How to Choose the Right Software Pricing Model for Your Business
Subscription pricing is the key aspiration for virtually all software companies not already using it. Here, Lotis Blue Consulting’s Lisa Thompson and Charlie Pope, discuss the ifs, hows, and whys (and why not), for companies looking to migrate to subscription pricing.
There are only two types of software companies these days – those selling on subscriptions and those who wish they were. There is a difficult path ahead for those who would like to migrate to recurring revenue. It requires executives to manage costs to serve, change revenue gradually and manage customer expectations during the transition. Overcoming these challenges can be well worth it: companies become less reliant on upgrades for growth, and the enterprise value of recurring revenue companies is several multiples higher. But, executives must consider all their options to ensure that subscription is the best choice for their company and customers.
Weighing the Choices
Costs to serve: Is the cost to serve a client spread over time, or is it front-loaded? If the former, a strong case can be made for subscription pricing; if the latter, it will be a difficult pill to swallow for software firms with few customers to spread those costs.
Customer value: Is the value customers get from the software high at installation? Does it remain steady? Does it decline over time? The greater the prolonged value of the software, the more a subscription model makes sense.
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 and
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
Because customers who pay over time expect to receive value, some software is unlikely to sell well as a subscription. This includes software that is primarily geared toward compliance or base infrastructure (e.g., workflow management, transaction processing, compliance reporting). Software of this type addresses static and well-known challenges, suggesting an upfront perpetual license is an appropriate model.
SaaS Doesn’t Mean Cloud-Hosted
For companies considering a subscription model but don’t want to move to a software-as-a-service (SaaS) deployment model, there’s some good news — SaaS is a business model, not a deployment framework. Therefore, just because a company has an on-premises deployment model doesn’t mean it can’t consider a subscription model. For example, in a subscription model, Citrix supports on-premise deployment or Citrix Cloud. SaaS means that customers pay over time, typically in a subscription model.
Though this type of software is typically deployed via the cloud, SaaS can be deployed on-premise.
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 over time 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 addresses new challenges or increases in complexity over time is ideal for subscription models. A subscription model makes good sense if new modules are frequently introduced to keep up with the business challenge or competitors’ offerings. This includes business processes like sales that evolve, solutions for manufacturing processes where retooling is frequent, or data management systems where the type and volume of data is constantly changing.
A product must provide steady 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 functionality gradually and consistently instead of waterfall development processes and the traditional trauma of periodic but massive 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
Driving sustainable revenue is critical to any business. Subscription pricing allows software developers to position themselves to build a substantial book of future revenue. But it doesn’t come without its challenges. Those who make the move for the right reasons and execute effectively will be well-positioned for success.
Do you think changing software pricing models could mean big growth for developers? Let us know your thoughts on LinkedIn, Twitter, or Facebook. We would love to hear from you!
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