The Zero-Sum Fallacy: ARR vs. Services

Some SaaS startups develop a form of zero-sum delusion early in their evolution, characterized by the following set of beliefs. Believing that:

• A customer has a fixed budget that is 100% fungible between ARR (annual revenue revenue) and services
• It is in the company’s best interest to turn as much of the customer’s budget as possible into ARR
• Customers never think to budget implementation services separately from annual software licensing
• A $25K StartFast offering that walks through a standard checklist is everything a customer needs for a successful implementation
• If the StartFast doesn’t work, it’s not a big deal because the Customer Success team’s mission is to offer free clean-up after failed implementations
• Since the only thing consultants do is implementations, their job title should be “Implementation Consultant“
• Any solutions practices or offerings should be built by our partners
• The services team should be introduced as late as possible in the sales cycle; ideally after contract signing, in order to eliminate the chance a post-sales consultant will show up, tell the customer “the truth,” and ruin a deal
• It is impossible and/or not meaningful to create and run a separate services P&L
• The need for services is a reflection of failure on the part of the product (even in an enterprise setting)

Zero-sum delusion typically presents with the following metrics:

• Services being less than 10% of total company revenues
• Services margins running in the negative 20% to negative 60% range
• High churn on one-year deals (often 25% or higher) due to failed implementations
• Competitors winning bigger deals both on the ARR and services side (and associated internal confusion about that)
• Loss reports indicating that prospects believed the competition “understood our problem better” and acted “more like a partner than a vendor”

Zero-sum delusion is a serious issue for an early-stage SaaS business. It is often acquired through excess contact with purely financial venture capitalists. Happily, with critical thinking and by challenging assumptions, it can be overcome.

‍OK, let’s switch to my normal narrative mode and discuss what’s going on here. First, some SaaS companies deliberately run with a low set-up product, little to no services, and a customer success team that takes care of implementation issues. Usually, these companies sell inexpensive software (e.g., ARR < $25K), use a low-touch sales model and focus on the small and medium business market [1]. If delivering such an offering is your company’s strategy then you should disregard this post.However, if your strategy is not to be a low-touch business model disruptor, if you do deals closer to $250K than $25K, if your services attach rate [2] is closer to 10% than 40%, if you consider yourself a somewhat classic enterprise SaaS vendor — basically, if you solve big, hard problems for enterprises and expect to get paid for it — then you should read this post.Let’s start with a story. Back in the day at Business Objects, we did a great business grinding out a large number of relatively small (but nevertheless enterprise) deals in the $100K to $200K range. I remember we were working a deal at a major retailer — call them SeasEdge — against MicroStrategy, a self-funded competitor bootstrapped from a consulting business.

SeasEdge was doing a business intelligence (BI) evaluation and were looking to use BI to improve operational efficiency across a wide range of retail use cases, from supply chain to catalog design. We had a pretty formulaic sales cycle, from discovery to demo to proposal. We had financials that Wall Street loved (e.g., high gross margins, a small services business, good sales efficiency) so that meant we ran with a high salesrep-to-SE (sales engineer) ratio and a relatively small, largely tactical professional services team. I remember hearing our sales team’s worries that we were under-servicing the account — the salesrep had a lot of other active opportunities and the SE, who was supporting more than two salesreps, was badly overloaded. Worse yet, MicroStrategy was swarming on the account, bringing not only a salesrep and an SE but about 5 senior consultants to every meeting. Although they were a fraction of our size, they looked bigger than we did in this account.

‍SeasEdge taught me the important lesson that the deal you lose is not necessarily the deal your competitor wins. We lost a $200K query-and-reporting (Q&R) deal. MicroStrategy won a $4M retail transformation deal. We were in the business of banging out $200K Q&R deals so that’s what we saw when we looked at SeasEdge. MicroStrategy, born from a consultancy, looked at SeasEdge and saw a massive software and services, retail transformation opportunity instead.I understand this is an extreme example and I’m not suggesting your company get in the business of multi-million dollar services deals [3]. But don’t miss the key lessons either:

• Make sure you’re selling what the customer is buying. We were selling Q&R tools. They were buying retail transformation.
• People may have more money than you think. Particularly, when there’s a major business challenge. We saw only 5% of the eventual budget.
• A strong professional services organization can help you win deals by allowing you to better understand, more heavily staff, appear more as a partner in, and better solve customer problems in sales opportunities. Internalize: a rainmaker professional services leader is pure gold in sales cycles.
• While partners are awesome, they are not you. Once in a while, the customer wants “one throat to choke” and if you can’t be that throat then they will likely buy from someone who can.

I call this problem zero-sum delusion because I think the root cause is a fallacy that a zero-sum trade-off exists between ARR and professional services. The fallacy is that if a customer has only $250K to spend, we should get as much of that $250K as possible in ARR because ARR recurs and professional services doesn’t [4]. The reality is that most customers, particularly when you’re selling to the information technology (IT) organization, are professional buyers — this isn’t their first rodeo, they know that enterprise software requires professional services, and they budget separately for it. Moreover, they know that a three-year $250K ARR deal represents a lot of money for their company and they darn well want the project associated with that investment to be successful — and they are willing to pay to ensure that success.

If you combine the zero-sum fallacy with purely financial investors applying pressure to maximize blended gross margins [5] and the fantasy that you can somehow run a low-touch services model when that isn’t actually your company and product strategy, you end up with a full-blown case of zero-sum delusion.

