How Much Services Revenue Can You Live With?

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Hi, it's CJ Gustafson.

I'm doing something a little different today and sharing a piece from my other newsletter, Looking for Leverage.

Mostly Metrics explores the mechanics of finance and business performance, typically from a VC backed lens. Looking for Leverage explores building, operating, and owning more valuable businesses, primarily in private equity backed settings. Same same, but different.

Stuff like balance sheet blind spots when acquiring founder owned companies, EBITDA adjustments, management equity packages, and professional services revenue. Which is exactly what we’re talking about today!

How much prof services revenue can you live with?

Today's term: services mix, meaning professional services as a percent of total revenue. Every software company carries some, most carry more than they "want" to, and very few of them came to that number intentionally.

Your implementation team might be holding your ARR hostage

You already know a services dollar is worth less than a subscription dollar. It shows up once, might carry a 20% to 30% gross margin, and no buyer is giving that line the same multiple as your software revenue.

You'd think the answer is to get rid of as much services revenue as possible.

Except sometimes the services work is what makes the software revenue possible.

And if every dollar of new ARR requires some fixed number of implementation hours that only your own employees can perform, eventually your ability to grow software revenue becomes tied to how many services people you can hire.

If your implementation team is booked five months out, your ARR growth rate is now partially locked into your staffing plan.

You can keep hiring AEs, but somebody still has to get the customers live.

Jeff Cooper has a pretty interesting problem

Jeff Cooper is the CFO of Guidewire, which sells the policy administration, claims and billing systems that P&C insurers run their businesses on. They are a great comp for most vertical SaaS companies at scale.

A small insurer can go live in 12 to 18 months on their software. It’s not a fast process by any means. Jeff told me they have large customers where the full rollout takes a decade, going state by state, with a CIO who has basically bet their career on it working.

So I asked him how he thinks about professional services, and how much of the implementation work Guidewire should own versus hand to partners.

His rule of thumb was sub-20% of total revenue coming from services, with services growing slower than software so the percentage keeps falling.

Admittedly, getting to those ratios is the harder part.

Guidewire can't just walk away from implementation. The insurance industry is littered with failed core system modernizations, and their delivery record on these programs is part of what earned them their market position in the first place.

A botched implementation means the customer never reaches the value you sold them on, which eventually becomes a renewal problem. Plus, there are only ~2,000 potential buyers in the sector, and they all talk to each other. Screw up a few implementations and word gets around pretty quickly.

So Guidewire lets systems integrators lead most programs while keeping a minority of the hours themselves. The work they keep tends to be the stuff nobody else knows how to do yet.

If you launch a new module, your own people probably need to handle the first few deployments. You're learning where implementations break, what customers need and what should eventually become repeatable. By implementation number 20, hopefully somebody besides you knows how to do it.

Jeff said he worries more about capacity than margin, which I didn't expect.

Think about what happens if Guidewire sells a bunch of new software but doesn't have enough people available to implement it. Customers can't go live on schedule, the company has to keep adding services headcount, and the software business is now growing at a pace partially dictated by its ability to recruit and train implementation consultants.

That's why Guidewire tells the street how many certified consultants exist across its ecosystem. Every consultant who can successfully implement Guidewire gives them capacity without another person directly sitting on Guidewire's payroll.

It's a pretty interesting way to think about a software company's ability to scale. Your implementation capacity includes a whole bunch of people who don't actually work for you.

Of course, handing the work out still comes with a bill. You have to train and certify partners, you give up the gross profit you were earning on those hours, and you lose some direct control over delivery quality. Some customers, particularly outside the US, also want one throat to choke and will push for the software vendor to own the whole program.

But if you can get the partner ecosystem working, you can sell more software without having to staff every implementation yourself.

Does the customer care who’s W2 they’re on?

I've been the customer for partner led implementations.

We implemented NetSuite with a third party and we implemented Workday with a third party. And in neither case did I ask or expect the software vendor's own employees to do the work.

I asked how many implementations the team had done, whether I could talk to two customers they'd taken live, and which specific consultant was going to be on my project in week one.

The software vendor's staffing model never came up once.

Jeff describes the same thing when he says Guidewire's job is to build software that third parties can implement. In fact, you aren’t really much of a software company if someone else can’t implement your software.

As the customer, I cared that someone had done it before.

I didn't really care whose W-2 they were on.

Warning: You might have to shrink revenue to grow the business

The P&L can get uglier on the way there.

Hand $8M of implementation work to partners and you just removed $8M of revenue and maybe $2M of gross profit. The benefit is that you can theoretically implement more customers without hiring a proportional number of services employees, but the resulting ARR doesn't replace that $8M overnight. Subscription revenue shows up over the life of the contract, spread out ratably. Implementation revenue may have fewer calories, but it’s instantaneous.

