Pay as you grow

The model of buying software outright and holding a perpetual license is challenged by a new approach that permits customers to subscribe for a limited time — and upgrades when they want

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By  Peter Branton Published  May 21, 2006

|~||~|The pay-per-use approach is mainly driven by necessity — that is, by companies needing to find more cost-effective means of investing in IT.|~|Necessity may or may not be the mother of invention but it is certainly a powerful motivator. This can be seen by its impact even on such a field as software licensing. The traditional, one-off purchases practiced before in the IT industry are now being replaced by a more dynamic, pay-per-use approach. This shift in the licensing pattern has been driven by necessity — that is, by companies needing to find more cost-effective means of investing in IT. Previously, enterprise software vendors sold their products through a perpetual license, where the customer buys and forever owns the software code and signs up for yearly maintenance and support for an added cost, say 15% to 20% of the license fee. Now, they are increasingly trying out pricing and licensing schemes that permit customers to subscribe for a limited period of time. The subscription model, which includes utility (or pay per use) agreements and hosted service deals, allows customers to rent software with a low up-front cost and then pay on an ongoing basis. If the fee is not paid, the software will be unplugged. The move toward subscription licensing is part of a wider shift in the software industry, triggered by companies that, for years, have grumbled about enterprise software’s cost and complexity. It actually started in the midst of the dotcom boom, where a raft of application service pro- viders (ASPs) emerged and promised to deliver software services via the internet. But weak business plans and technical glitches caused many ASPs to disappear, leaving only a few, such as Salesforce.com — a hosted provider specialising on customer relationship management (CRM) applications — to challenge large enterprise software vendors. While the first forays with subscription models were unimpressive — as seen during the dotcom bust — at present the software-for-rent approach is maintaining a slow, steady acceptance among firms wanting to get value for every dollar they spend on their IT assets. According to a recent IDC report, worldwide revenues from subscription software licenses are expected to increase at a 16.6% compound growth rate (CAGR) through 2008, when the market is expected to reach US$43 billion. Perpetual license revenues, on the other hand, are expected to decrease during the same period by a 0.3% CAGR, according to the research firm. “The increased interest in subscription licensing stems from industry consensus that traditional licensing models are no longer suitable,” Amy Konary, IDC programme manager for software pricing and licensing, says in the report. “It does not work for vendors, and it does not work for customers,” she notes. The renewed appeal for subscription licensing does not remain unnoticed by software vendors, who have immediately remodelled their licensing programmes to accommodate pay-per-use packages. In fact, a study conducted by Macrovision and the Software and Information Industry Association (SIIA) reveals that software publishers are moving aggressively to the subscription model, with 40% of software vendors offering subscription-based models as their primary pricing model today compared to just 7% last year. By 2007, an additional 20% of vendors are expected to use subscriptions as their primary licensing model. The data, according to Fred Hoch, vice president of software programmes for the SIIA, suggests that the perpetual licensing strategy will continue its gradual decline and subscription-based methods will likely soon become the pervasive model in place. “There is a marked trend to move away from licensing toward the subscription model,” he says. “The likelihood is that the subscription model will continue to rise across all segments of the software industry, but we believe the perpetual license model will continue for some time,” he adds. One of the first vendors to dabble with subscription licensing is Sun Microsystems, which currently offers its whole stack of Java-based software under a subscription model, alongside its perpetual license packages. “We were the first people to do it en masse,” says Jamie Bliss, software sales manager, Sun Microsystems Middle East and North Africa. “What we did is spot the need from the customers and implemented what we understood the customers’ needs to be, rather than say, ‘Let’s put this for whatever reason,’” he reveals. “Essentially, what we saw in a lot of customers was a lot of spiralling software costs due to an increasing amount of machines or number of customers that they were bringing on board,” Bliss continues. “As a company, we made a call that we are not going to penalise an organisation for being successful. What we came up with is a subscription model based on a per-employee basis, and not on how many customers you have got,” he adds. Bliss believes that customers prefer subscription licensing because it not only gives them the best value for their money but it ensures that there are no hidden licensing costs every time they change something, for example in the configuration of their servers. “The customer knows exactly what their software licensing is going to cost them year-on-year. There is no ambiguity. There is nothing like that,” Bliss says. “What we give them is more choice. In every deal we look at individually, we look at whether or not it is going to be more cost effective for an organisation to have subscription-based licensing or is it going to be more