How to Choose Right Software Pricing Model for Your Business
There are only two software companies these days – those that sell on subscriptions and those that would like to. Those looking to migrate to recurring revenue have a difficult road ahead. It requires executives to manage service costs, incrementally change revenue, and manage customer expectations during the transition. Tackling these challenges can be rewarding: businesses are less dependent on upgrades to grow, and businesses with recurring revenues have many times more enterprise value. However, executives need to consider all options to ensure the subscription is the best choice for their business and their customers.
weighing the decisions
Cost to serve: Are the costs of looking after a customer spread over time or are they brought forward? In the former case, a strong case can be made for subscription pricing; In the latter case, it will be difficult for software companies with few customers to spread these costs.
Customer Value: Is the value customers get from the software high upon installation? Does it stay stable? Does it decrease over time? The higher the value of the software, the more useful a subscription model is.
Assessment of the migration path
Migrating to a subscription-based (or SaaS) model presents an organization with three key challenges:
Cash flow and sales: Perpetual licensing models allow developers to capture all software revenue and receive associated cash payments up front when a contract is signed. The move to subscription spreads revenue over the life of the contract, a significant shift for companies that publicly report earnings or for which short-term cash is an operational concern.
maintenance support (M&S): In a perpetual model, increasing software sales typically do not translate into a proportionate increase in support demand, so M&S was viewed as a source of profit. Transitioning to a subscription model can present two challenges:
1. Resistance from an organization that was a profit center and
2. A likely increase in costs as the burden of hosting, maintenance, software updates and patches is shifted to the developer.
Product development and innovation: Perpetual software contracts monetize innovations through additional module sales or customer upgrades. However, in a subscription model, innovation is often achieved through monetization long-term customer value B. through contract renewal, change of business case and product development/innovation equation.
What to migrate/What Not migrate
Because customers who pay over time expect value for their money, some software is unlikely to sell well as a subscription. This includes software geared primarily towards compliance or basic infrastructure (e.g. workflow management, transaction processing, compliance reporting). Software of this type addresses static and known challenges, suggesting that a perpetual pre-license is an appropriate model.
SaaS does not mean cloud-hosted
For companies that are considering a subscription model but don’t want to move to a Software-as-a-Service (SaaS) delivery model, there’s some good news – SaaS is a business model, no deployment framework. Just because an organization has an on-premises delivery model 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 over time, typically in a subscription model.
Although this type of software is typically delivered through the cloud, SaaS can also be delivered 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 that pays over time rather than selling perpetual licenses. Many on-prem solutions have subscription revenue models (although cloud-based perpetual software is fairly rare).
For subscription models, on the other hand, software that addresses new challenges or increasing complexity over time is ideal. A subscription model makes sense when new modules are introduced frequently to keep up with the business challenge or what competitors are offering. This includes business processes such as sales that are evolving, manufacturing process solutions that are subject to frequent changeovers, or data management systems where the type and volume of data is constantly changing.
A product must offer constant or increasing value over time to successfully transition from perpetual to subscription pricing. It also requires an agile development structure to introduce new and better features gradually and consistently, rather than waterfall development processes and the traditional trauma of regular but massive version upgrades.
How do we migrate?
The abrupt shift from perpetual to subscription pricing for software will likely reduce the company’s revenue while increasing reported costs. With EBITDA driving bonuses for many executives, this could be a career-ending move! But stay the course—while making the switch is challenging, there are steps software leaders can take to reduce the near-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 use maintenance and support, the contract element that is already recurring revenue. To achieve this, leaders should increase the value of maintenance to include upgrade protection and access to additional features. The change to the maintenance contract has two effects: it will entice customers to continue to renew and justify an increase in the maintenance contract price. This move increases recurring revenue within the perpetual subscription basis and allows both the customers and the software developer to gradually transition to subscription pricing.
- Software, maintenance & support and installation services should be combined for tax purposes. How will the accounting change facilitate the business model migration? Because it addresses a margin tug-of-war between software, service and M&S, where each group has an incentive to optimize its profit center, often to the detriment of the whole. By aligning incentives with a single profit target, executives can shift resources to support the new model without having to worry about company policy. Expressed differently; if a service or support hotline only exists because the software exists, then it should be part of a software P&L.
- Introduce software backlog as a key business metric. A high software backlog of Committed future revenue is the goal and increases the value of the company. While some loss of short-term revenue is inevitable, the overall value of the business 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 revenue is vital for any business. Subscription pricing allows software developers to position themselves to build a sizable book of future revenue. But it doesn’t come without its challenges. Those who take the step for the right reasons and execute it effectively will be well positioned for success.
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