EXPOSED SUBSCRIPTION MYTHS AND HOW HARDWARE AND SOFTWARE BUSINESSES CAN SWITCH TO RECURRING-REVENUE MODDEL

May 11, 2021
|
Emmanuel Umukoro
“The advantages of transitioning to flexible subscription pricing are closer than they look, but common misunderstandings keep businesses from making the switch.”

Switching your business from an up-front to a recurring revenue model can appear to be a hard task that might take years before it brings a payoff. High-tech companies frequently embark on large-scale initiatives that necessitate significant capital investments in new products, such as multitenant cloud solutions or managed-service offers with multiyear lead times. High-tech firms miss out on an opportunity to quickly adjust their business model to the new way customers prefer to purchase software and hardware: flexibly, without large upfront expenditures, and with costs that reflect the economic value, they obtain by focusing solely on the long term.

Gratifying latent demand for flexible subscription pricing not only allows the company to acquire substantial lifetime value from existing customers, but it also allows them to reach previously untapped customer segments, such as business units that prefer operating expenses over capital expenditures or businesses with cash constraints that prevent them from making large upfront investments (Exhibit 1). Furthermore, businesses who are hesitant to commit fully yet desire flexibility might be open to experimenting on a subscription basis. In addition, subscription pricing helps high-tech companies reduce the end-of-quarter "fire sales" that are common in up-front models.

“Flexibility and the ability to manage cost are driving customers to subscription”

Vendors that do not adapt to these new market realities will find their existing business strategies under increasing pressure. The demand for discounts on large up-front deals is rising as customers shift their software and hardware purchases from the capital to operating expenses and as expectations for lower year-one costs for high-tech purchases rise. For all of these reasons, most high-tech companies can no longer afford not to switch to a subscription-based revenue model.


The Myths

There is enough "case law" in the market to prove the value of subscription pricing, as seen by the numerous successful business-model conversions in software, printing, and even aviation engines. Despite this, we find that organizations frequently misinterpret crucial components of the transition in our engagement with them. Let's demystify that now Here.


1st Myth - It's difficult to handle offering both perpetual and subscription options for the same product.

Adobe and AspenTech, for example, implemented some of the most successful subscription model changes by phasing out perpetual offerings immediately or within a 6- to 12-month time frame. While this method can be quite effective, it isn't appropriate for every transformation. A hybrid strategy combining perpetual and subscription products for a two- to three-year term can protect income and provide a safe transition for B2B software vendors serving large companies. A still decisive—but not big-bang—transition allows vendors to capture the full benefit from customers that value the subscription model’s flexibility most. Your salesmen need to be able to position the best offering in such a hybrid scenario. Giving sales agents a compensation scheme that is neutral between perpetual and subscription items with the same lifetime value allows suppliers to fully capitalize on the latter.


2nd Myth - Customer hunger for subscriptions dictates the speed of your transition.

Vendors typically wonder if demand will be sufficient for a quick transition before releasing a subscription item into the market. Experience has shown that demand nearly always exceeds expectations, and the vendor's internal constraints become the limiting factor for the transition's speed. The ability to bear the likely short-term cash outlays and revenue declines, operationalize subscription offerings from the opportunity to cash, and give your sales force real incentives to sell subscriptions are typically the three critical success factors for a fast transition to the subscription model. Even simple accounting issues (such as vendor-specific objective-evidence treatment for licenses) can prevent companies from moving forward with subscriptions more aggressively. The adoption of the new ASC 606 accounting standard, fortunately, has created a natural window of opportunity to speed the transition.

The ramp-up can be swift if done correctly: going from single digits to 30% or even greater levels of subscription bookings in the first 12 months of the shift is possible and even common.

3rd Myth - You must migrate to the cloud to make the transition

Many businesses use the terms "cloud" and "subscription" interchangeably. To capitalize on the recurring revenue opportunity, distinguishing between the deployment model (cloud versus on-premise) and the business model (perpetual versus subscription) is crucial. There is undeniably rising demand for cloud solutions in the industry, and for most software organizations, a portfolio shift toward software as a service is the best long-term plan. However, in most market groups, one type of customer demand outstrips even the need for the cloud: flexible subscription options. For instance, we discovered that over the last few years, the preference for on-premise software subscriptions has risen to 82% from 63%. The subscription model's simplicity and flexibility are highlighted as the major reasons for this transition.

“Market demand for on-premise subscription software has greatly increased in the last 3 to 5 years.”

We consider the cloud or hosting as one of many methods to provide a differentiated subscription product to your customers through this perspective. With on-premise subscriptions, you can also offer customers a stepping-stone for their eventual migration into the cloud—they can flexibly “remix” their on-premise subscriptions into cloud subscriptions, thus avoiding the problem of under-appreciated perpetual licenses. And establishing new on-premise offers is easier than developing new cloud offerings: you may convert your existing price book to subscriptions in one or two quarters rather than one or two years.


4th Myth - It's a zero-sum game between vendors and customers when it comes to subscription pricing.

It may sound contradictory, but subscription pricing can help you enhance client lifetime value. After all, your consumers can and will calculate the total cost of ownership of a subscription and may or may not be willing to pay a considerable premium over the cost of a perpetual license. However, we've noticed that there's usually always a window when both the vendor and the customer's economics are beneficial. The rationale is simple: if you can demonstrate the commercial value of your software to clients and ensure their success, churn will be low and customer loyalty will last far longer than the three to five years business case. They'll happily continue to pay for commercial value, but not for what may be considered "shelfware."


The vendor's client lifetime value can be significantly increased by striking the correct balance between high subscription fees and strong adoption rates. Vendors also can't overlook the increased sales efficiency that comes with subscriptions' enhanced focus on actual cross-sells and new functionalities. Vendors are also less likely to be subjected to discounting pressures, which helps to protect long-term value.


5th Myth Your clients will never give up their existing licenses in order to switch to subscriptions.

It appears to be paradoxical. Why would customers switch from single-use licenses to subscriptions? After all, they'd be returning a product they already own to the vendor to rent it again. We discovered that more than half of customers are open to doing so, a quarter has already made the decision, and over 15% are in the process of doing so. The reason is simple: the migration allows them to clear up years of complicated perpetual contracts, eliminate unused licenses, and negotiate a subscription contract that is more aligned with the business's genuine needs. A critical element of a successful transition is rightsizing customers. Vendors must carefully categorize them based on criteria such as fresh demand and underused licenses, and personalize the value proposition of the subscription to each segment. The migration benefits both the vendor and its customers with the correct safeguards in place, and it speeds up future subscription upsells and cross-sells by avoiding the complications of a hybrid licensing contract.

“Most enterprise software customers are considering or already transitioning to subscription products.”

Taking advantage of the subscription opportunities

The switch to subscription is becoming common, as seen by numerous successful case studies in the industry. We discovered four fundamental steps that are crucial to success in our work with multiple software and hardware companies that achieved this transition. The steps are:

  • Differentiate your subscription offers through packaging, pricing design, customer-success services, and contractual flexibility so that customers don't perceive the switch solely as a price change.
  • Take a segmented approach to migrate existing customers—proactively, selectively, or reactively—and provide dedicated teams to assist your sales force in executing such migrations with suitable guardrails.
  • Treat the transition to a subscription business model as a cross-functional transformation that affects every department in your company, including sales, marketing, services, product management, engineering, and finance.
  • And lastly, make a bold move into subscriptions, with aggressive adoption goals.

We've adopted this simple approach over the years and it has worked for many putting their recurring-revenue transformation on a path of success. And if you need help with replicating the success with your business, click the get started button or write me at success@trychargezen.com.

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