effective for them to have normal perpetual licensing. If it’s close, we give them both options,” he says. The continuing market acceptance and understanding of emerging trends, such as hosted software and on-demand and utility computing, have shown vendors that these new methods deliver improved value and satisfaction to their customers, while providing greater revenue predictability. In the SIIA study, 43% of the vendors interviewed disclosed that the primary reason why they were moving to the subscription model is to enjoy greater predictability of revenues. The second most popular reason was to foster customer adoption by offering a lower up-front price for their software. As a result, companies are in a good position to negotiate lower costs and licensing deals that favour themselves. That, however, does not necessarily mean that vendors will just bow down to their customers’ whims. CIOs and others involved in negotiating subscription licenses must remain vigilant and push for the best deals. There are a number of advantages when subscribing software. When companies license software on a subscription basis, they get predictable, low costs, access to the product’s latest features, a strong bargaining position with vendors, and good vendor service. At the same time, firms can avoid a “sunk-cost” mentality, where they are trapped in the idea that since they spend a lot of money buying software, they need to keep it and make it work. Software licensing lets them avoid feeling locked in and gives them the flexibility to move forward if the software is not a good fit.||**||Future flexibility|~|Jacqueline-Woodsbody.jpg|~|The capital expenditure is less, says Oracle’s Jacqueline Woods. |~|“Some of the positive attributes of a subscription model are related to your upfront investment,” says Jacqueline Woods, vice president, global pricing and licensing strategy, Oracle. “Typically, with a perpetual licence where you’re owning the software in perpetuity, there is an investment which is required up front. It’s like leasing versus buying; if someone was “leasing” a car rather than buying a car, if you lease a car the upfront capital you must lay out to do that is significantly less than if you were in the purchasing mode. The same goes for software; the capital expenditure is just less,” she goes on to say. And since rental software is considered a service, subscription licenses are treated as a business expense and not a capital asset in the accounts. Recognising software as an operating expense saves accounting personnel from having to track monthly depreciation. Treating software as an expense also coincides nicely with other PC-related monthly lease payments that enterprises may have undertaken. Some enterprises wish to lease software in much the same way that they now lease computer hardware. IT organisations can still fund projects with small capital budgets by renting the software portion of the project. IT organisations can expense the hardware as well by subscri- bing to rental-based application services and managed services. “Most companies today don’t want to spend out of their capital expenditure budget. So for customers to have a choice of licensing on an annual basis, it means it comes out of their operational expenses,” Bliss explains. “That way they avoid having to spend more of their capital budget, which consequently minimises the depreciation of the assets that they buy,” he adds. With subscription-based licen- sing, acquisition and maintenance are bundled into one calculable bill. Organisations can negotiate contracts to cover multiple years, providing price protecti- on. And although a subscription agreement includes financing charges, it also furnishes customers with the right to install software upgrades. On the other hand, when a company buys and maintains software, there are usually version jumps not covered in the maintenance agreement. Subscription licensing is simple because it keeps license administration to a minimum. Since organisations pay for licenses as they use them, it eradicates the constant tracking of the number of used versus purchased licenses. Some subscription-based software tracks actual usage and bases invoices on this usage, enabling IT personnel to add or subtract clients at any time without necessitating a license inventory. Other subscription-based software only requires a year- over-year PC count to renew. It also allows companies tohold vendors accountable for their quality of after-sales customer support and service. If a customer is not satisfied with the vendor’s post-sales treatment, he or she can end the subscription at any time — depending on the contract notice period — and move to a competitive solution with little financial loss. Consequently, vendors offering subscription licensing must ensure customers are always satisfied to guarantee subscription renewals. Most companies will find a greater commitment to customer care in vendors offering subscription licensing. Flexibility is another major benefit companies will experience when they opt for subscription licensing. If, for instance, an organisation is to use software for a certain project, it can easily discontinue the subscription after the project is completed without incurring the financial and technological risks of a lifelong license. Similarly, if a company undergoes budget cuts, it can simply stop the subscription of certain software. “[In some cases] companies may be piloting something, they haven’t necessarily decided that the project is 100% go, and they want to minimise some of the risk associated with that kind of cash outlay — particularly if it’s not a project that has been necessarily fully funded by their company or their organisation. So you will see those kinds of opportunities that lend themselves well to a subscription model,” Woods says. By