By Eric Mersch
The dominating popularity of SaaS applications among end users, enterprise software buyers, and investors continues to create tremendous pressure on perpetual software and hardware businesses to offer subscription versions of their applications or even to transition their entire business to a subscription model or SaaS model. Software companies that still sell perpetual licenses on a transactional basis, i.e., a one-time exchange of product for money, are looking for ways to build a cloud-native software product that can be sold on a subscription basis. CallidusCloud is a prime example of a company that transitioned its business from a perpetual to SaaS model. Hardware-first companies with combined software and hardware appliances seek to outsource hardware and offer cloud-based versions of their software. Datrium is a great example of a company that converted its data storage business to a pure SaaS business in which customers acquired the necessary hardware separately. That successful transition led to its acquisition by VMWare in 2020. These are unusual examples though; approximately 50% of businesses that attempt a SaaS pivot fail at doing so.
The business case for moving to SaaS is so strong that this business model will continue to dominate the software industry, managing an increasingly large percentage of the world’s data activity. According to Cisco projections, by 2021 75 percent of the total cloud workloads and compute instances will be SaaS workloads and compute instances.
At FLG, we’ve worked with many native SaaS companies as well as technology companies that seek to transition software and hardware businesses from a single transaction-based business to a SaaS delivery model. As strategic advisors, we help companies manage the financial and operational requirements of the SaaS business.
One question we frequently hear from clients who ask for our leadership in planning and managing transitions is how to differentiate between transactional and subscription models.
In this article we put forth a framework that addresses this question. Understanding how to make this differentiation is the first step in making the transition to a SaaS model.
Software Licensing Revenue Classifications
There are four test criteria that companies should use to determine the proper classification for software licensing revenue. At a high level, these tests refer to:
- Right to Use the Product
- Physical Transfer of the Product
- Obligation for the Product
- Product and Service Bundling
For the purpose of detailing the specifics of the four tests below, “Vendor” is the software vendor and the “Customer” is the purchaser.
1. Right to Use the Product
Under the Perpetual Model, the Customer has legal title to the asset in perpetuity and acquires this right through a single payment to the Vendor. The fee arrangement can be a per user basis or enterprise-wide flat fee, colloquially referred to as an “all you can eat” deal. In any case, the single fee allows for access forever.
Under a Subscription Model, the Customer has the right to use software only during the term of the contract. The subscription fee arrangement can take the form of a flat subscription per a certain period, a per-user rate, a usage-based fee, or some combination of the three.
At the end of the stated term of a subscription contract, the software must be made unavailable to the Customer. The Customer’s software may be instructed to halt operation or even disable or remove itself permanently upon certain conditions being satisfied. For cloud-based and delivered software, customer accounts are disabled, and access is denied. For on-premise software that employs a routine connection to the Vendor’s servers, a signal can initiate the disable feature. On-premise software with no connection can feature a built-in timer that disables the software. This last feature is frequently referred to as a “software kill switch.”
2. Transfer of Product
Under the Perpetual Model, the Vendor has transferred physical possession of the software to the Customer. This is typically done via online download.
Under the Subscription Model, the Vendor maintains control of the software and has an obligation to provide bug fixes, updates, and upgrades. In a very real sense, the Vendor never makes a physical transfer of the software to the Customer. This is true whether the Vendor chooses to deliver it remotely from its own servers, leased servers in a third-party data center, or via a third-party cloud provider.
3. Obligation for Product
Under the Perpetual Model, the Vendor transfers the obligation for the product to the Customer, which incurs the risks and enjoys the rewards of ownership of the asset. The risk associated with ownership is in the internal management of the software delivery. The Customer must maintain the systems and manage the personnel necessary for the delivery of the product to users. It must also train end users to maximize the adoption and engagement among employees. The software’s functionality is static, meaning that it will become obsolete at some point.
In return for accepting this risk, the Customer enjoys all of the rewards of the software purchase. High availability and effective training may generate value far in excess of the purchase price thereby, lowering the Total Cost of Ownership. Customers that need highly secure environments value the control over the software operation and the data stored by the software. Because of this risk/reward profile, only large companies and federal agencies tend to purchase software on these terms.
Under the Subscription Model, the Vendor retains the obligation to maintain the software and systems necessary for the delivery of the product to the customer throughout the subscription term. The Vendor also retains the obligation to deliver upgrades and enhancements, usually on a fixed routine. The reduced operational risk makes subscription software licenses attractive to startups.
