exist and the company is unable to become a profitable entity. Moreover, if the first condition is not true (and the product is not phenomenal), then no one will use it to begin with. Just because something is free does not mean that someone will automatically use it.

If all four of these conditions are not true, then freemium probably should not be a core part of the distribution and go-to-market strategy of the company.

A Tale of Two Startups
Ever wonder what happened to the company Xdrive? It went out of business. On the surface, Xdrive was doing the exact same thing as Dropbox. Ever hear of Dropbox? 😉

Why did one fail and the other succeed? Against the above list of conditions, Xdrive did not have a delightful product, and it did not have a business model that ever made money (Xdrive was ad-based whereas Dropbox is capacity-based). Finally, the two products are really not the same: Xdrive was an extension of your hard drive and Dropbox is a file sharing application. The interesting aspect about Dropbox is that viral uptake is compounded by the fact that every file share requires another user to sign up for the service. While these companies may look the same on paper, they are really quite different from a user acquisition/market and pricing model standpoint.

Where Free Does Not Work
There are many cases where free may not work. Many enterprise products (whether SaaS, on-premise, or appliance-based) do not have immediate appeal to a massive user base. Often, enterprise products are targeted at smaller market segments and grown from that starting point. Also, for the enterprise market, the features of free may not be sufficient to gain viral adoption. In such a case, your company may offer something for free, but the market does not choose to use it. A small market with an un-interesting product will likely result in disappointing adoption. Remember that the driver to success is massive adoption of free such that a small percentage of paid upgrades can yield interesting revenue.

Considerations for SpiderNet
The CEO of SpiderNet has a feeling that many of the freemium conditions exist, but he really does not know. Before deciding on one model or another, I would recommend that the company do a live beta and test the thesis. If during that process, rapid and viral uptake occurs, along with a reasonable understanding of the revenue potential, then freemium makes sense. Otherwise, charging for the entire product may be a more pragmatic approach.