CIO

Subscribe Now, Pay Later?

CIOs need to protect themselves against the unforeseen price increases that often accompany subscription licence deals. If customers aren't careful to negotiate protection against steep price jumps, they could end up with ballooning software costs

While subscription licensing offers certain advantages, beware unforeseen price increases down the road.

READER ROI

  • How subscription licensing can save money in the short term
  • Ways to protect yourself from price increases
  • When subscriptions don't make sense

Two years ago, Whole Foods Market CIO Mike Clifford surveyed the software landscape with a sense of dread. He knew he had to replace his ageing home-grown data warehousing systems and do a better job of connecting inventory information from Whole Foods stores across the US. Like most CIOs in his position, he was on the lookout for the best deal and fit for his company. But he didn't want to go the usual route: tough negotiations leading to a million-dollar deal to buy the software code outright. He was tired of the typical software pricing and licensing agreements that can trap customers into lengthy deployments and saddle them with hefty maintenance and consulting fees. "I find the pay-in-advance software licensing approach appalling," says Clifford.

Instead, Clifford negotiated a subscription deal with retail software vendor Retek last year, for which he pays a yearly fee and is expected to renew only if he is satisfied. Clifford admits that, in the long run, he may not save money with his subscription licence. But if he isn't happy with the software, he is free to walk away. "The savings are huge on the risk side," he says. And he adds that the vendor is more responsive and eager to get a new system up and running quickly, knowing that the renewal is dependent on the initial performance. (Retek has since agreed to be bought by Oracle.)

Clifford is capitalizing on a gradual shift in the way that enterprise software is being sold. Enterprise software vendors that have long sold their wares via the perpetual licence (in which the customer buys and forever owns the software code and signs up for yearly maintenance and support for an added 15 percent to 20 percent of the licence fee) are increasingly experimenting with pricing and licensing schemes that allow customers to subscribe for a limited period of time. The subscription model, which includes "utility" (or "pay-per-use") agreements and hosted service deals, allows customers to rent software with a low up-front cost and then pay on an ongoing basis. If the fee is not paid, the software will be unplugged. The "on-demand" approach emerged to prevent some of the software blunders of recent years, in which corporations made large bets on ERP and CRM systems that ultimately failed. It can also provide a welcome choice for CIOs who want to try software for a short period of time.

But the new opportunities also bring added challenges. CIOs need to protect themselves against the unforeseen price increases that often accompany subscription licence deals. If customers aren't careful to negotiate protection against steep price jumps, they could end up with ballooning software costs. CIOs also need to predict usage patterns carefully, since the price tag on some subscription deals can suddenly rise if usage unexpectedly increases. And while subscription licensing is saving money and aggravation for some CIOs, it isn't for everyone. Subscription fees paid year after year may create a greater financial burden than a hefty up-front payment if a company ends up using the software for 10 years or more. In order to get the best deals as new licensing and pricing options proliferate, CIOs need to analyze the financial benefits, calculate the expected time frame for the IT investment and work with their CFOs to make sure they are choosing the right model.

"With no killer apps on the horizon, the percentage of software vendors offering this type of model is going to grow," says Amy Konary, software pricing, licensing and delivery analyst at IDC. "CIOs need to be prepared."

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Software for Rent: The Appeal

Roughly 80 percent of software today is still sold as a perpetual licence, according to IDC. By 2008, however, IDC predicts that 34 percent of worldwide software licences will be sold as subscriptions. Anticipating this shift, Jason Maynard, a software analyst at Merrill Lynch, has come up with a new method for assessing and valuing software companies, taking into account the deferred revenue that comes with subscription sales. Maynard's Merrill Lynch On Demand Index shows a gradual shift toward on-demand or subscription licences, he says, reflecting a "radical shift" in vendor strategies.

The trend toward subscription licences, though moving at a slower pace than the hype originally suggested, is part of an overarching shift in the software industry. For years, CIOs complained about enterprise software's cost and complexity. For every dollar spent on a perpetual software licence, they could expect to pay another six to eight times that amount on services, according to Merrill Lynch. "In what industry can you charge a customer, and then have your product fail half the time?" asks Maynard.

At the height of the dotcom boom, a raft of hosted service providers, known as ASPs, popped up and promised to deliver on software services via the Internet. Poorly thought-out business plans and technical glitches scuttled most of these ASPs, but a few, including Salesforce.com, persevered to challenge large enterprise software vendors such as Siebel Systems. Siebel now has its own hosted subscription offering, joining software giants Computer Associates, IBM, Microsoft, Oracle and SAS. And Oracle's planned acquisition of Retek will give the software giant a stronger presence in this market.

Since the tech market collapsed four years ago, buyers have been gaining leverage in vendor negotiations. CIOs have limited budgets, and consequently, software sales have taken a nosedive. According to Gartner, software pricing will continue to shrink over the next three to five years due to the advent of Web-based subscription services and low-cost offshore development.