4. Product and Service Bundling
Software Vendors offer a variety services such as one-time fees for integration and set-up, as well as ongoing, recurring services, maintenance, and support services. These recurring services are often referred to as Post-Contract Support (PCS). In public filings, companies use terms such as Maintenance and Support to describe these services and one-time items carry the “Professional Services” title.
The key term to understand here is Vendor-Specific Objective Evidence, or VSOE. VSOE is a GAAP revenue recognition method that enables companies to recognize revenue on specific service items when these items are bundled into a contract. For example, if a vendor offers software and service for a single price, the vendor recognizes revenue on a single line item. However, if the vendor can demonstrate that current market data allows specific pricing on the service, then service revenues can be disaggregated from the total revenue and recognized as a separate line item.
For either perpetual or subscription business models, the Vendor’s ability to determine VSOE impacts the amount recognized as a subscription revenue, and when it’s recognized.
Taking a step back, Vendors that offer software on a perpetual or subscription (or a hybrid) basis offer a variety services such as one-time fees for integration and set-up, as well as ongoing, recurring services, maintenance, and support services. These recurring services are often referred to as Post-Contract Support (PCS). In public filings, companies use terms such as Maintenance and Support to describe these services and one-time items carry the “Professional Services” title.
Under the Perpetual Model, Vendors typically offer some level of ongoing PCS and include the fees in the total deal. The Vendor will offer PCS over some period of time, which usually ranges from 1 to 3 years. If the Vendor can establish VSOE, then it will break out these services into a separate line item for reporting separately. This methodology has the effect of generating subscription-like revenue, especially when the Customers renew.
Under the Subscription Model, ongoing PCS is a standard part of the licensing agreement. VSOE is typically difficult or impossible to account for separately and revenue is therefore recognized ratably over the term of the contract.
Here’s an important point regarding perpetual licenses with separate revenue line items for software licenses and PCS: although the PCS looks like subscription revenue, it would be wrong to categorize it as SaaS. Maintenance and Support revenue requires significant labor, which reduces the scalability of this revenue. Additionally, as with any labor-heavy service, gross margins will be much lower than those for software sales.
Use Cases for Revenue Classification
There are a number of applications for which one can employ the Four Tests for revenue classification. The most obvious is in financial reporting. The greater the percentage of your revenue that is classified as subscription, the more important the need to use SaaS metrics in measuring your business. Therefore, you will want to track and report top-line metrics such as Bookings, Billings, Annual Recurring Revenue (ARR), Net Expansion, and unit economics measures such as Customer Lifetime Value (CLTV), Customer Acquisition Cost (CAC), and Net Retention metrics.
A second use case is not as obvious but can be very valuable in bridging the parameters under which your customers operate and the need for financial reporting best practices. For enterprise software deals with a relatively high average selling price, large enterprise customers (i.e., Fortune 1000) will likely want to use capital budgets for the purchase of perpetual licenses. Yet the vendor will continue to innovate on the original software version and this innovation can create compelling reasons for the customer to upgrade from the original purchase. In such cases, the Vendor-Customer relationship looks very similar to that of a subscription model and should be measured and tracked as such in your financial reporting. Using the Four Tests, you can craft a subscription model contract that enables your customers to use capital funds, while highlighting the recurring value add of your business.
A third use case relates to a company’s product development strategy. Perpetual software license vendors who recognize the compelling financials of the SaaS business model will want to pivot in that direction. In this situation, the Four Tests can guide the early development of your technology roadmap. For example, online connectivity between the customer’s on-premise software and the vendor not only makes the perpetual license relationship look more like a subscription relationship, but such a feature also provides activity and availability monitoring, diagnostic feedback and upsell/upgrade opportunities.
A fourth use case refers to companies engaged in SaaS pivots, which is the phrase describing how companies – from software to hardware technology businesses – transition from a transactional model to a subscription business model. Using the Four Tests, a company can track change in revenue mix during the transition and use this metric to communicate the success of the transition.
FLG Partners is well versed in providing guidance to clients when evaluating the subscription versus perpetual business models. Distinguishing the well-established benefits of the SaaS business model will help you develop your go-to-market strategy but adequately understanding the importance of contract structure when negotiating enterprise deals is even more critical.
If you need further advice and counsel with regard to revenue classification, revenue recognition and SaaS business model evaluation, contact our team at FLG Partners.