In-Depth

Shaping a New Identity

How the recession is forcing partners to reinvent themselves and is changing the structure of the Microsoft ecosystem.

• By Scott Bekker
• May 01, 2009

The deepest global recession in 60 years is hitting the channel like a sledgehammer. Partners that are finding business under the impact-scattered rocks consider themselves lucky. As Gartner Inc. channel analyst Tiffani Bova puts it succinctly, "Flat is the new up."

With about 640,000 partner companies, according to one of Microsoft's most recent public statements, Microsoft's ecosystem accounts for as many as two-thirds of all the channel companies in the IT industry worldwide. As goes the Microsoft channel, so goes the IT industry as a whole.

The sharp global downturn in spending on everything-including IT-combined with the global credit crunch are radically reshaping the Microsoft partner ecosystem and the way each partner company does business. Companies are going out of business, laying off employees, shifting to services of all kinds, seeking suitors and turning to vendors for help. While these moves are fundamentally altering the channel in the short run, many of the repercussions will stay in place in a fundamentally reformed channel when the economy comes out of recession, be that later this year, in 2010, in 2011 or later still.

Forced to Fold
"There was an interesting theme at the Microsoft Convergence conference in March-this notion that this economy has exposed your warts. Those were some of the best attended sessions," says Reed Overfelt, CEO and founder of Optimize Now Technologies LLC, a venture capital-backed consultancy that advises companies on social media strategies. "Realize that Microsoft partners are not cash-flow rich. A lot of these companies are going to end up folding," says Overfelt, a former general manager at Microsoft.

As founder of the Heartland Tech Group (HTG) partner-to-partner organization, Arlin Sorensen is in a unique position to see deep inside the books of many peers' companies. He's undertaken a few emergency consultations with peers to advise them through the tough times, and Sorensen gets regular calls from partner company executives seeking a sounding board.

"The partner channel is not that healthy. It's sort of scary when you see the financials as I do at HTG," says Sorensen, also CEO of Harlan, Iowa-based Gold Certified Partner Heartland Technology Solutions Inc. Companies on the infrastructure side that are hardest pressed come in two forms, says Sorensen. There are small companies of one to five employees with just a handful of customers and fast-growth companies of all sizes that have never been well capitalized.

"I'm seeing cash flow drive out smaller partners that were marginal in profitability," Sorensen says. Any kind of slow payment or other burp from their limited handful of customers and those partners struggle or close. "They give up the ghost and try to find a job."

The other type is companies with dynamite sales teams that started without financial capital behind them. "They've always just operated on their ability to sell their latest success. That's great as long as payment comes in, but when the economy slows the payment down, you're continually outselling your cash flow and the cards can tumble pretty fast," Sorensen says.

One example of an ugly situation exposed by a down economy is a company doing between $2 million and $3 million in sales that Sorensen wouldn't name. "They were buying a significant amount of their product on eight personal credit cards. They had tapped them all out, paying 18 percent to 20 percent interest and were losing money like crazy. But it was their only way to stay in business. Once you're in that spiral, it's impossible to get out of it," he says.

Problems are especially acute in the Microsoft Dynamics channel, several channel insiders say. Mo Edjlali, CEO of TalentFamily Inc., a Fairfax, Va.-based recruiting company, which places Microsoft professionals with partner companies nationwide and does much of its business in the Dynamics space, notes: "We've seen about 75 percent of clients freeze all hiring. On the permanent placement side, where people are paying premium fees to find individuals-they've just stopped doing that," Edjlali says. "Its' pretty brutal out there."

Some small firms in the four to 15 person range in the Dynamics space have shut down, and larger Dynamics firms have been laying off employees aggressively, Edjlali says.

One of the hardest hit sectors in IT has been hardware. Microsoft OEM Division Corporate Vice President Steve Guggenheimer has seen the economy take a toll on the OEMs and system builders he works with. The dozen multinational OEMs, the Dells, HPs, Lenovos, Acers and the like, can play around with currency fluctuations to survive and even grab some market share. Similarly, small system builders with good niches and low overhead are also doing OK. But the middle tier? "The people that are large enough to compete with the multinationals, but too large to have the agility to be in all the little areas with the smaller folks, I think that's the hardest part of the market to be in," Guggenheimer says.

