The growing preference for companies to use third-party cloud-based software services is having a profound impact on the enterprise technology market. For software providers, the subscription business model is becoming the dominant one. Worldwide, perpetually licensed software revenues will shrink by a compound annual growth rate (CAGR) of 6.1% between 2020 and 2024, while software subscription revenues will grow by a CAGR of 16.6%.¹
New Software-as-a-Service (SaaS) entrants were “born in the cloud,” but numerous hardware and software companies started out with traditional on-premises licensing models. Those companies want to add a subscription element to their business. Eventually, many companies may also offer their products on a pure consumption or “by-the-drink” basis, although this model is still in its early days.
While there are certainly risks involved in transitioning away from the traditional on-premises licensing model, there are also great rewards. Valuations of enterprise technology companies that adopt subscription models with new value metrics like annual recurring revenue (ARR) and net revenue retention (NRR) are higher than those that generate most of their revenues from perpetual licenses. The higher valuations occur because subscription earnings are more predictable, and companies that offer them can generate more revenue over the long haul. A recent CIBC World Markets study found that, on an annual basis, SaaS stocks outperformed the mature software names, with an average stock price return of 83% vs. an average year-to-date mature software return of 22%.²
Subscriptions don’t necessarily generate big up-front fees like traditional licenses do, but the lifetime value of each customer is often greater, as long as enterprise technology companies effectively manage churn and are successful at selling additional services to their clients. Subscription models are tremendously scalable, so providers can grab a bigger slice of an expanding pie. Using a land-and-expand strategy, enterprise technology companies can sign customers up to small deals and expand their footprint to more products and services over time. This also applies to by-the-drink consumption models, where customers can try new products for a very low cost (or even free) and expand usage as their needs grow.
But this transition is neither simple nor rapid, particularly for those enterprise technology companies that offer traditional products and services. EY professionals interviewed subject-matter resources in the enterprise technology industry to identify the key operational, financial and strategic challenges companies face as they consider making the transition. These discussions uncovered several key learnings and leading practices, but the pace of change varies; some companies are rapidly adjusting, while others are struggling to work out which steps to take, how and when. Often, the determining factors are based on the nature and complexity of their product offerings and the need to maintain certain legacy businesses.
The transition away from traditional licenses doesn’t happen by flipping a switch. Respondents are typically taking five to seven years. Regardless of where enterprise technology companies are in their transition, our research shows that moving to a subscription model requires an extensive enterprise transformation, not just technology re-platforming. Our interviews uncovered several transition challenges, but they largely encompassed four main areas:
- Pricing and bundling
- Sales transformation and customer incentives
- Operating model change
- Key performance indicators (KPIs), accounting and revenue management