The IT Financing Paradox

The IT Financing Paradox

Companies have traditionally purchased the equipment and software for their IT infrastructures and then capitalized the cost, turning to a variety of entities—from vendor financing to third-party commercial equipment financing company—to finance those purchases. But what happens in a world in which much of that infrastructure is taken over by utility service providers, with the computing capacity sold back to corporations on an on-demand basis, in which there are no assets to back up financing deals and the costs that need to be financed are variable?

Moving to a utility model will save so much money that the costs can be paid for out of operating cash flow, say many experts. And even if corporations need to finance those costs, finding financing should be straightforward. Says Charles Rutstein, research director at Forrester Research Inc.: "The captive financing guys don't much care. 'You want to buy a server? Here are the financing terms. You want to buy on-demand services? Same financing terms.' This is a fairly routine decision."

Others, however, insist that it's not so simple. Says CGE&Y's Parkinson: "CIOs are saying to themselves: 'I'd really like to take my computing platform costs off my balance sheet and put it on my operating statement so I only pay for what I need rather than what I have to buy.' " As he notes, that's a "hugely attractive deal." But its very attractiveness holds some hidden traps. Consider just the bottom 500 companies in the Fortune 1000: They spend an average of $57 million on IT annually, according to CGE&Y's calculations, of which capital costs associated with IT account for 20 percent. That leaves about $46 million in annual IT operating costs. An outsourced utility computing effort will reap $6 million in savings in the first year, increasing to $15 million in the sixth. Not bad. That means the average company in the sector will spend some $237 million in operating costs over the first five years of an on-demand program—about $120 billion for the whole sector. By the sixth year, that works out to some $15 billion annually—and that's just for these 500 companies. Says Parkinson, "You've still got to have a source of financing for those operating costs and you've got to find someone who's willing to take the financing risk."

That's a large amount for vendors to finance alone, and the equipment financing industry is not yet structured to accommodate much of it at all. "The product risk is different in a usage-based program. Without knowing how much or how long the customer will use the service, it's very difficult to come up with a schedule of lease payments to recover costs. And that's not a risk finance companies have traditionally taken," says Greg Goldstein, head of portfolio management at CIT Group Inc., a commercial and consumer finance company. "And I can't foresee that happening. So if there's three parties to a transaction—the customer, the vendor and the finance company—who's going to accept that risk? Probably the vendors. A further challenge is that vendors may not be willing to accept the additional credit risk in financing the ongoing expenses of less creditworthy companies."

Equally problematic from a cost perspective is how to price the software needed. Software companies have traditionally priced their wares on a per-seat or per-box basis. Variably pricing software as a function of demand or utilization isn't quite as easy. Says Leon Billis, president and CEO of AXA Technology Services: "In some cases you're finding software companies saying, 'Okay, I see the trend, and I'm willing to repackage my pricing for you.' Others are saying, 'No, you're going to pay for the size of the box that license sits on, regardless of consumption.'" About 10 percent of AXA Tech's total annual IT spending of about $1 billion goes to OEM software (not including desktop software), so gaining cost variability on software would mean significant savings.

Software companies will not be able to hold the line against increasing demand for variable pricing, say most observers. "Software vendors understand that the world is changing," says Forrester's Rutstein. "But in terms of what to do about it, they're not so sure. Is it a perpetual license? Is it a subscription? Do I create some elasticity? Do I do it by user, by CPU, by capacity? We're going to go through a period where it's a very ad hoc negotiated settlement, case by case."

This article was originally published on 04-01-2003
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