What is a Profitable Distribution Model?
October 1, 2009
As growth venture capital investors, we look for companies that can scale with capital efficiency. The first key requirement for capital efficiency is a profitable distribution model. The goal of a profitable distribution model is quite simple to conceptualize, but quite complex to achieve and maintain through the expansion stage.
What is a Profitable Distribution Model?
In simple terms, a profitable distribution model is one where the cost of sales and marketing in any given quarter results in the acquisition of enough new customer bookings to pay for that cost, plus more to pay for all other costs, fund growth and eventually lead to healthy profits.
Let’s take an example. A software company offers a SaaS-based solution that is sold directly to business customers. The company licenses the software with an annual subscription that is billed at the time of sale. Renewals are due starting in the second year with the same billing cycle. At that point, customers can choose to churn, renew the same license or buy more licenses. The same goes for subsequent years.
A profitable distribution model in this case starts with the relationship between the all-in sales and marketing costs associated with winning new customers and the first year bookings associated with those customers. A simple metric to aim for is that each dollar of sales and marketing spent in a given quarter to acquire the new customers in that quarter should generate a minimum of a dollar in the combined first year bookings of those customers.
Simplistically, this relationship ensures that the distribution side of the business is paying for itself within the first year. Now, this assumes that the vendor can invoice and collect the dollar soon after the deals are booked. Why is that important? Because the distribution costs are being incurred ahead of the bookings; and will continue to be incurred while the customers are invoiced and funds gathered. In the meantime, the vendor will theoretically be burning cash.
Overall profitability then comes from subsequent year bookings/billings from that same customer set. A simple metric to aim for is that second year renewals for those customers, minus a subset that churn, plus additional licenses up-sold, should generate a minimum of a dollar… Another way of saying it is that the renewals bookings from that original customer set should be at or over 100% of the original bookings.
In effect, the second year bookings would/should be paying for non-distribution costs (R&D, Support, Administration, etc.) incurred in that first quarter when the customers were originally booked.
And from here on, the trick is to keep the customers as long as possible to make up for the expansion capital it took to pay for the non-distribution costs… and to throw some profit to the bottom line.
Potential Complications in Determining a Profitable Distribution Model
So far, this has been a rather simplistic representation of a profitable distribution model, and for the purpose of this blog, I would like to keep it that way. Here are some ways that the model can vary and/or get more complicated:
- Different software delivery models: for example, delivering a solution as a perpetual software license in the form of a hardware appliance. In this case, Gross Profit would be a better substitute for first year booking, and the multiple of the first dollar of cost should be 3-5x that of the annual subscription example provided above.
- Different distribution models: for example, selling a solution through a two-tier distribution model or an OEM model adds complexity to the true cost of sale, and the means of tracking the flow of revenue from sales.
- Mix of licensing choices: for example, vendors may give customers the choice of monthly, quarterly, annual and multi-year billings. This can dramatically confuse the definition of a “one year new customer booking.” This is especially an issue for SaaS vendors. I refer to Bryan Deeter’s “Bessemer’s Top 10 Laws for Being SaaS-y”.
Regardless, the key for the CEO and CFO is to start with a definition that the entire company can understand and agree to; to understand and choose the economics with which to grow the company (and the associated expansion capital requirements); and to start with a simple model which can get more complex over time.
I have seen many entrepreneurs and venture capital advisors miss this point entirely, or try to over-complicate it. From my experience, nailing the economic discipline through a simple model is better than missing it through lots of fancy acronyms and complex financial modeling.