How to Drive Competitive Advantage with Subscription-Based Business Models

July 27, 2016

John Donnelly

I can’t tell you how many times I have heard, “how you pay the reps influences their behavior.” This rings even more true in the public cloud space. Take Amazon as an example: Amazon’s AWS team is laser-focused on building a world class offering in public cloud. Outside of their technology, they have accomplished this through an extremely targeted compensation plan—one which has created an immense competitive advantage. Of course, AWS doesn’t carry the legacy baggage like EMC, VMW or IBM… they got to start from scratch. But even with this advantage, they didn’t mess it up. They never wavered from compensating on cloud consumption. If you are looking to transition your organization to a utility-pricing model, there are many lessons you can learn from AWS.

The evolution and now rapid adoption of utility computing has disrupted many of the legacy solution providers. In the past, selling technology was very straightforward: you sold a perpetual license, and got paid in thirty days. While the utility software model has been around for forty years, back to the mainframe days when companies would pay by the hour for mainframe time, Salesforce—and other software as a service (SaaS) companies—brought this model back into the light.

However, subscription-based pricing posed several obstacles early on for vendors. How do you quota and compensate a sales team while keeping expenses and revenue in check? Companies love the recurring revenue aspect of subscription deals. However, sales reps have a W2 expectation based on the past perpetual mode where they were comped on full deal value. The numbers don’t work. So companies became clever with compensation. The reps would be paid for collecting cash up front, or   they would receive compensation for multi-year commitments. Still, reps always felt like they were leaving money on the table when they sold subscription deals.

When I was at MobileIron, we faced the difficult challenge of transitioning to a subscription based revenue model. In our plan early on, we paid 100% on year one subscription,75% on year two and 50% on year three. More art than science. We constantly struggled to strike a balance between beating our quarterly number while transitioning to a subscription model. This revenue management became nearly impossible. Ultimately, the customer would make the choice on a model, which was not always the one we wanted them to choose.

Most legacy companies still haven’t fully made this transition. Now, along comes utility based pricing. Amazon, through its Marketplace, allows companies to buy solutions by either a monthly or hourly charge. In addition, if you cancel during the month, Amazon will prorate your bill. Customers love this flexibility, and AWS has become the gorilla in the public cloud space. Huge IT dollars are quickly shifting to funding cloud versus’ funding internal infrastructure. In fact, Gartner recently estimated that more than $1 trillion in IT spending would be directly or indirectly affected by the cloud.  I would compare the current shift to Cloud/Utility computing to the other great compute shifts, LAN adoption, the Internet explosion and eventually SaaS.

Let’s focus on one of the most important competitive advantages for AWS: their sales team and comp plan. AWS pays their team on usage/adoption, and the sales reps are paid thirty days in arrears. Translation, reps don’t get a dime when the deal closes unless there is an up-front purchase. Further, they point customers to the AWS Marketplace for 3rd party solutions. Today, AWS reps aren’t paid on Marketplace 3rd party business, but I suspect as the ecosystem gains momentum, this would be a natural move. Overnight, the AWS sales team could become one of the largest resellers in the world.

Taking a look back at the missed opportunity several vendors had in this new space, EMC sticks out. They had the technology and probably the best sales team on the industry. Yet EMC was hooked on the perpetual, single transaction model, where the comp plan encouraged homerun, front-loaded transactions. EMC sales teams led with the “Enterprise License Agreement” model.  ELA’s allow customers to consolidate spend under one agreement. They help vendors “lock in” customers and gain upfront cash. (And sales reps make a ton of money from ELAs.) While many products are bundled into the ELA; many are never implemented. ELAs don’t encourage adoption or long term investment by the vendor. None of this helps the customer maximize their investment.

What could they have done differently? EMC did team up with VMware to offer a competitive solution to AWS. The sales teams partnered on deals. The big challenge would be when a customer expressed an interest in cloud. The sales teams would often re-focus the customer on an ELA or perpetual deal. Why? The sales folks made more money these deals.

Microsoft has done the best job at changing their compensation culture. They have teams completely dedicated to selling subscription, but they do fall into the ELA challenge at times, which can leave Microsoft living with shelf-ware within their install base.

