How to choose the right software pricing model for your business

There are only two software vendors these days – those who sell subscriptions and those who want to. There is a tough road ahead for those who want to migrate to recurring income. This forces leaders to manage service costs, incrementally shift revenues, and manage customer expectations during the transition. Overcoming these challenges can be worth it: businesses become less dependent on upgrades for growth, and the enterprise value of recurring revenue businesses is many times higher. But executives need to consider all of their options to make sure the subscription is the best choice for their business and their customers.

Weigh the choices

Costs to serve: Is the cost to serve a customer spread over time or is it a priority? If so, strong arguments can be made for subscription pricing; in the latter case, it will be a hard pill for software vendors with few customers to swallow to spread those costs.

Customer Value: Is the value customers get from the software high upon installation? Does it stay stable? Does it decrease over time? The greater the continued value of the software, the more a subscription model makes sense.

Migration Path Assessment

Migrating to a subscription-based (or SaaS) model requires a business to face three key challenges:

Cash and income: Perpetual licensing models allow developers to accrue all software revenue and receive the corresponding money upfront when a contract is signed. The move to subscription spreads revenue over the life of the contract, a significant change for companies that report profits on the street or for whom short-term cash flow is an operational concern.

Maintenance and support (M&S): In a perpetual model, increasing software sales generally do not proportionally increase support demand, so M&S was considered a source of profit. Transitioning to a subscription model can present two challenges:

1. the resistance of an organization that has been a center of profit and

2. A likely increase in costs as the burden of hosting, maintenance, software updates and patches falls on the developer.

Product development and innovation: Perpetual software contracts monetize innovation through sales of additional modules or customer upgrades. However, in a subscription model, innovation is often monetized by long-term customer value by renewing contracts, changing the business case and the product development/innovation equation.

What to migrate/What not migrate

Since customers who pay over time expect to receive value, some software is unlikely to sell well in subscription form. This includes software that is primarily oriented towards compliance or core infrastructure (eg, workflow management, transaction processing, compliance reporting). Software of this type responds to static and well-known challenges, suggesting that an initial perpetual license is an appropriate model.

SaaS does not mean hosted in the cloud

For businesses that are considering a subscription model but don’t want to move to a software-as-a-service (SaaS) deployment model, there’s good news: SaaS is a business model, not a deployment framework. Therefore, just because a business 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-premises or Citrix Cloud deployment. SaaS means customers pay over time, usually in a subscription model.

While this type of software is typically deployed through the cloud, SaaS can be deployed on-premises.

Just because your software hasn’t migrated 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-premises solutions have subscription revenue models (although perpetual cloud-based software is quite rare).

On the other hand, software that takes on new challenges or increases in complexity over time is ideal for subscription models. A subscription model makes sense if new modules are introduced frequently to keep up with the business challenge or competitor offerings. This includes business processes such as sales that are changing, 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 consistent or increasing value over time to successfully transition from perpetual to subscription pricing. It also requires an agile development structure to gradually and consistently introduce new and better features instead of waterfall development processes and the traditional trauma of periodic but massive version upgrades.

How do we migrate?

Suddenly moving from perpetual pricing to subscription-based software pricing will likely reduce business revenue while increasing recognized costs. Since EBITDA generates bonuses for many executives, this could be a career-ending decision! But stay the course – while change is difficult, there are steps software leaders can take to reduce the near-term impact and position themselves for future success:

  1. A subscription model should be introduced gradually rather than abruptly. The best option for developers is to take advantage of maintenance and support, the already recurring element of the contract. To do this, leaders need to increase the value of maintenance to include upgrade protection and access to additional features. The modification of the maintenance contract will have two effects: it will encourage customers to continue their renewal and justify an increase in the price of the maintenance contract. This move increases recurring revenue within the perpetual subscription base, allowing customers and the software developer to gradually transition to subscription pricing.
  2. Software, maintenance and support, and installation services must be combined for tax purposes. How will the evolution of accounting facilitate the migration of the business model? Because it is a tug of margins between software, service and M&S where each group has an incentive to optimize its profit center, often to the detriment of the whole. Aligning incentives with a single profit objective allows leaders to shift resources to support the new model without worrying about organizational politics. In other words; if a service or support line only exists because the software exists, so it should be part of a software P&L.
  3. Introduce software backlog as a key business metric. A high software backlog of committed future revenue is the goal and generates value for the company. While some short-term revenue loss is inevitable, the overall value of the business relies on a secure future revenue stream. This is best measured by backlog, which is even more important than 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 volume of future revenue. But it is not without challenges. Those who take the step for the right reasons and execute effectively will be well positioned to succeed.

Do you think changing software pricing models could mean big growth for developers? Let us know your thoughts on LinkedIn, TwitterWhere Facebook. We would like to hear from you!