An old maxim in channel marketing goes that nothing's sold until it's sold at retail. That means that just because a reseller has taken possession of OEM goods it's not to say they can be booked as completed transactions. While apocryphal this aphorism has much to instruct today's cloud-based VARs and managed service providers (MSPs). While many rely on top Salesforce growth hacks to supercharge their monthly quotas, others cannot resist the temptation to take shortcuts that can lead to big problems the next quarterly statement and beyond.
The previously mentioned channel marketing tactic—known informally as channel stuffing—became a gray area method for software solution providers to boost their top-of-the-line revenue. But in the end returns of unsold goods always reverses it. Most likely, channel stuffing will occur where insufficient executive controls on salespeople exist, according to legal experts who have reviewed the practice.
Channel Stuffing in IT, Auto, Liquor and Other Industries
Of course, channel stuffing is not limited to the IT field because it has become an issue in the auto dealer, financial products, liquor producer and other industry channels. However, in IT, salespeople seem uniquely insulated from oversight, and their communications with prospective customers are often highly individualized and unmonitored, due to unique IT customer needs, according to attorney Sarah K. Rathke, partner, Squire Patton Boggs (US) LLP.
“Although IT companies will hate this, the solution to channel stuffing is increased management,” Rathke says. “Managers too busy to monitor their sales staff create conditions in which channel stuffing can grow. Creating a 'peer review' process, where salespeople are more open with each other about the status of their prospects can also increase accountability. Finally, executive management and board members must be given data that will reveal channel stuffing. Something about channel stuffing is cultural. It is rare that just one or two salespeople within a company participate in the practice.”
What other lessons do cloud channel VARs and MSPs need to learn to stay on the right side of accounting rules? What other financial engineering schemes must they avoid?
Return Policy and Accrual Accounting
With a channel marketing strategy, a key component that must have a place remains a return policy, according to software executives. With an explicit return policy, even the worst salespeople would have a bright enough line to know where out of bounds starts for channel stuffing. This will give them a countdown to when they can begin booking sales as recognized revenue.
“If there is a return policy you cannot count the revenue until the clock starts on the product being consumed, then you can only count the revenue as it is consumed,” says Steve Benson, founder and CEO, Badger Maps, a maker of sales route planning apps. “If a channel makes a purchase that they could return, a software maker is fooling itself if it counts it as revenue. You can think of it as a loan that may be forgiven, but you may have to pay it back. In cases where a customer can return the product on a prorated basis, we don't recognize the revenue until the software has been consumed so that it can no longer be returned.”
Such a return policy would also sync with accrual accounting, which happens to suit SaaS infrastructure and other intellectual property driven businesses, as well. And according to Intuit QuickBooks, understanding basic accrual accounting not only can keep businesses—especially SMBs and solopreneurs—out of restatement trouble but also gives them a more accurate picture of their financial performance by matching revenues to the time the goods sold actually get used.
“This is one of the key tenets of accrual accounting and similar with a channel,” Benson says. “If you sold a physical product and your channel had a physical warehouse for inventory but they could return the product if they didn't sell it, then you really haven't made a sale. If you pretend you have, you are just making fools of your investors and other stakeholders—and yourself.”
On-demand as-a-Service Model Cure-all for Channel Stuffing
Some feel that channel stuffing could be less a malevolent, premeditated sales tactic and more a benignly negligent outgrowth of IT reselling ecosystems. For example, in the days before on-demand computing and cloud software companies struggled with innovation management and providing enough storage capacity to their customers. So disk-drive makers, their channel partners and others created a buffer solution to smooth out the peaks and valleys in demand.
“Channel stuffing is similar to enterprises over-provisioning storage,” says Kevin Liebl, vice president of marketing, Zadara Storage, an enterprise storage as a service provider. “Customers put up with it because they didn’t want to fail to have what was needed on hand for a mission-critical application. VARs put up with it in part because deploying storage took three to six months and without an inventory of sorts they might miss a deal.”
However, with the utility-like nature of cloud solutions the bad old days of channel stuffing could be a thing of the past. Because in the views of some experts the as-a-service model can provide a cure-all for this myopic selling disease by eliminating its underlying premise.
“By definition, the as-a-service model eliminates channel stuffing because you only recognize revenue after the service is consumed,” Liebl says. “This is a win-win-win for everyone—the customer, VAR CFO, and VAR itself whose cost structure now aligns perfectly with the business. They only order as much as they need to fulfill customer demand and pay for it after the customer has consumed what they wanted—no bloated capex payments and no over-purchasing of inventory.”
Cloud Subscriptions and Revenue Recognition
A beneficial byproduct of the move to cloud-based software away from on-premises has got to be the 12-month seat license. The subscription money gets collected all upfront in annual contracts, but the revenue recognition is performed on a monthly basis.
“Cloud vendors recognize revenue in the month the service is used,” says Dan Mannion, vice president, partners and alliances, Armor, a cloud security company. “While annual term contracts still exist from a revenue recognition perspective, it's still counted by month due to the dynamic nature of a cloud service. Revenue recognition drives all the adjustments to downstream incentive plans, licensing and subscriptions.”
With the industry standard in cloud subscriptions following an annual model, channel stuffing has been highly disincentivized. Any additional subscription beyond 12 months expires before it could be used, effectively preventing channel stuffing.
“There are no rollover minutes in the cloud,” Mannion says. “If the channel partner does a ‘pre-commit’ to sell $1 million of cloud consumption because the vendor provides a higher margin, the vendor recognizes that revenue by the month as the subscription is consumed. At the end of 12 months, the channel partner pays the difference or buys more because they sold in excess of $1 million.”
Cloud Services Tougher to Deliver, Margins More Important
Cloud and managed security services engagements can provide profitable, long-lasting relationships with customers, according to solution providers. However, when selling subscription or cloud services, it's important to understand how and when to recognize revenue for acceptable operating margins, in their expert opinions.
“When you sell 24x7x365 services, your exposure to service issues is higher than a traditional product resale,” says Lee Sher, senior director, channel sales, Proficio, a managed security service provider offering managed detection and response services. “A few bad deals can negatively impact overall profitability, which degrades their service through unsuccessful engagement that hurts all major players in the long run.”
For example, areas that can affect margins include service term and termination clauses, indemnification and services that aren’t committed to or are improperly scoped, according to Sher.
“It’s important for the partner community to understand what terms matter to their vendor of choice—this can make or break a successful partnership,” Sher says. “If that information isn’t readily available or easily communicated, partners may want to select another vendor.”
In the end, because channel stuffing is illegal, these practices can lead service providers outside their business models. And down a slippery slope that affects the entire customer base—including current and future deals.