A few companies have made billions using the cloud, but most aren’t even close to profitable. Here’s how to make sure yours is.

It’s cool to be in the cloud. It’s where the venture money flows freely. It’s where visionary entrepreneurs can unseat legacy incumbents. It’s where growth is routinely triple digits.

The fact is, it has never been faster or cheaper to build software. Ideas can literally move from the whiteboard to the App Store or the Salesforce App Exchange in months. That’s enabling venture-backed and shoe-string budgeted start-ups to be quickly ‘born in the cloud’. It’s also attracting traditional companies of all sizes who are enticed by the prospects of high growth and huge stock valuations. Everyone wants in, from industrial equipment manufacturers to local delivery services. The cloud is truly accelerating innovation (and disruption) at every level of the economy.

But so far, cloud-based business models are a cautionary tale of three realities:

1. While software is relatively cheap to build, it doesn’t guarantee you anything. A bad idea is still a bad idea, whether it’s in the cloud or not. For every LinkedIn and DocuSign, there are thousands of dead or dying start-ups who lacked a compelling product-market fit, the capital, or the management aptitude to prosper in the cloud.

2. If you can successfully navigate your product-market fit, your cloud offer has a realistic chance at rapid growth. The right offer can slingshot into meteoric growth – growth that would take far longer to achieve through traditional go-to-market models like direct sales people or reseller channels.

3. Then there’s the reality no one likes to talk about. That so far, cloud-based business models have largely proven unprofitable and capital-intensive.

So yeah, it’s cool to be in the cloud. But what would be REALLY cool is to be amongst the first graduating class of cloud businesses to crack the code on how to turn a profit. We’re not just talking barely-over-the-line, once-in-a-while profits. We’re talking the kind of profits that have long been the envy of corporate America – the kind of double-digit profits that traditional tech companies have been putting on the board for the last 50 years, quarter after quarter.

Why hasn’t this happened yet?

Well, the overly simplistic answer is that the allure of high growth has often over-powered the attention management places on profits. It seems that everyone from VCs, to cloud CEOs, to the media, to our own high school kids have all expressed a clear preference for wildly fast-growing companies over slower-growth but solidly profitable ones. The logic is that if you are fast growing, there will be plenty of investors around to fund your losses.

While that may be true for most Silicon Valley start-ups, it may be less true for many small and mid-size companies who don’t have the investor connections or who don’t promise the gigantic upside they seek.

Perhaps most importantly, traditional companies who want to enter the world of cloud-based, subscription business models usually don’t have the patience (or the capital) to continue to fund money-losing new businesses indefinitely. They want profits and they want them sooner, rather than later. So is it possible to get both solid growth and high profits in a cloud-based business model?

By studying the financial performance of hundreds of the world’s most successful tech and near-tech companies and comparing them to many of the world’s hottest cloud companies, we see some clear patterns emerging that can help business leaders think more completely about the journey to profitable SaaS.

Cloud offers will live through three stages of evolution where the priorities for management decision-making are vastly different.

1. Future Value Aggregator Stage

This is where you are trying to get a critical mass of initial users. You may still be experimenting with pricing models and marketing tactics. Here you want to minimize the friction associated with using your service. You are going to make it fast, easy and cheap to try your offer. In this stage, you may not have much revenue to offset your costs.

2. Mid-Term Wedge

Now that you have proven your product-market fit, you have to begin proving your financial model by smartly increasing the friction in your offer. That could mean charging for things you used to give away, creating premium offers, or adding offers you can sell to users of your core offer. Here you need to start making a profit on each customer. You can see the day in the next few years when your revenue will surpass your costs. We call that the “wedge moment.”

3. Current Profit Maximizer

Now you are–or will soon be–generating a profit and want to maximize that outcome. In this stage, you must have a well-developed portfolio that monetizes each customer in multiple ways. You will also have well developed strategies for keeping customers on your platform by consciously making their switching costs high. While these tactics may make your offers a little more complex and expensive (more friction), they also create highly profitable ‘unit economics’. The goal here is to keep your core offer simple to consume and then smartly layer in your advanced monetization strategies as the customer engages more fully.

The Friction Curve is a critical concept because price pressure is even more intense in the cloud than in traditional markets. This is the bad news about rapid, low-cost software development. Whatever cool things you can do in the cloud, a competitor can probably do, too. You must have a core offer that sets the hook on new customers but where you plan for competitive price pressure and supplement it with related offers that your customers can only buy from you. That way your total business model is a combination of low margin initial offers and higher margin, follow-on services. Add them up and you can build a financial model for your cloud offer that features BOTH double-digit growth rates AND double-digit profit margins. Now THAT is cool!

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