The numbers bear that out. Microsoft's "named" accounts among system builders, the category right below the 12 multinationals, has fallen from 520 worldwide a year ago to 482 this year, according to a Microsoft spokesperson.

An IDC survey of channel companies released in March tapped into broader signs of trouble. Nearly 20 percent of resellers with annual revenues of less than $5 million reported that they didn't have enough capital to continue "business as usual." A further 37 percent of that group weren't sure if they had enough capital to get through.

In a conference call to discuss the results, IDC analyst Janet Waxman compared that lack of knowledge to flying a plane across the ocean without knowing how to read your fuel gauge. Between nearly 20 percent without the necessary capital and nearly 40 percent who weren't sure if they'd make it, that's a lot of potential planes ditching in the ocean.

'Embracing the change'
Matt Scherocman isn't seeing a lot of other channel companies fold their tents in the Cincinnati area, but he says it's definitely been harder to scare up work.
"Somebody called it a grind the other day," Scherocman says with approval. To illustrate, he mentions a best practices event his company put on for customers recently. "The event was twice the money, twice the work and half as many attendees."

PCMS IT Advisor Group, where Scherocman is vice president of consulting services, is a mix of project work, outsourcing and managed services. "I'm seeing that our project work has slowed down significantly," he says. The company's balance has let them fairly seamlessly shift to more services work. "A midsize company got rid of their Cisco resource. They said, 'you guys handle it,'" Scherocman explains of a typical recent deal.

Shifting the balance toward services is one of several methods that Microsoft partner executives say they're seeing among partners who are managing best in the current environment. "The partners that are thriving right now are those who are embracing the change in the industry and talking to customers about the business value technology can create/unlock. They are evolving to deliver Software plus Services [S+S] solutions. They're moving from project-oriented businesses to services-oriented businesses. It's a more stable business model for partners," explained Cindy Bates and Robert Deshaies, vice presidents in the U.S. Partner Group, in a joint e-mailed response to questions for this article.

M&A
For some partners, meeting those realities requires a simple shift in priorities. For others, adjusting is harder and some are looking for an exit strategy. One possibility is to get acquired. As Gartner's Bova notes, valuation in this environment can be tricky. "For VARs, no matter what size they are, if 90 percent of their revenue is project-based, 2009 is going to be very stormy. I think the valuations of VARs are also becoming much more tied to health and predictability in the business versus top-line revenue."

That said, deals are happening, according to Mike Harvath, CEO of Revenue Rocket, which specializes in business and management advice for solution providers with less than $50 million in revenues. "If you look at overall merger and acquisition activity, almost all major indicators show that M&A activity has fallen off dramatically and completely stalled," Harvath says. Not so, for the solution provider segment. "It feels like the demand for these types of transactions in 2009 will be 20 percent to 30 percent over what it was in 2008, and in 2008 it was pretty good."

"I think it's really two things that are driving [M&A among smaller solution providers]," Harvath says. "It's access to capital, but it's also the desire to grow quicker than they can fund through just cash flow."

Sorensen has seen M&A activity, too. "I'm getting lots of calls from brokers that are trying to put together deals. They're looking for larger partners, primarily managed services organizations, that they want to roll up right now."

No Magic Bullets
At the same time, many vendors are working overtime to help their channel partners by advising them on how to thrive, or at least survive until the recession ends. IDC analyst Darren Bibby, who advises vendors on relations with their channels, says, "Every vendor expected that every other vendor is going to launch some magic bullet program." Nobody has that magic bullet, he says.

Instead, each vendor's materials tend to be repackaged, greatest hits-style tips and programs that are still extremely relevant. Microsoft is a good example, Bibby says, with pragmatic advice about using Microsoft Financing; pushing cloud computing-style services; capturing customers' spending out of operational expenditures, which are still flowing, rather than capital expenditures, which are not; and good sales practices. "After all," Bibby notes, "getting sales has never not been an issue."

To that point, Microsoft's Deshaies and Bates said in their response, "You have to really focus on the basics of salesmanship. That means being prepared when you go on customer calls, adjusting plans in a timely way, and really checking in with [buyers] a lot more often than you did before."

