Service Charge: How Recurring Revenue Models Are Changing The Channel Financing Game

While one of the top benefits touted about cloud and managed services is its affordability, traditional VARs looking to move to recurring revenue models often find that transformation to be expensive.

When his company first broke into managed services, Tim Burke, CEO of Quest, said he had to make significant investments in infrastructure, training and software. While some other companies see the move to managed services and cloud as an inexpensive one, he said, those companies are often just skimming the surface of the services market through third-party systems instead of building a full practice from the ground up.

The problem with making big investments in services, Burke said, becomes finding a financing company that understands cloud and managed services and is willing to invest in that model, or at least believe in the underlying balance sheets of the established reseller business.

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"The challenge in the managed services space and the cloud space is you invest in infrastructure and capacity and obviously finance that unless you have deep pockets and can do it yourself," Burke said. "But how do the financial people look at that model?"

Dan Ransdell, general manager of IBM Global Financing in North America, said that, in his experience, many solution providers start off thinking they can do it themselves but ultimately find out that the transition is not that simple -- or inexpensive. Solution providers frequently view the transition as flipping a light switch, he said, when there is usually a longer transition period for services and resources, resulting in duplicate costs.

Many different parts of the market had to re-evaluate as the cloud transformation changed how customers and companies think about their IT assets, according to Susan Middleton, research director for IDC's Technology Financing Strategies and Technology Valuation Services programs.

"The whole industry is going through this seismic change, so regardless of where you play you're undergoing this big change. Change is good, but it can be difficult," Middleton said. "At the end of the day, there are many different parts of the market that had to change."

The problem is, not all financing options are evolving quickly enough to mirror the market's move to a recurring revenue model, solution providers and financing companies told CRN. There are plenty of options, from traditional banks, to vendor or distributor programs, to venture capital, but the real trick is finding a financing company that understands the new business model, Quest's Burke said. That can be harder than one might think, he said.

In fact, Burke estimated that 70 percent of the traditional financial community doesn't understand the cloud and the new recurring revenue models. In his own search for financing, Burke said he has tried to explain it to many banks as similar to a real estate model, such as how a business might buy an apartment building to lease out apartments. He said some banks, such as the Silicon Valley Bank, have worked to understand the model, but others have had a hard time or are completely disinterested.

"You have to zero in very quickly with financial organizations. Do they really get it?" Burke said. "You have to really zero in on someone who gets the concept of what you're doing and understands."

IDC's Middleton agreed, saying that banks are working to adjust to the newer models and often rely on a company's previous history and credit as a basis for financing, instead of looking the evolved business model, which might be unfamiliar to them.

"[Understanding it is] something that everyone's capable of, it's just a different sort of mind-set," Middleton said. "I think banks are adjusting but [the business] needs to be a known entity and you have to have a track record. It's more of a loan or project-based financing, now it's just a different model and sometimes change is hard."

The cloud and managed services models are difficult for banks in particular because they lack that collateral on which traditional hardware reselling financing was based, said Robert Wagner, managing director of business development for Wells Fargo's Supply Chain Finance Group. Banks such as Wells Fargo are collateralized lenders, he said, with the reseller's hardware product acting usually as the collateral.

"The landscape has changed a lot," Wagner said. "The channel is moving more toward managed services and the cloud-based recurring revenue models. Those are new models for us to finance, but we're used to product financing."

With cloud and managed services where the value is tied to long-term service contracts, banks have to adapt their model and find unfamiliar kinds of collateral, whether it is liquidity or additional assets. One way for banks to offset that risk, Wagner said, is to use the OEM partner behind the deal, which can serve as a "backstop" to make sure the solution provider stays on track with its business and services.

NEXT: Financing Based On Numbers, Not Technology​

Paul Bay, president of Ingram Micro North America, said that he has seen a lot of banks having a tough time dealing with the difference in recurring revenue. The problem, he said, is that banks often see the financing conversation based on the numbers, not necessarily on the technology and business itself. Bay said distributors and vendors with a financing arm often have a better understanding than the banks, which might be further removed from the channel conversation.