licensing software by subscription from a good vendor, companies can ensure the software’s future viability. The subscription model forces the vendor to recognise that spending operational dollars on its client’s software subscriptions must provide value now as well as in the future. But new opportunities offered by subscription licensing also bring added challenges. First of all, companies need to protect themselves against unforeseen price increases that often come with subscription license deals. If customers are not careful to discuss protection against sudden price jumps, they could end up with inflating software costs. At the same time, they also need to be able to calculate usage patterns carefully, since costs of some subscription deals can escalate if usage unexpectedly increases. And while subscription licensing is seen as a cost-effective outlet for some companies, unfortunately, it is not for everyone. Paying subscription fees annually may create a greater financial burden for some customers compared to a more expensive up-front payment, particularly if a company ends up using the software for 10 years or more. In order to get the best deals, they need to analyse the financial benefits, calculate the expected time frame for the IT investment and work with their financial managers to make sure they are choosing the right model. If a company is going to use the software for a long time, it is better for them to go with perpetual licensing. It also does not make sense if the software involved requires extensive customisation as it is less appealing because subscription costs can mount over time. “There is a rethink with regards to how software should be licensed. I think it’s quite clear that there is a consensus towards subscription of low-end software, things like CRM software, Salesforce.com, Microsoft products, those kind of technologies,"says David Brierly, regional manager, Cognos Middle East. "But when you get to the higher end of core performance management, ERP, all those large enterprise solutions, the industry is looking at redefining charged licenses. Subscription, at the moment, is some way off,” he continues. “None of the other major vendors in our vertical are looking at this. If you think about subscription licensing, typically it’s all web-based. Salesforce.com is an ASP application provider of CRM solution. You can sign up whether you are just one user or a thousand users, and they give you access to basic CRM functionality. There’s very limited customisation that can take place,” Brierly adds. “If you look at what we do, which is core performance management, or what an ERP vendor does, every single implementation is different by as much as a factor of 50%. At the moment, it would be very difficult to set up an ASP model for large enterprise solutions simply because they’re so customised,” Brierly continues. “Subscription really works for software that can be contained into certain amounts of functionality that users can take on. When you’re looking though to embed a technology into a very complex infrastructure in a large organisation, then it starts getting more complex because there is so much services around implementing, the customers typically want to own everything themselves, they don’t want to rely on third-party hosting. So it gets a little bit difficult to go with a pure subscription method,” he adds. Instead of subscription licensing, Brierly says they are moving towards a role-based licensing model where customers pay only for the functionalities they use rather than shell out a hefty, one-off fee. “We have redefined our licensing and pricing model about 18 months ago. It’s safe to say that the major reason why any company changes its strategy model is to be more customer-friendly,” he states. “And the old model of you pay one price per usage irrespective — if you use 5% of that functionality or 100% — you pay one fee, is something that Cognos felt was not being fair to the customer. So we came up with role-based pricing, which means that we only charge you for the functionality you’ll be using out of our platform, and that’s gone down very well with our customers,” Brierly claims. Ultimately, the choice of whether or not a company should go for subscription licensing boils down to a simple financing question driven by usage. Will it be more cost-effective for the company to rent software or purchase software? And when you do decide to go for subscription licensing, make sure that your license agreement is flexible enough to allow for growth at reasonable rates, advises Jitendra Kapoor, business development manager, Online Distribution. “In the Middle East, we found that most companies do not have a choice. They have to go with subscription licensing because it is what is being offered by the vendors,” he adds. “However, while most clients do not question the model, they should make sure that the license agreements they sign give them enough leverage to protect their investments in the future,” Kapoor explains. “Ideally, customers should go through their contracts carefully to make sure that they get some sort of price protection against unexpected annual increases as well as warranty coverage,” he goes on to add. Subscription licensing, compared to perpetual licensing requires companies to plan ahead. While, initially, vendors agree to provide you certain price caps, most of the time, they will not agree to give customers price protection forever. The best thing companies should do is to constantly review contracts, ideally a year before the contract expires so that you can start exploring other options to minimise the risk of the subscription agreement or begin renegotiating with your current vendor while you still have enough time to look for alternatives.||**||

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