Curing the Zero-Sum Delusion

If your organization has this problem, here are some steps you can take to fix it.

• Convince yourself it’s not zero-sum. Interview customers. Look at competitors. Look at your budget in your own company. Talk to consultants who help customers buy and implement software. When you do, you will realize that customers know that enterprise software requires services and they budget accordingly. You’ll also understand that customers will happily pay to increase the odds of project success; buying quality services is, in effect, an insurance policy on the customer’s job [6].
• Change your negotiation approach. If you think it’s zero-sum, you’ll create a self-fulfilling prophecy in negotiation. Don’t frame the problem as zero-sum. Negotiate ARR first, then treat that as fixed. Add the required services on top, negotiating services not as a zero-sum budget trade-off against ARR, but as a function of the amount of work they want done. I’ve won deals precisely because we proposed twice the services as our competition because the customer saw we actually wanted to solve their problem, and not just low-ball them on services to sell a subscription.
• Change sales’ mental math. If you pay sales reps 12% on ARR and 2% on services, if your reps have zero-sum delusion they will see a $250K ARR, $100K services deal as $5K to $10K in lost commission [7]. Per the prior point, we want them to see this as a $30K ARR commission opportunity with some services commissions on top — and the higher the services commissions the higher the chance for downstream upsell. Moreover, once they really get it, they see a 50% chance of winning a 250/25 deal, but an 80% chance of winning a 250/100 deal. An increase in expected value by over $10K.
• Put a partner-level, rainmaker leader in charge of your services organization and each region of it. The lawyer who makes partner isn’t the one with the best legal knowledge; it’s the one with the biggest book of business. Adopt that mentality and run your services business like, well, a services business. Create a services P&L and let your VP of Services fully manage it. They will know to get more bookings when the forecast is light. They will increase hiring into a heavy forecast and cut weak performers into a light forecast. They know how to do this. Let them.
• Set your professional services gross margin target at 5-10%. As an independent business, it can easily run in the 30-40% range. As a SaaS adjunct you want services to have time to help sales, time to help broken customers (helping renewals), time to enable partners, and the ability to be agile. All that costs you some margin. The mission should be to maximize ARR while not losing money.
• Constrain services to no more than 20% of revenue. This limits the blended gross margin impact, is usually fine with the board, keeps you well away from the line where people say “it’s really a services firm,” usually leaves plenty of room for a services partner ecosystem, and most importantly, creates artificial scarcity that will force you to be mindful about where to put your services team versus where to put a partner’s.
• Force sales to engage with services earlier in the sales cycle. This is hard and requires trust. It also requires that the services folks are ready for it. So wait until the rainmakers in charge have trained, retrained, or cleared people and then begin. It doesn’t take but a few screw-ups to break the whole process so make sure services understand that they are not on the sales prevention team but on the solving customer problems team. When this is working, the customer buys because both the VP of Sales and more importantly, the VP of Services looked them in the eye and said, “we will make you successful” [8].
• Outplace any consultant who thinks their mission is “tell the truth” and not help sales. Nobody’s saying that people should lie, but there is a breed of curmudgeon who loves to “half empty” everything and does so in the name of “telling the truth.” In reality, they’re telling the truth in the most negative way possible and, if they want to do that, and if they think that helps their credibility, they should go work at an independent services firm [9]. You can help them do that.
• Under no circumstances create a separate services sales team — i.e., hire separate salespeople just to sell services [10]. The margins don’t support it and it’s unnecessary. If you have strong overall and regional leadership, if those leaders are rainmakers as they should be, then there is absolutely zero reasons to hire separate staff to sell services.

Notes‍

[1] Yes, they can eventually be enterprise disruptors by bringing this low-touch, cheap-and-cheerful approach to the enterprise (e.g., Zendesk), but that’s not the purpose of this post.

[2] Services attach rate is the ratio of professional services to ARR in a new booking. For example, if you sell $50K of services as part of a $500K ARR deal, then your attach rate is 10%.

[3] We had neither that staffing levels nor the right kind of consultants to even propose, let alone take on, such an engagement. The better strategy for us would have been to run behind a Big 4 systems integrator bidding who included our software in their proposal.

[4] Sales compensation plans typically reinforce this as well. Remediating that is hard and beyond the scope of this post, but at least be aware of the problem.

[5] At the potential expense of maximizing ARR — which should be the point.

[6] If you think from the customer’s perspective. Their job is to make sure projects succeed. Bad things sometimes happen when they don’t.

[7] On the theory that the perfect deal, compensation wide, is 100% ARR. Math wise, 0.12*250+0.02*100 = $32K whereas 0.12*350+0.02*0 = $42K. More realistically, if they could have held services to $50K, you’d get 0.12*300+0.02*50 = $37K. Note that this way of thinking is zero-sum and ignores the chance you can expand services while holding ARR constant.

[8] And, no offense, they believed the latter more than the former. And they know the latter is the person on the hook to make it happen.

[9] Oh, but they want the stock-options upside of working at a vendor! If that’s true, then they need to get on board and help maximize ARR while, yes, still telling the truth but in a positive way.

[10] Wanting to do so is actually a symptom of advanced zero-sum delusion.

‍This blog was authored by Dave Kellogg. Republished with permission.