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."

Microsoft's Suite Response to Google, Partners

As the saying goes, Microsoft will rob Peter to pay Paul.

Today, at its Worldwide Partner Conference, Microsoft announced pricing and partner compensation for its suite of Online Services. The venue is somewhat surprising, because Microsoft-hosted services directly compete with similar offerings from its partners. Microsoft's solution: Cut in partners on the action.

In a Google world of free services supported by advertising, Microsoft's competitive response options are limited. Microsoft doesn't have a successful enough search and advertising platform to compete with Google in free services such as Docs; there is too much risk of hurting sales of desktop and server products such as Exchange Server and Office; and Microsoft is dependent on a large network of partners to sell its wares. There are few giveaway options.

Microsoft's compromise is to offer services cheap, while compensating partners. It's a risky move, because channel conflict is inevitable. Microsoft can coat this bitter pill in sugar, but the taste lingers: The company is directly competing with its partners.

The company's first Online Service is called the Deskless Worker suite. Ala carte offerings for "light" online versions of Exchange or SharePoint cost $3 per employee per month. The whole Business Productivity Online Suite—hosted Communications, Exchange, Live Meeting and SharePoint—is $15 per employee per month. The math looks good for Microsoft and its customers. A company with 50 employees would pay $750 a month or $27,000 over three years, which is a typical time period for Microsoft volume-licensing contract with Software Assurance.

My initial response to the pricing, without doing a hard volume-licensing comparison, is positive. But Microsoft still charges quite a bit more than does Google for Apps, which are $50 per user per year. Microsoft's suite is $180 per user per year, assuming there are no hidden discounts or other devil-in-the-details considerations.

Microsoft gets recurring revenue from real subscriptions, not just volume-licensing commitments. Customers get hosted services from Microsoft that are in some ways better than packaged software. Microsoft takes on the administrative and technical burdens, which conceptually would reduce staffing and other IT Management costs. You can buy a home, or you can rent. If you rent, the landlord assumes responsibility for maintenance, upkeep and taxes. Microsoft is going into the IT landlord business.

But Microsoft has a problem: Its partners, whom Microsoft relies on to sell and service its products. The company has no large, dedicated sales force. Microsoft can't afford to piss off its partners. Microsoft Online Services compete with partners, whether they're selling or servicing on-premise software or selling their own hosted services using Microsoft partners.

Microsoft is trying to alleviate partner conflict by cutting them in on the action. Partners selling Productivity or Deskless suites will get 12 percent of the first-year contract, plus 6 percent of subscription fees. So, first-year bang is 18 percent. The aforementioned 50-seat example that could work out to $1,620 for the first year. I say could, because the devil is in the details with respect for what Microsoft accounts for when. Regardless, that's recurring revenue for the partner. In this scenario, $540 per year ($45 a month) from the subscription's second year.

Is that compensation model enough to alleviate channel conflict? Ideally, customers would still require something on the desktop, meaning Office and Windows. So there is real software that partners could sell and service. But the big money is on the server, and Microsoft would take away from some partners recurring service and maintenance fees. The hosted service kickback fees wouldn't make up for them, not for truly successful partners. Channel conflict is inevitable.

Should Microsoft be blamed for competing with its partners? Yes and no. The "yes" is Microsoft's over-dependence on the partner model. This isn't the first time Microsoft had to kick back money to partners, simply to avoid competing—or just the appearance of competing—with them. Best example: volume licensing, which technically should be a direct relationship with customers, but Microsoft cuts in partners. It's hush money. Don't complain. Be happy.

The "no" acknowledges a changing marketplace. Competition from Google and other Web 2.0 platform companies is real. There has to come a point where, say, Google's online suite, including Calendar, Docs and Gmail, is good enough for many businesses to stop buying Office. Increasing mobility—the need for informational access anytime, anywhere and on anything—creates a clear future for hosted software, whether done by the enterprise, Microsoft or one of its partners—or coming from competing, ad-supported or lower-cost products. Change is inevitable, too.

These changes affect the partner model by commoditizing some of the products and services they offer today. From that perspective, Microsoft is being generous to its partners. Microsoft is adapting its business to a changing computational marketplace, and it's cutting in partners on a piece of the action. It's adapt or die. If you're a dinosaur, extinction is inevitable.