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License Versus Subscription (SaaS) Pricing – What’s Better For Your Business?

License or subcription

In the last 10 years, we have seen a great migration from license-selling to subscription selling. Once thought impossible, Microsoft is selling its best-selling productivity software (The Office Suite) in subscription mode.

This offers a lot of benefits to the end-user:

  • They have access to the latest version of the software
  • They have access to the latest bug-fixes and technical support.
  • The pay-as-you-go model eases the cash flow
  • You can drop at any moment (depending on the contract) if you are not satisfied, and find a better service provider.

There are also benefits for the software developing companies:

  • Moving users to latest edition, the resources traditionally allocated to maintaining previous editions can be allocated to developing new features.
  • The salespeople have to sell the product once (not each time the license expires), therefore more resources can be allocated to hunting instead of farming.
  • Initial investment by the buyer is one of the barriers to sales. Lowering (or removing) the initial one-off purchase, selling becomes easier.

On the other hand, moving from license selling to subscription selling comes with certain risks:

  • Many companies do not have an automated billing platform. Current traditional / manual billing processes cannot handle up-to-12x increased workload.
  • Since the company has to collect receivables more often, it increases the credit risk.
  • Customers can drop any moment. The engagement of “customer success manager” type of resources become necessary to keep customers loyal (at an additional cost).
  • The transition year (the first year of switching from license to subscription) poses a great cash flow risk, and has to be managed closely.

In this article, we would like to address two challenges in transitioning from license selling to subscription selling:

  1. How to set subscription prices?
  2. How to manage the cash flow during the transition year?

How to set subscription prices?

We all know that price-setting must be done outside-in, looking at the market, competition and substitutes first. However, in this article I will mostly focus on the inside-out part (profitability concerns) of the price-setting activity.

First, let’s set an easy-to-analyze scenario:

You have a software that you sell for $240, which comes with 2 year technical support (including version upgrades, bug fixes and technical support). You expect customers to renew the license every two years to keep covered. Your company is also in a rhythm to come up with the new edition of the software every 2 years.

In this case, you could easily calculate that your monthly revenue generated out of this software is $10/month, and you might want to set your subscription prices at $10/month.

However, we should also consider the increased costs that come along with the monthly-billing:

  • Cost of additional invoices sent (especially if they’re sent by post)
  • Cost of customer loyalty – do we need to engage customer success managers?
  • Increased revenue-drop due to churn (in an license-sales customer pays the 2-years-worth license fee up-front. Even if they do not renew the license, you did your revenue for 2 years. But in subscription model the customers can drop after x months, leaving you with less revenue).

We should try to balance these down sides with the following up-sides:

  • Increased number of customers thanks to low initial investment (1-month subscription payment versus up-front 2-years payments).
  • Resources freed-up from maintaining previous editions.

I estimate the cost of serving to be higher at a subscription model. Also, taking the “benefits to the end-user” (I drafted at the top), I believe the subscription price should be higher than the $10/month. Based on how you weigh in the above arguments (and comparing against the market), you can come up with how higher it should be.

How to manage the cash-flow during transition year?

Receiving the full-amount of license at the beginning of the period will boost your cash the first month and then you will be able to spend according to the plan. However, cash flowing in the same speed as it goes out is scary – a short period of customer churn can drive you to bankruptcy.

To avoid the risk of illiquidity, consider transitioning the customers from license to subscription in segments. Start with new customers, and some of your existing customers that generate 10%-20% of your revenues first. At this first iteration, although you have encouraging results, wait a period of 6 months to collect data. Critically review your pricing – if the churn increases, will you be able to keep your profitability? Does the price you set prove to be correct? Check with customers, whether they are happier with the subscription or license model. And once you calibrate your model, go an and transition another segment of your existing customers to subscription model.

Also, have a look at your payables. Are there large expenses you make that could be paid in settlements? Can you switch to subscription model with your large suppliers to balance the cash flow?

The start-ups that start selling their services as subscription-only are usually on funding, and have incorporated this business model into their business cases. They will have less to worry about transitioning. However companies with an existing revenue (and a customer base) that use licenses will need to manage the transition carefully.

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