"They don't know the end user that they're extending it to necessarily, which are the resellers or partners," Bay said. "As far as the technology goes, we're out having that conversation of how do you migrate to a hybrid solution. A bank would never know what that means. All they see is more of a black-or-white conversation."

IBM Global Financing's Ransdell said he has seen a lot of customers turning to the IBM financing program because they understand the recurring revenue model and how much retired equipment is worth. In fact, the company's understanding and rates for financing are so good that their biggest customers are actually banks themselves looking to move to the cloud and refresh technology, Ransdell said.

"That’s not the bank's specialty area, but it is mine," Ransdell said. "I think that gives us a competitive advantage and we are here to help customers in the IT space."

On the bright side, some solution providers said that the need for financing isn't as great when using a recurring revenue model, especially if they are building it around the cloud. Some said they've even been able to avoid financing institutions altogether by using their own cash reserves to move into the market in more manageable steps.

They have that option because many of the businesses turning to focus on recurring revenue usually aren't starting from scratch. Instead, they are usually evolving from a more traditional reseller model to take on services and cloud capabilities.

Robert Anderson, principal and founder of New York-based ingenuIT, said the cloud provides a low barrier to entry for that transformation because it's a pay-as-you-go model, instead of having to invest a lot up front on infrastructure.

"You can do those things that you want to do without this huge capital investment," Anderson said. "I think up to a certain point with critical mass that would be a better approach anyway."

Most of the traditional VAR companies making the switch to managed services are not building from the ground up, at least that he has seen, Anderson said. Instead, they are transforming their existing reseller business into a recurring revenue model.

"As far as from the channel, so to speak, you'll see folks transform into that," Anderson said. "In fact, it's an ongoing battle to transform."

The self-financing model is especially appealing as the investment costs start to add up, Kyle Cebull, chief marketing officer at Fort Myers, Fla.-based Entech US, said. He estimated that financing can cause investments to end up costing six, seven or even eight times more than financing through the company's cash reserves. For that reason, he said that his company has self-funded all of its service offerings to save money on its expansion.

"The numbers they give you are not amazing. It's not like it's a no-brainer. For most cases you're paying a lot more [with financing]," Cebull said. "It's really not an ideal scenario."

However, Quest's Burke said that, while tapping third parties might be a good way for solution providers to dip their toes into the market, ultimately they will have to make some serious investments into their services if they want to fully embrace the managed services and cloud model.

NEXT: Outlook On Financing Market

Despite all the upheaval in the financing market with the move to recurring revenue, IBM Global Financing's Ransdell said the shift is clearly an opportunity for both the market and the financing companies. In 2013 alone, IBM Global Financing gave out $15.8 billion in client financing volumes, including leases and loans.

The amount of lending isn't slowing, Ransdell said; it's just changing direction. Instead of being focused on financing resellers for end user data centers and hardware, they're financing cloud data centers and technologies for the service providers themselves.

"It's clearly an opportunity. I wouldn’t call it a threat -- I would just call it a shifting model," Ransdell said. "Basically my customer may look different. My end-user customer that maybe I used to finance their data center, they look different because I might be financing their software and services instead of their hardware. I still have a lot of opportunity because that hardware infrastructure resides someplace."

The pace for financing requests overall isn't slowing down, Ingram Micro's Bay said, it's accelerating.

"Those financing options have to change, and we're talking about billions of dollars in any one month that we have extended as a company on a global basis. It's still a critical element that solution providers need distribution for, which is financing," Bay said. "We're close to them, so we know it, how their businesses are and the health of their businesses and the strategies that they're trying to drive towards. Being able to help subsidize and support them is important."

The bottom line, IDC's Middleton said, is that the financing market, just like the cloud and managed services industry itself, is in a state of transition. While it may be difficult, she said that doesn't mean that the change will be impossible.

"I don't think it's a hurdle that can't be overcome; you have to prepare for it and be ready for the change," Middleton said. "It took a few years but I think we're now at a good place where the market is really starting to build models around what customers need. Before, the customer wasn't even sure what they needed. It really went from two years ago -- now it's just really starting to pick up speed."