Your bench doesn't disappear overnight either, so utilization can fall while the same people are still sitting on payroll. Services gross margin gets worse before the services revenue is fully gone.

As a result, you can do exactly what you planned to do and spend a few quarters explaining why the P&L looks worse.

Let's put some numbers behind it.

Say you're at $60M of revenue. $45M is subscription at an 85% gross margin and $15M is services at 25%.

Services are 25% of revenue and you generate about $42M of gross profit, for a 70% blended gross margin.

Now you decide to push repeatable deployments to partners over the next two years while growing the subscription business.

Here's one way that plays out:

Look at Year 1.

Your subscription revenue grew 11%, but your total revenue actually declined 5%.

You lost $8M of services revenue and replaced it with $5M of additional subscription revenue. Gross profit improved, but anybody looking at your top-line growth rate is going to have some questions.

By Year 2, the numbers look considerably better. Revenue is up 17% from where you started, gross profit has grown more than 30%, and services have gone from a quarter of the business to a tenth.

You also went from $45M of recurring revenue and $15M of services to $63M of recurring revenue and $7M of services.

I wouldn't pretend there is one magic multiple you can slap on those two buckets. But a buyer is going to care that a much larger percentage of the business is now recurring, higher-margin revenue that doesn't require you to keep adding implementation people as it grows.

Now, to be fair, the example assumes the subscription business keeps growing while the services work moves to partners. The ARR growth isn't guaranteed by the outsourcing decision, and the additional partner capacity only helps if there is customer demand to fill it.

Which makes the transition a little more uncomfortable. You're giving up revenue you already have in exchange for the ability to support software revenue you still need to go win.

Now explain that to your investors

Let's say you're a PE-backed software company with 25% services revenue, and your sponsor has underwritten a certain revenue growth rate and EBITDA trajectory over the next few years.

You decide you want to get services down to 15%, and the plan involves handing a meaningful amount of implementation work to partners.

That might make the business more valuable at exit. You'd have a larger share of recurring revenue, better blended gross margins, and a software operation that can scale without hiring a proportional number of services employees.

But you still have a budget to hit.

The revenue you've been generating from implementations is baked into that plan, and simply removing it can create a pretty large hole before the incremental subscription revenue has time to show up. Depending on how quickly you can rightsize the services team, the same decision can put pressure on EBITDA too.

Now you've got a company that's potentially becoming more valuable while missing the financial targets everybody agreed to.

And if you have debt covenants tied to EBITDA or a management incentive plan that rewards total revenue growth, those details are going to matter quite a bit.

Jeff's answer on the public-company side is to get employees, the board and investors aligned around ARR as the measure of success, then stick with it every quarter instead of pointing at whichever number happens to look good.

For a PE-backed company, I'd want the services mix baked into the plan before starting the transition. If you're at 25% today and want to get to 15%, everybody should know what that does to reported revenue, gross margin, headcount and EBITDA along the way.

You should also agree on how you're going to measure whether the change is working. Subscription growth, partner implementation capacity, time to go live and customer outcomes all matter here.

Otherwise you end up successfully shrinking the thing everyone agreed needed to shrink and still miss the plan.

What to do Monday

• Split services into work only you can do and work someone else can do: Cut it by module and deployment number, with hours and gross margin for each bucket. The first three implementations of a new product may belong with your team. If you're still doing implementation number 300, ask why.

• Measure the actual capacity constraint: How far out is your implementation team booked? How many implementations can you run concurrently? If sales can sell faster than services can implement, adding another AE isn't going to fix your problem.

• Count the people outside your company who can implement your product: Not partner logos. Actual certified consultants. If the number is too small, find a few firms willing to specialize, train the hell out of them and give them enough deals to make the investment worthwhile.

Wishing you a services line that shrinks on purpose,

CJ

A little more on Looking for Leverage

If you enjoyed this, I write Looking for Leverage for CFOs, CEOs, and operators who spend their days figuring out how to make companies more valuable, particularly inside private equity portfolio companies.

If you read Mostly Metrics, you'll recognize some of the subject matter. Looking for Leverage just approaches it through the lens of private equity ownership.

Run the Numbers Podcast

Apple | Spotify | YouTube

The hierarchy of metrics bullsh*t! From the creator of the list itself, Managing Director Brian Neider.

In this episode we cover how to spot misleading metrics, the difference between a good company and a good investment, and the worst EBITDA add-backs.

We also look at how AI is changing software defensibility, and Brian tells the story of delivering a giant Happy Gilmore check to a potential portfolio company.

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