How do I manage the transition to utility pricing?

What would I do today if I were a legacy software vendor? I firmly believe public cloud, with its utility pricing model, is going to win. If you are looking to move your organization to a utility model, here are a few suggestions (before touching the compensation plan.)

  1. Gain senior management buy-in—This process will resemble your customer’s discussion about whether to go to public cloud. Expect it to be painful. It will feel like a complete company rebuild, as utility pricing touches everyone.
  2. Gain sales engineering mindshare—Train all sales engineering resources on both the offering and the benefits, including the utility payment model. You will need to provide differentiators around owning versus renting. The utility story needs to be woven into all customer pitches. Treat your existing model as a competitor, even if they are the same product.
  3. Meet with your top 10 customers—Obviously gauge interest, position product velocity and understand financially the impact of a paced migration or a complete shift. This will allow a frank conversation on pricing and overall cost. Factor in attrition from competitive loss. Utility computing opens the door to your competitors.
  4. Support AWS Marketplace—This is a significant undertaking. Don’t underestimate this but also, don’t spend a minute on any other platform until you support Marketplace. Lean on AWS for help, they have excellent resources to guide the journey.
  5. Consider setting Marketplace pricing—Base this on your current maintenance rate, and be sure to factor in AMZN margin. While you won’t see a bump from existing customers, you will see a significant shift to recurring revenue.

Now, let’s look at your compensation plan. If you have nailed the above, this should move quickly.

  1. Create a cloud overlay team– this is a short term need—roughly 3-4 quarters. Hire them outside the current team, and knock out the kinks in the playbook.
  2. Stop doing free evaluations—Customers can now evaluate your solution through Marketplace and pay! This also takes a huge issue of contracts and paperwork out of the way. Now it’s all about driving consumption.
  3. Join both the AWS and MSFT ecosystem partner programs—Leverage existing internal BD/Marketing resources. Invest on how to work best with their respective field teams. Focus on reference customers.
  4. Build out support—They need to be experts on cloud/utility/AWS. Support should be sharing the new utility purchase program liberally with customers.
  5. Three quarters out, “split the lanes.”—Take your top revenue-producing legacy customers into a separate team. Set a bar, say your top 100, 200, 500 customers, depending on how big your company is. Now, lower the Install Base compensation plans by 35-60%. The Install Base team should have zero quota for utility. Take the savings and enable the utility sales team. More on this in a minute.
  6. Eighteen months out—Transition team to 100% subscription/utility model. Provide an incentive to the install base to move. Leverage reference customers to avoid doing evals.

How do I build the right comp plan to incent utility/Sub purchases?

We always need to think about the complexity of building a recurring plan. If the reps can’t understand it and the ops team can’t track it, you have a problem. Keep it simple. In the past you looked at a perpetual plan somewhere in the (5-6x) OTE for an annual quota. When you first launch a subscription/utility plan, use a (2-4x) OTE to start. Deal size becomes obsolete; you now need to think about consumption. What and how much is the customer using? Internal tracking is critical; a firm understanding of AWS Marketplace billing is crucial. You will need to pay the reps on the previous month, in some cases even the previous two months. This trailing comp model isn’t difficult once you have the machinery and knowledge in place. The reps will become very close to the customer in helping to remove obstacles to ramping consumption—a huge benefit. Now, sales management can look at individual accounts and apply a monthly growth rate, while building a stronger, more accurate quota plan. I’ll address utility forecasting in the future in a future post.

So what type of deal volume can the reps handle with this new scenario? Don’t count on any significant partner help. My experience has been a rep can close a max 12-15 transactions <50K. The average was closer to six transactions. If you don’t see north of 50% attainment, there is a problem.

I am also a believer in monthly driven quotas. You must be prepared to pay monthly. There are several companies in the HR/payroll space that have quota models like this. Ramping the quota through the quarter by month makes a ton of sense, 20%, 30% and 50%. Incent closing early through monthly fixed attainment bonus. Don’t focus on penalties, initially.

That’s the high level for now, and I’ll be back with more in a week or two.