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Most of the Cloud Business Models Have Been Wrong

Many Cloud startups have built their business models assuming that the cost of acquiring a customer can be recouped in a reasonable amount of time through recurring revenue.   These calculations based on Customer Acquisition Costs (CAC) and Long Term Value of the customers (LTV) have omitted a major factor in running a recurring revenue business – Customer Management Costs (CMC).  As a result, a lot of the Cloud Startups are overvalued because investors incorrectly assume there will be little or no marginal cost to maintain recurring revenue from existing customers.

One of the popular resources (http://www.forentrepreneurs.com/saas-metrics-2-definitions-2/)  talks about this problem in calculating LTV: “However in most SaaS businesses, the gross margin % is high (above 80%), and it’s quite common to use the simpler version of the formula that is not Gross Margin adjusted.” A few other popular resources like Kissmetrics blog (https://blog.kissmetrics.com/9-metrics/) continue making this mistake:

That means you first have to know how long most customers stay with you. It could be six months, 12 months or longer. Then you multiply the monthly revenue you expect from that customer and you get the LTV.
Keep in mind that you should include any expenses related to installation or maintenance of your product.

If you read most startup business blog posts and go to the startup bootcamps there is little to no mention of customer success and customer service.  Everyone talks about simplicity and how you need to do a better job designing your systems.  There is an illusion that your customers will just get going and virally adopt your software within their organization.  The truth is that adopting a new software system goes way beyond just creating an account or putting some data “in the cloud.” There are a lot of elements of using a system starting from legacy data migration, to connecting to other systems, setting up information architecture, configuring the system, training existing and new employees, managing permissions and a myriad of other things.  Sure, the cloud has vastly improved costs related to installation, upgrades and patching of the systems, but the rest of the problems have not gone away.

In the early days of startups, the founding team and the energized early employees deliver these additional services and basically mask the CMC numbers.  It’s important for the technical teams, sales and marketing teams to stay close to the customers and learn about the usage.  The software does improve over time and possibly some of the customer management activities can be automated.  However, anyone who thinks that you can sell someone a system and without any account management just perpetually get recurring revenue forever hasn’t been in this business long enough.

There are a few great products that require little help – Dropbox, Slack, Google Docs.  These apps are in a well understood space and are building on existing knowledge.  Folks who used Microsoft Office largely understand what they need and how to use word processing and spreadsheets.  Anyone who was in the corporate world with file servers gets what’s basically an externally hosted (Cloud) file server does for them.   Anyone who used chat rooms growing up can get going with a corporate chat room from Slack.  Most of the other Cloud Services are a non-starter without some amount of implementation, rollout and ongoing management.

If startups do not account for CMC and just do not provide help and support, they are running into danger of failing to get usage and adoption.  No usage or adoption mean no recurring revenue.  Sooner or later people stop paying for the things they don’t get value from.



The chart above is a simplified model that explains this common miscalculation.  The CAC is $300 while at $19/mo the unadjusted LTV makes the customer profitable 17 months later.  When added a cost of just one support call or one account management check-in a month at the value of $10 the CMC starts adding up, so the true customer costs (TCC) keeps being above the LTV for close to three years.  All of this is of course without the up front costs of building the software.

The Cloud and recurring revenue model are in their infancy.  There are great strides to simplify and provide a better self service experience, but it will be a long time before entire organizations just virally adopt business software without any help.  Until then – adjust your expectations.

-mb

PS: if you liked this article you might also enjoy So you want to start a mobile app business...


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