The Perpetual Software License Model as an Addiction
Almost all software companies that sell software with a perpetual license are addicted to the end-of-quarter “hockey stick” that drives the CFO to drinking. The hockey stick is the folksy description for how the revenue profile of a software company might look on a quarterly basis if plotted over time: The sales of software licenses tend to be slow early in the quarter, then escalate rapidly during the last week of the quarter when 70 – 80% of the licenses are “booked”. An accounting process known as “revenue recognition” allows the software company to allocate all license fees associated with the sale or bookings of the perpetual license to be recognized as revenue during the quarter during which the license is sold and delivered. The problem is, the executives don’t know if they are going to “make the numbers” until the last day of the quarter.
I Want to Go to Heaven, but I Don’t Want to Die to Get There
Executives often think, “There must be a better way – how about the subscription license model?” However, any mention of the subscription license model and the common response tends to be: “we can’t do that! We are a public company and can’t handle the revenue dip”.
Such a statement reveals the fear that the revenue recognition process associated with selling subscription licenses will have a disastrous transition effect – the revenue associated with the sale of the software license affects the P/L statement for several quarters over the lifetime of the subscription license. In effect, the hockey stick gets flattened. The positive for company management is that revenue becomes more predictable in subsequent quarters after the initial sale. But there will be a revenue reduction or “revenue dip” in the quarter during which the subscription license was sold. In the steady state business model of a company that sells subscription licenses, there isn’t a problem as there isn’t a transition. In fact, the CFO’s job can be simplified as the revenue for subsequent quarters becomes more predictable based upon the sales bookings of previous quarters.
While many of the statements in this paragraph are factual, they don’t lead to the truth behind what happens when companies adopt subscription license models. Subscription licenses don’t lead to a corporate-wide revenue dip when they are rolled-out. Furthermore, subscription license models aren’t best used to fix sales behavior or revenue recognition problems. They should be used to open up new market opportunities.
So, let’s dig a little deeper…..
What Really Happens – Establishing a List Price for the Subscription License
In previous postings we described the subscription license model and the value it brings. Let’s now start with how a company might price the subscription license model to understand the situation more fully. It seems on the surface that trying to compare the pricing of a subscription license model to a perpetual license model is like comparing the pricing of apples and water!
However, software license “assets” tend to be viewed as having a useful lifetime, not unlike a physical asset such as a computer. It is this perceived useful lifetime that forms the basis for valuing and pricing a subscription license.
Most companies that buy software licenses view software has having a 3 – 5 year lifetime. So let’s assume for the sake of an example that a particular customer values the software as having a useful life of 4 years. If the perpetual license for this software is sold for $100, and there are $20 of additional annual license maintenance fees, then after 4 years (ignoring the time value of money), the customer has invested $180. If 4 years is the perceived lifetime of the software, then the annual value must be about $45 ($180 / 4). This example is very close to what happens in real life, even though pricing is a much more nuanced and complex topic.
Clearly, if the customer purchases the subscription license rather than the perpetual license, then the software publisher only receives $45 for the first year of license fees, rather than the $120 they might otherwise (assuming no discounts). If the relationship remains steady, then the software publisher actually makes more money in the long run. This is very much the financial arrangement present in leasing assets.
What Really Happens – Revenue Recognition
In a nutshell, because the subscription license combines the software license and the delivery of ongoing software updates in a single offering, the revenue associated with the subscription license has to be recognized in a smooth way (monthly or quarterly) over the term of the license to reflect the ongoing delivery of new value in the maintenance releases.
If we take the example from the previous section, in a subscription model, the $45 that would have been paid for the annual license must be “recognized” as occurring in either $11.25 quarterly increments or $3.75 in monthly increments.
It is true that quarterly revenue for a company would be significantly reduced quarter over quarter if in Q1 all of the users purchased a perpetual license, and then in quarter 2, all users purchased a subscription license. However, in reality, this is never what happens. Usually, revenue increases when a company introduces a subscription license model.
What Really Happens – Subscription License Models as a Way to Increase Revenue
The market reality that we have seen in many market segments is that the subscription license model is offered as an alternative to address market needs not met by the perpetual license model. It becomes another choice and not a wholesale change to another license model.
In this context, the subscription license model is offered to address unmet market needs. Several years ago at a SoftSummit conference in Santa Clara, I asked how many attendees offered a subscription license model for their softgware. About 1/3 of the room raised their hands. When I asked those 1/3 how many had a revenue dip when they offered the subscription license model, all of them lowered their hands. When I asked how many had increased their revenue when they offered the subscription revenue, 2/3 of the original 1/3 raised their hand.
While this wasn’t scientific, it was illuminating.
The Unspoken Lever – Sales Compensation
If you do have a business objective to sell either the subscription license model or perpetual license model as your primary license model, be sure that your sales compensation program is aligned with your objective. For example, if your goal is to sell more subscription licenses, don’t compensate your sales force solely on recognized revenue because they’ll be incented to sell more perpetual licenses. On the other hand, if you compensate the sale of a subscription license model at a higher percentage of bookings than for a sale on the perpetual license model, you may get different behavior.
The Subscription License Model can be a powerful addition to your product offering, be sure not to sell it short!
Are you tired of the hockey stick model?
Have any of you tried offering a subscription model at your company? Why or why not? What has been the impact? Let me know..
Next – Beyond Subscription Licensing: Establish Market Leadership With Even More Flexible License Models
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