Does Cloud POS Crash This Year?

23 May

The technology sector is off to a rocky start for 2016. The NASDAQ has already fallen by 10%, large venture-backed startups are seeing downward corrections, and pundits everywhere are talking about a return of 2000. It’s not quite as bad as a meltdown, but there are definitely a sizable number of highbrow startups with uneconomic business models.

Unlike 2000, many tech companies today have real revenues and scale. They’re earning tens of millions in revenue, or have tens of millions of eyeballs that they can monetize at some level. Will the scale of monetization be such that it produces positive unit economics for the startups? That’s what 2016 will lay bare.

A few of these later stage companies are already profitable. With the technology market trending down and a coming vacuum of private financing, it just means that their margins might be less than optimal. Instead of a company earning $100M in revenue it might only earn $50M because it has to cut its R&D on new product. Fundamentally it’s a small discrepancy because both outcomes produce relatively large companies, though it’s probably the difference between a founder having some ownership and looking for a new job if the company took “venture” capital.

But what about startups with inherently low profitability? How much wiggle room is there once venture funds pull back? Think about it this way: Google earns 60% gross margin. If that margin sinks to 20% it’s still above water. But what happens to a startup that’s expected to earn a low margin ( like 10%) at scale when venture capital stops subsidizing the business model?

This is the conundrum I expect cloud POS companies will face in the very near future. POS is a very low margin business. Cloud POS has made margins fall even lower. The name of the game in cloud POS is to decrease the upfront cost of ownership and make money as a platform. It’s the right idea, but without the financing to see it through to scale it’s an utter disaster. And by scale, I mean 20+ years since it will take any POS company several decades to reach enough customers for a platform play.

A big problem is that there are just too many cloud POS systems out there. I blame software. Developing software has never been easier. Don’t believe me? Give me $5,000 and an Elance account and I’ll come back with a working POS in 3 weeks. The product might be complete crap once you get under the hood, but I’ll have one to sell.

Cloud POS is also having a difficult time with its distribution model. First it spent a lot of money on SEO and handled all the sales directly. Investors realized this was the definition of linear – not exponential – growth, and told the POS companies to build a channel. Well, cloud discovered what legacy POS companies have been frustrated with for decades: very few resellers can actually sell product at a repeatable rate. With no ability to control the channel, cloud POS companies turned to a referral model, whereby payment processors would send POS companies merchant referrals. This last effort is still being sussed out, but the data I have shows that the rate of growth remains linear with a pretty low constant.

Ultimately product is not the hard part about brick and mortar: distribution is. It’s at least 80% of your cost structure. Few people really seem to understand why it took Micros 35 years to scale to only 60K restaurants. It’s a very competitive world with low margins, high churn, and customers who look at you as a cost center.

I expect cloud POS consolidation soon. I think payment processors will continue acquiring cloud POS so they have something sticky to offer merchants, preventing churn in their core processing business. This will fit well with many cloud POS companies who are struggling to support themselves. However, most processors don’t know the value of POS, nor how to sell product on value, and that shall be a fun dance to observe.

The irony in all of this is that cloud POS will need to rely on the POS models of old. Since cloud POS is so cheap it is betting on selling additional products to merchants who use its POS. Who ultimately builds, sells and supports these additional products is moot: can the merchant afford them? Cloud POS’s current customers are very small merchants (sub $500K/year revenues). They aren’t going to pay for analytics or marketing. For cloud POS to be successful, it will need to convert chains and large independent merchants.

The makeup of the decision makers at chains and larger merchants are not young, 20-something Stanford grads. They don’t really understand technology, but they get relationships. They know that it took their current POS rep three years to prove his worth before they even entertained the notion of switching systems.

These kinds of sales take time. It takes feet on the street and solid rapports. It takes a business model that incentivizes the sales person to make the sale… which is hard to do with cloud pricing today. Ultimately, it takes ingredients that the cloud POS were created to eliminate. Yes, in a generation merchants will do self-discovery and buy their POS online, just like they do most everything else these days. But then is not now. And I don’t know if current cloud investors will wait a generation to see it through.