Last year, the Professional Services Council and Market Connections conducted a study on the e “convergence” of technology and professional services. Convergence is about more than just IT and technology: It involves changes in how government scopes and procures services and technologies, how contractors shape their offerings to the government, and the up-front investments contractors make to build and support “as a service” (XaaS) models. The study found the industry on the cusp of a shift in the marketplace.
A year later, the shift indicated in the study continues steadily. Now as government adopts the XaaS business models, shifting from capital expenditures to operational expenditures, there are financing implications for companies making the transition.
At the Professional Services Council Annual Conference in early October, a panel of experts discussed how, in this era of severe budget constraints and shifting market dynamics, XaaS models are affecting the capital markets. The panelists included:
- Susan M. Gabay, managing director, Bluestone Capital Partners
- Robert D. Kipps, managing director, KippsDeSanto & Co.
- Ed Stucky, president and CEO, Republic Capital Access
- Greg Wheeless, senior vice president, Government Contractor Group, Bank of America, N.A.
- Diane Zanetti, senior vice president and market manager for Government Contractor Lending, Capitol One
- Mitch Martin, principal, The McLean Group
The shift to the XaaS model has several implications on the financing options for service providers in federal contracting. As customers shift to flat, monthly payment plans, contractors are forced to amortize up-front hardware and software costs across a much longer term, Kipps said. In turn, lengthened payback periods created a need for financing. With the advent of XaaS services, contractors can now avoid large up-front hardware and software costs and instead pay a monthly expense for the software license/cloud/etc. By shifting their costs and revenue to a more variable XaaS structure, contractors are able to easily align the timing of cash inflows and outflows, again shortening the payback period and reducing the need for financing.
Wheeless notes that the size of the company determines how much financing impacts the contractor. For larger companies, where XaaS offerings are just a part of their overall business, their related funding requirements are simply a part of their corporate financing needs. This is different for small and middle-market government contractors that have developed XaaS as the bulk of their business. For them, the availability of financing is affected.
For example, these smaller businesses may need to fund upfront capex and software development costs or acquisitions of existing XaaS businesses. Wheeless said that given the predictability of the recurring revenue associated with successful XaaS businesses, a growing number of large and tech-oriented banks are willing to lend more to XaaS companies for working capital, R&D, capex or acquisitions. This type of financing is increasingly done as a multiple of revenue or higher multiple of EBITDA than most government contractor financing because it is based on a recurring subscription business model. The key is determining the present value of the government contractor’s future recurring revenue and cash flow stream.
While the outlook for financing is good, it may take some time for the government to embrace creative financing options. Stucky noted that the government is looking at creative financing methodologies, and as a result contractors are approaching his company with very inventive solutions. However, few have been implemented. It seems that while the program offices are interested, the contracting shops are reticent. He believes it will happen; it’s just a question of when.
Gabay agrees. She said that while there is more momentum within commercial markets toward XaaS business models, the government will take longer to effect a complete paradigm shift. She says that large, well-capitalized businesses in the sector seeking to shift their business models will likely be able to finance this transition with their own balance sheets. However, small and middle-market businesses will need to be more thoughtful in executing any transformational shifts in their business models. In all likelihood, the government’s adoption of XaaS purchasing patterns will occur over multiple years, providing companies with ample time to carefully plan for this transition.