Power Shift - InformationWeek
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John Foley
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Power Shift

Users gain flexibility and influence with new software pricing models

A one-year experiment in subscription-style software licensing by the University of Florida's IT department has yielded an enviable outcome: Access to the most up-to-date software, predictable costs, and increased bargaining power, as well as the ability to walk away from it all at any time for any reason. The experience has made the school's decision to renew the license with Mercury Interactive Corp. an easy one. And it shows why subscription licenses are fast becoming a popular way of acquiring new software, accounting for about half of new deals for some vendors.

"This is a good thing for us," says Mike Conlon, the University of Florida's director of data infrastructure. "We didn't put out a big pile of money to get a particular piece of software. And the vendor has a different kind of incentive to be responsive to us--they don't have our money."

Some industry analysts predict subscription-based licensing models are about to break into widespread acceptance as alternatives to perpetual licenses, the status quo in the software industry. Research firm IDC last month predicted "dramatic shifts" in software business models as a growing number of customers shop for more flexible licensing options. "Vendors that can't accommodate these models will eventually be at a competitive disadvantage," predicts IDC analyst Amy Mizoras Konary.

As a result of this change, business-technology managers responsible for software purchases find themselves with more options in dealing with vendors and in stronger negotiating positions. Tech buyers who opt for subscription-based licenses say the deals force their vendors to be more accountable and responsive. "They really want to make sure they keep your business," Conlon says.

Even nonconverts see the logic. "That's the way the industry will be going," says David Gillhouse, VP of IT with Chamberlain Group Inc., a manufacturer of garage-door openers. Chamberlain uses software from 40 or more vendors, but Gillhouse counts Microsoft's Software Assurance program as the only subscription deal among them. "The key in doing those arrangements is in selecting the companies you think are going to add value to your business and be your partner," he says. "As far as a basic business model, I think it's very good."

IDC estimates a quarter of all software sales today are tied to subscription licenses, so the transition is already in gear. In a recent IDC survey, 61% of vendors and 60% of customers say they expect the software industry to move to subscription-based licenses in the next year. And 43% of software vendors surveyed believe a majority of their business will be done via subscriptions six years from now.

"It's good to have an option," says Jim Trupiano, manager of IT contracts and vendor relations at Southern Co., an electric utility. Southern uses SAS Institute Inc.'s data-analysis products under a subscription license and has been approached by three other software companies with subscription offers in the past year. So far, Southern hasn't opted for the new licenses. "You have to look at it on a case-by-case basis," Trupiano says. "It's all in the analysis of the dollars."

Jason Maynard -- Photo by Jonathan Sprague Redux Pictures

It's time to change the way Wall Street values software companies as more of their revenue is deferred through subscription licenses, says Merrill Lynch analyst Maynard.

Photo of Jason Maynard by Jonathan Sprague Redux Pictures
The trend is gaining so much momentum that Merrill Lynch software analysts have come up with a new method of assessing and valuing software companies, one that takes into account the growth in deferred revenue that results when vendors move in this direction. "Our view from a Wall Street perspective is, this is starting to ripple through in how the reported [financial] results look," says Merrill Lynch software analyst Jason Maynard. "The way we value companies has to change."

The brokerage firm has devised a formula, called the Merrill Lynch On-Demand Index, for measuring the performance of software companies using metrics that go beyond the standard stock-price-to-earnings or stock-price-to-sales gauges. Applying the index, Merrill Lynch analysts have crunched the numbers on 75 software companies, including Autodesk, Computer Associates, IBM, Mercury Interactive, Microsoft, PeopleSoft, and SAP, and this week they'll release the results. The numbers will provide a baseline for evaluating companies' future performance.

The trend toward subscription contracts is being driven in part by customers' dissatisfaction with the old way of deal making. Perpetual licenses can entail large up-front costs and annual maintenance fees that can reach 20% of a contract's initial value. Also, because software companies have become dependent on big, onetime perpetual-license deals to meet quarterly forecasts, high-pressure sales tactics come into play.

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