The Danger of a Recurring-Revenue Bubble

Long-term nontransferable licenses and inflexible payment terms are imposing undue risk on partners that can sell only short-term contracts to their customers.

By Larry Walsh

In their zeal to capitalize on the benefits of recurring revenue, some vendors are creating a bubble in the channel that could put their long-term earnings and valuations at risk by using channel partners as a buffer against customer defaults. The practice of imposing recurring-revenue risk on partners may create a bubble that could damage many channel partners if the economy turns sour – as is happening as a result of the coronavirus outbreak and containment measures.

Technology vendors are looking past their traditional episodic sales models and embracing recurring-revenue go-to-market strategies. No longer the exclusive purview of managed and cloud services, recurring revenue is fast becoming the norm for vendors selling software licenses, maintenance support contracts, and Hardware-as-a-Service. Virtually all vendors are selling part of their portfolio on a recurring-revenue basis; some even aim to convert all revenue to recurring.

The recurring-revenue model is appealing to vendors because of its predictability. Once a customer books a service, vendors can project a steady stream of income over the term of the engagement. That predictability translates into higher valuations, as private and Wall Street investors equate predictable revenue to higher value and lower risk.

The challenge vendors face is creating and maintaining recurring revenue. Customers appreciate the benefits of predictable costs and having expenses registered as operational rather than capital; they also want the flexibility of being able to amend or cancel contracts. Moreover, most customers don’t want lock-in, so they shy away from long-term contracts.

Vendors Want Recurring-Revenue Stability
Vendors’ response to this conundrum is selling long-term to partners. By pushing three- to five-year contracts on partners, vendors are placing the burden of maintaining and renewing customers into the channel. Under this model, which is widespread but not universally practiced, vendors gain the benefit of predictable and secure recurring revenue.

What works for vendors in this scenario doesn’t necessarily work well for partners. Several large solution providers say vendors are assigning the risks of their service to partners, putting them in jeopardy if customers cancel or default on their contracts.

Cloud computing – which is often synonymous with recurring revenue – promises customers flexibility and agility in their technology consumption. Customers can change their consumption based on need. In theory, flexibility is a valid attribute, but vendors appreciate flexibility only if it results in greater consumption. Downgrading doesn’t support the sustainability of recurring-revenue projections.

Through 2112’s various research programs, we’ve seen consistently that channel partners predominantly sell recurring-revenue engagements on month-to-month and annual contracts. This term aligns with customers’ desires for shorter commitments but runs contrary to many vendors’ financial models. Vendors mitigate their risk by selling multiyear contracts to partners, who then parse the terms in single-year increments to customers.

Vendor Stability Imposes Risk on Partners
Partners, though, face a problem with this approach: complete risk exposure. In cloud and service contracts, vendors sell virtual products or capacity on virtualized and multitenant systems. It’s not like the old days when vendors sold customers one box at a time. Vendors can reassign capacity at will should a customer’s needs change or if a contract goes foul. However, vendors sell partners nontransferable licenses, meaning they can’t reassign capacity to another customer.

The model makes perfect sense from the vendor perspective. If capacity was transferable, partners could swap utilization based on a customer’s needs or to compensate for abandoned contracts without an appreciable increase in vendor revenue. By locking partners into nontransferable licenses, vendors force partners to pay even when their customers default, which keeps the existing recurring-revenue stream flowing for vendors. Also, partners have to buy more capacity when they sign new customers, which accretes more revenue to the vendor.

Solution providers tell 2112 that this contractual mismatch is too much burden for them to bear. They do not appreciate vendors using them as a risk-mitigation mechanism. To compensate, some solution providers are imposing an internal tax on their recurring-revenue sales as a buffer against defaults. It’s an ineloquent solution as it decreases a product’s profitability and makes a vendor less attractive to sell.

The cost and potential risk of these nontransferable, multiyear vendor contracts are causing some solution providers to rethink their supplier relationships and look at alternatives with friendlier terms.

A Disruptive Bubble?
A more significant concern lurking in the background is what happens if the economy deteriorates into a recession. Throughout 2019, economists and pundits predicted the U.S. and global economy would slip into recession in the fall of 2020. At the beginning of the year, recession fears calmed as indicators pointed to sustained economic activity through 2021. Then coronavirus hit, disrupting economies around the world.

Economists and government officials are uncertain of the total global and regional economic impact coronavirus will have. Most believe the disruptions will push even the healthiest of economies into recession. If that happens and businesses start failing, it could have a cascading effect through the service sector. Customers defaulting on service contracts will force solution providers to default on their vendor contracts. The net result: Vendors’ revenue and valuations will get disrupted, and the bubble will pop.

Vendors and distributors are not oblivious to the recurring-revenue bubble. Several vendors are looking to distributors – which traditionally act as the financing arm of the channel – to figure out ways of mitigating the risk. Third-party financing companies are addressing the problem by buying out service contracts at a discount; partners and vendors get their money up-front in exchange for shaving off a few points for the finance company. And some vendors, such as Microsoft, avoid the problem altogether by not selling contracts of more than one year unless requested by the customer.

Financing solutions may take the sting out of the dilemma for some but won’t solve the problem entirely. The nontransferable licenses and multiyear contracts are the root causes. Vendors will need to compromise on their contract terms when selling through partners or risk building their recurring revenue – on which much of their inflated valuations are based – on shaky ground.

Coronavirus Impact
Managed service providers are bracing for the financial fallout of the coronavirus containment measures. Many MSPs fear that businesses will slow pay or stop paying for their services because of cash flow disruptions. While MSPs are seeing higher demand for support as customers shift to a “work from home” footing, they’re also seeing the beginnings of customers canceling service to cut back on expenses. Some customers, they say, were weak financially and are using coronavirus as an excuse to walk away from service agreements.

Coronavirus-related disruptions will cause some MSPs to recalibrate their services arrangements with vendors and either payment deferments or amended payment terms. MSPs say they some vendors are relatively understanding of changing circumstances, while others will take a hard line on payment obligations.

Just as other businesses are adjusting their expectations as they cope with the coronavirus effect, tech vendors will need to re-evaluate their services agreements with partners during this period of extraordinary stress.

Larry Walsh is the CEO of The 2112 Group, a business strategy and research firm servicing the IT channel community. He’s also the publisher of Channelnomics, the leading source of channel news and trend analysis. Follow Larry on Twitter at @lmwalsh2112 and subscribe to his podcast, Pod2112, on iTunes, Google Play, Spotify, and other leading podcast sources. You can always e-mail Larry directly at lmwalsh@the2112group.com.