How to Choose Right Software Pricing Model for Your Business
Today there are only two software providers – those who sell subscriptions and those who want to. There is a tough road ahead for those looking to transition to recurring income. This forces leaders to manage service costs, incrementally increase revenue, and manage customer expectations during the transition. Overcoming these challenges can be worthwhile: businesses become less dependent on upgrades for growth, and the business value of businesses with recurring revenue is many times higher. But executives need to consider all their options to make sure that subscription is the best option for their business and customers.
Weighing the Choices
Costs to serve: Does the cost to serve a customer spread over time or is it preferable? If so, could make a strong case for subscription pricing; in the latter case, it would be a difficult panacea for software vendors with few customers to swallow to spread those costs.
Customer value: Is the value customers get from the software when they install it? Is it stable? Does it decrease over time? The higher the continuation value of the software, the more significant the subscription model.
Assessing Migration Path
Migrating to a subscription-based (or SaaS) model requires a company to face three key challenges:
Cash flow and revenue: Perpetual license models allow developers to recognize all software revenue and receive the associated cash upfront when a contract is signed. Moving to subscription spreads the revenue out over the full contract term, a sizable shift for companies who report earnings to the street or for whom near-term cash is an operating concern.
Maintenance & Support (M&S): In a perpetual model, increasing software sales typically does not proportionately increase the demand for support, so M&S has been viewed as a source of profit. Transitioning to a subscription model may introduce two challenges:
1. resistance from an organization that has been a profit center
2. a likely increase in costs as the burden for hosting, maintenance, software updates, and patches shifts to the developer.
Product development and innovation: Perpetual software contracts monetize innovation through additional module sales or customer upgrades. However, in a subscription model, innovation is often monetized through long-term customer value through contract renewal, changing the business case, and the product development/innovation equation.
What to Migrate/What not to Migrate
Since customers who pay overtime expect value, some software is unlikely to sell well in subscription form. This includes software primarily focused on compliance or core infrastructure (e.g., workflow management, transaction processing, compliance reporting). Software of this kind responds to static and well-known challenges, suggesting that the original perpetual license is an appropriate model.
SaaS Doesn’t Mean Cloud-Hosted
For businesses that are considering a subscription model but don’t want to switch to a software-as-a-service (SaaS) deployment model, there’s good news. SaaS is a business model, not an implementation framework. Therefore, just because a business has a deployment model in place doesn’t mean it can’t consider a subscription model. For example, in a subscription model, Citrix supports on-premises or Citrix Cloud deployments. SaaS means customers pay overtime, usually on a subscription model.
Though this type of software is typically deployed via the cloud, SaaS can be deployed on-premises.
The fact that your software hasn’t moved to the cloud doesn’t mean you can’t change your business model. “Cloud” vs. “On-Prem” are deployment models. “SaaS” is a business model decision, paid overtime instead of selling perpetual licenses. Many On-Prem solutions have subscription revenue models (although Cloud-based perpetual software is quite rare).
On the other hand, software that presents new challenges or increases in complexity over time is ideal for subscription models. The subscription model makes sense if new modules are introduced regularly to keep up with the business challenge or competitor offerings. This includes business processes such as sales that are changing, solutions for manufacturing processes that frequently must be retooled, or data management systems where the type and volume of data are constantly changing.
A product must provide consistent or incremental value over time to successfully transition from perpetual to subscription pricing. It also requires an agile development structure for the gradual and consistent introduction of new and better features instead of the traditional waterfall and trauma development processes of periodic but major version upgrades.
How do we migrate?
Switching abruptly from perpetual to subscription software pricing will likely reduce revenue for the company while increasing recognized costs. Because EBITDA drives bonuses for many executives, this could be a career-ending move! But stay the course while the switch is challenging, there are steps software leaders can take to reduce the short-term impact and position themselves for future success:
- A subscription model should be introduced gradually rather than abruptly. The best option for developers is to leverage maintenance and support, the contract element already recurring revenue. To do this, leaders should enhance the value of maintenance to include upgrade protection and access to additional features. Changing the maintenance contract will have two effects: it will entice clients into continued renewal, and it will justify a price increase in the maintenance contract price. This move increases the recurring revenue within the perpetual subscription base, allowing both the customers and the software developer to transition gradually to subscription pricing.
- Software, maintenance & support, and installation services should be fiscally combined. How will changing accounting facilitate business model migration? Because it addresses a margin tug-of-war between software, service, and M&S where each group has an incentive for optimization of their profit center, often to the detriment of the whole. Aligning incentives to a single profit objective allows executives to move resources to support the new model without worrying about organizational politics. Put another way; if a service or support line exists only because the software exists, then it should be part of one software P&L.
- Introduce software backlog as a key business metric. A high software backlog of committed future revenue is the goal and drives enterprise value. While some loss of short-term revenue is inevitable, the business’s overall value is based on a secure future revenue stream. This is best measured by the backlog, which is even more important than the current Annual Recurring Revenue (ARR).
Positioning for Future Success
Generating sustainable income is essential for any business. Subscription pricing allows software developers to position themselves to build a substantial future revenue volume. But not without its challenges. Those who take the step for the right reason and execute it effectively will be well positioned for success.
