COVID-19 Impact - Time to revisit pure-play MSP recurring revenue model

Consider these statistics from Techaisle’s recent worldwide channel sizing and channel trends studies. 62% of MSPs have less than 25 employees, 92% of MSPs have less than US$5 million in annual revenue. A large majority of these MSPs sell to smaller SMBs who are currently experiencing gut-wrenching disruptions to their businesses. MSPs are not immune to the COVID-19 crisis. 15% of MSPs either want to sell their business or wind down and 52% of MSPs need external capital to grow and remain viable or are seeking M&A opportunities. While MSP business model success is predicated on recurring revenue, profitable MSPs drive more than 40% of revenue from non-recurring sources. Pursuit of recurring revenue is not a bad idea as it provides a foundation for future revenue and it is important to business valuations. But data shows that recurring revenue is not the sole indicator of business success.

Recurring revenue can predict earnings thereby reducing risk, however, selling licenses or seats alone does not create a high margin business. MSPs who have moved to predominantly recurring revenue model are more likely to run out of operating capital than they are to reap the benefit of enhanced business valuations or the ability to manage cash flows during an episodic global crisis. Techaisle’s survey data clearly shows that channels with high percent of recurring revenues have been consistently unsuccessful in managing uncertainties in business climate. MSPs that lack margin also lack the ability to invest in improving their capacity to innovate and compete in the long-term and for weathering business interruptions. MSPs that do have meaningful margins, on the other hand, have the ability to invest in capabilities that enable them to expand into new market areas or overcome periods of economic crisis.

A typical pure-play MSP’s 84% to 90% of recurring revenue is spent on human capital, RMM/PSA solutions and other overheads, leaving between 10% to 16% for margins.

In general, we assess channel business models in terms of contribution from external sources and internal sources. External revenue sources provide roughly 10%-15% gross margins and 3%-8% net margins, while internal revenue sources deliver 50% gross margins, 10%-25% net margins. MSPs who have built service delivery capacity have a distinct margin incentive to sell internal services and those that lack internal service delivery capability will need to be diligent about managing costs. Both require profitability and profitability requires that MSPs combine sales of recurring revenue services with sales of one-off consulting and products. It is important to drive revenue from multiple business lines.

The market is comprised of two revenue sources: an on-premise business, and a rapidly-growing cloud business. Successful MSPs are those who participate in both revenue pools thereby finding real advantages over single-market competitors. For example, think about a situation in which an SMB is looking for a new M365 solution. Those who propose only on-premise solution will be very expensive. Those who propose only cloud-based services will be much less expensive, but will not enjoy a substantial revenue. An MSP blending both on-premise and cloud might get both the recurring revenue plus additional product/service revenue – laptops, MDM, security software, migration and deployment services, etc. They would also achieve better margins for the on-premise products than the on-premise-only provider.

There are excellent arguments in favor of making monthly recurring revenue (MRR) a priority – principally, because not only customers want to buy that way, but also, business valuations are higher than for firms which follow a traditional channel business model. But the value gained from MRR is largely theoretical until an MSP business owner sells. On a day-to-day basis, the operations of an MSP’s channel business often relies heavily on cash that is available in the form of credit offered by distributors on product transactions.

Techaisle argues that MSPs need to move from “recurring revenue” to “margins for operations” because MRR on its own is not satisfactory as an end point. MSPs need to ensure that they have sufficient margins to fund operations (and future investment) within the MRR-centric model. This can be achieved by having a deliberate mix of recurring, non-recurring, product-led and services-led contracts to generate healthy margins for survival and investment. We believe that MSPs will need to layer services to ensure that a shift towards MRR doesn’t collapse the financial underpinnings of the operation. For their part, it is important that vendor programs and pricing aligns with the need for MSPs to derive workable profit levels from MRR deals – and if the channel needs to layer services into MRR-centric engagements, vendor terms and operational practices need to align with this services imperative.