Financing is tricky. Dave Sobel, CEO of Evolve Technologies, a Gold Certified Partner in Fairfax, Va., has had good luck with the Microsoft Financing program. His customers have been able to get approved, and he notes that Microsoft Financing continues to reach out to him for new deals. But in the channel survey, IDC noted that nearly half of the respondents reported having more difficulty getting their customers financed across all financing and leasing programs (not just Microsoft's). And Heartland's Sorensen says word is getting back to him that partners are having more trouble getting credit-card limits increased and that distributors aren't as quick anymore to approve deals bigger than ones they've OK'd in the past.

"A year ago, if you had a large deal, you could go to a distributor and they'd upgrade you to get over a hump. Everybody is just more cautious. The distributor is being fiscally responsible, which is what they should do. But a lot of partners have operated based on the fact that the distributor [didn't used to be] as responsible as they should be," Sorensen says.

Which Changes Will Last?
Sobel, like many people interviewed for this article, saw business fall off a cliff in January. Also like others we interviewed, Sobel saw orders pick up slightly in March. "My sense of this, from talking to my customers, was they were holding off to see what happens. Now they are actively engaging in the projects that they need to do. They're definitely not doing any fluff projects. They've decided that this is the way things are going to be for a little while, and they've got to get back to business."

Even if things start to turn around quickly, several trends have begun or accelerated that will leave the Microsoft channel a different place than it was before the recession began in late 2007.

Structurally, there are the partner companies that have gone, or will go, out of business. That includes everything from massive Gold Certified Partner and systems integrator BearingPoint Inc., which is being liquidated in bankruptcy court, down to the sole proprietor who puts herself on the job market.

Employees caught up in the layoffs in the Dynamics channel and elsewhere may have a hard time finding new jobs in the field amid the glut of candidates and could be forced to move to fields other than IT. That could mean even some highly skilled, well-known channel veterans won't be back.

Partners report their attitudes toward business are becoming more conservative, now that they've experienced how bad things can get. Says Sobel, "We're doing a lot tighter financial projections. What's our non-growth plan look like? We have a version of the plan that says, 'What happens if we shrink, and what are the trigger points?' I wasn't talking like that two years ago. Part of me has to say maybe I should have been doing this before."

The recession is highlighting for many partners how important it is to develop and promote business-process expertise. The next major meeting of HTG will feature sessions about business-process standards. "That's where I see our next step needing to be in the channel in 2011 or 2012. We're working on helping our members with service delivery that's consistent and follows process," Sorensen says.

Throughout the recession, partners have been trying to tap into customers' operational budgets through cloud computing, managed services and outsourcing. Will partners revert to project-based revenues again when things turn around?

"That's the million-dollar question isn't it?" notes Gartner's Bova. Views on the question vary widely.

Bova contends that solution providers have been nodding their heads for years about the need to move from project-based business models to business process-based models or trusted-advisor models, and toward recurring revenues.

"You don't have the masses that have moved to cloud opportunities or managing based on service-level agreements. Although you've had partners say they need to move from products to solutions and from transactions to predictability, I would say the bulk fits in the value-added reseller [category]," Bova says. At the end of the recession, she adds, "There's still going to be a majority of technology purchased exactly the way it's purchased today. If partners want to continue focusing on doing business the same way they have for the last 10 years, they absolutely can. What will start to get challenging is pricing."

Scherocman sees the recession-based shift toward S+S, SaaS and managed services as part of an old cycle.

"Do I think it's a shift? Yes. I don't think the economy is changing that shift but it's accelerating it. It's similar to the centralization and decentralization of IT. We go through cycles where everybody says centralization makes sense. Then it shifts back," Scherocman says.

Optimize Now's Overfelt is emphatic that the change toward the cloud is more permanent, and the channel needs to adjust. "This economy is going to hasten SaaS and the cloud as primary providers." Moreover, Overfelt says those changes don't bode well for the current size of the Microsoft channel. "Because of that, the Microsoft channel is going to have to shrink. That business is coming from some place. Some Microsoft partner or channel partner is losing that business."