Microsoft's Extinction-Level Event

If you're a dinosaur, extinction is inevitable.

But dinosaurs aren't replaced by mammals overnight. Evolution is a long process, which is why Microsoft can get away with its convoluted approach to partnering on hosted Web services. And I don't believe Microsoft's partner pitch; snake oil salesmen and pyramid schemers have made it before.

Simply put: Microsoft hosted services will bring some partners to extinction, because to make the big money they'll have to commoditize their own market. Shall I repeat that?

To quickly recap: Today at the Worldwide Partner Conference in Houston, Microsoft announced pricing for its Online Services, which initially will be available in Deskless and Business Productivity suites. The Deskless version costs $3 per employee per month for light versions of Exchange or SharePoint. The full suite, at $15 per employee per month, offers up hosted Communications, Exchange, Office Live and SharePoint products. Microsoft partners that sell the suite get up to 18 percent back the first year and 6 percent back thereafter.

"Once a quarter we send them a check," said Eron Kelly, director of Microsoft Online Services, during a conference call today.

Eron used the example of a partner selling 3,000 seats of Microsoft Online Services, which would have "almost $100,000 in residual fees." By my reckoning, that's $540,000 to Microsoft the first year and $97,200 for the partner—or $24,300 for the first partner payment. That's a helluva lot of upfront incentive for a partner to sell Microsoft hosted services.

But Eron's additional-year partner payback didn't initially add up for me. "By the end of the third year, that would grow to $162,000 if they were able to add those 3,000 seats each year." By my math, the partner would get $32,400 per year or $64,800 at the end of the third year. Near the end of the conference call, I asked Eron to explain his math. He's assuming that the partner would sell an additional 3,000 seats, not keep them as I assumed he meant.

Let me be clear: I know Microsoft isn't selling some kind of pyramid scheme, but it sure feels like it. The only way to sustain the revenue stream is to sell more seats in subsequent years. Here's how the math works out: In year two, the partner would make $129,600 by selling 3,000 more seats. In the third year, that take would be the aforementioned $162,000. In the fourth year, again adding 3,000 seats, the incentive would be $194,400. Half that amount, $97,200, would be equivalent to the partner's take from the first year incentive.

Partners must continue selling more hosted services seats to sustain Microsoft's payback. From Microsoft's perspective, it has got to be a sensible model. Partners make more by selling more. It's Partnering 101. But the process also cannibalizes the partners' market, by commoditizing server software that they would otherwise sell or service.

Microsoft Is the Landlord
Eron put forth some lamebrain perspective about how much partners would make selling additional services, such as Active Directory and Exchange e-mail integration, to support Microsoft Online Services. D`oh, these are short-term, not long-term services. There is a point where the work is done, because the customer has moved out of the owned property into a rental unit.

Microsoft is the new landlord, when the moving is done. The partner then gets paid by property owner Microsoft rather than by the enterprise business owner. Microsoft pays less over time, unless the partner moves more of its customers to rental units. By providing direct services under contract to businesses that own their own property, so to speak, the partner can collect ongoing services, maintenance and help desk fees.

I haven't done the hard math on this yet, but let's try a hypothetical scenario. Partner Bill has 12,000 seats, same number which in my aforementioned example he would have converted to hosted services over four years. Hypothetically, Bill collects a mere 10 bucks per seat for providing comprehensive site maintenance, including testing, deployment and management services. That's $120,000 a month in service fees, or $1.4 million a year. What if Bill made just $3 per seat per month, same as Microsoft charges for its Deskless suite? That's $36,000 a month, or $432,000 in one year. Bill doesn't need to aggressively sell 3,000 more seats each year, but simply organically grow his business and properly service existing customers to maintain them.

The example oversimplifies, because the partner assumes additional costs that would reduce margin of profits. For Online Services, Microsoft would assume more of the costs of doing business, but by no means all. Example: Sales and marketing. In the ownership example, the partner maintains customers and steadier revenue stream. For Microsoft rentals, the partner turns over customers to Microsoft, reducing the long-term pool of customers, commoditizing server software services and requiring further commoditization to continue generating revenue.

For partners looking to expand their businesses, Microsoft has given them incentive to get new customers and for a handsome first-year cut of the proceeds. But the gains, whether from hosting sales or partner-provided migration services, are short term. First benefit goes to Microsoft, which fosters commoditization to its benefit; better that Microsoft gets paid for hosted services than Google, Salesforce.com or other Web 2.0 platform companies.

Microsoft doesn't want to be the dinosaur, which is why the model now embraces hosted services. But Microsoft's partner approach to hosted services is sure to ensure that many partners will remain dinosaur's bound for extinction. Perhaps this year's Worldwide Partner Conference should be called Microsoft's "Extinction-Level Event."