As a result, CIOs are in a good position to negotiate lower costs and licensing deals that favour the customer. But don't expect software vendors to roll over. CIOs and others negotiating subscription licences need to remain vigilant and push for the best deals. For example, Whole Foods' Clifford says he and Retek did some tough talking before they arrived at a consensus. They finally agreed to a fixed usage fee for each year Whole Foods uses the software, with maintenance bundled into the minimum usage fee. Clifford says he would have preferred no minimum usage fee at all and adds that the fee is "still too high". But he knows he can't single-handedly transform the way software vendors do business.

Indeed, the software-for-rent model will likely always coexist with the perpetual model. CIOs are sometimes reticent to try new licensing models because they are accustomed to the perpetual model and unsure about how to calculate benefits from subscription offerings. "In many ways, it's easier to stick with the traditional perpetual licence," Clifford says. "Alternatives such as subscription licensing take a lot more work, attention, financial acumen and modelling."

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When Subscriptions Make Sense - and When They Don't

A year and a half ago, Mercury Interactive approached Mike Conlon, director of data infrastructure at the University of Florida, with a new kind of licensing offer. For a year, Conlon would rent Mercury's case tracking and load testing software, which monitors and improves performance of the university's enterprise applications, at a relatively low cost. Then, he would have the option to renew at the same price for three years. Conlon decided to take the leap because he saw little risk in renting this type of software. "We didn't have a big outlay up front, and we didn't have the burden of thinking we would have to stick with it," he says.

Since then, Conlon has renewed his deal with Mercury and says he is open to subscription deals for other software licences. The biggest advantage, he says, is the freedom to change his mind. In the 90s, he recalls that the university had a terrible experience with several perpetual licences it bought for e-mail software from various vendors. In one case, university officials had to abandon the licence; another time, they spent lots of money on fixes because of user complaints. "If we had a subscription licence for those e-mail packages, we would have saved a lot of time and money," he says.

Conlon admits that the subscription model isn't for everyone, especially those who believe they will be using the software for a long time. "There are a lot of people who believe (rightly or wrongly) that they will own the software for 10 or 20 years," he says. In that case, they should go with a perpetual licence. He advises CIOs who are tempted to try subscription licences to start with an application that they could imagine having for only two to three years. Michael Overly, a lawyer at the Los Angeles firm Foley & Lardner, also advises clients that subscription arrangements can be useful from a budgeting perspective because of low up-front investments. But if they believe they will be implementing the software for a long time and will need extensive customization, it is less appealing because subscription costs can mount over time. In those cases, forking over the money for a perpetual licence and paying up front for customization would be a better investment than paying a subscription fee year after year. CIOs also need to consider how strategic their systems will be. "When you're talking about sophisticated supply chain management that could give you a competitive advantage, then it wouldn't be the best candidate for a subscription," says IDC's Konary, adding that customers should be wary of signing up with a vendor that may not survive over the long term.

Wayne Bennett, a partner at the Boston law firm Bingham McCutchen, sees the debate over whether to go with a subscription licence as a simple financing question. "It's really the same way you would buy a car," he says. "It's a financing determination driven by usage. I have an 11-year-old car, and it's no question that I got a better deal from buying than leasing." If you use your software for as long as you might drive a car, then perpetual licences make more sense.

However, Bennett adds, "If you call your usage pattern wrong, you can get screwed." If you buy a subscription based on the number of people who will be using the software, the software vendor can increase its rates if the number of users goes up. With a perpetual licence, the customer generally pays a hefty fee up front that often covers a large number of users, so there are fewer surprises down the road. In fact, it is common for companies to overbuy software and end up with more than they actually need.

How to Protect Against Price Shocks

Jim Trupiano, manager of IT contracts and vendor relations at Southern Company, a Georgia-based utility, has used data analysis software under subscription licence for more than four years. Each year, he carefully picks the number of employees who will be using the software in order to determine the price. "Your risk is in making sure you don't have more people using it than you've paid for," Trupiano says. "If you become dependent on the software and the cost begins to double, you will find yourself in trouble." Trupiano says it's of utmost importance in the subscription licensing arena to make sure you have a flexible contract that allows for growth at reasonable rates.

In addition to the usage question, CIOs must comb their contract to make sure they are getting some sort of price protection against outrageous yearly increases as well as warranty coverage. "It's essential to negotiate with the vendor to make sure there is price protection in there," says University of Florida's Conlon. "You can't have an escalator in there."

According to lawyers who work on subscription contracts, those just now signing up for subscription deals may have some nasty surprises down the road. It's still early to point to a lot of cases in which enterprise software customers have run into trouble with subscription licences; the number of CIOs who have gone this route is still small. But the first major problems are emerging. One large national company, for example, signed a subscription deal for ERP software without negotiating price caps. The vendor, which had agreed to keep prices stable for two years, came back with a 30 percent increase in the third year. With the new fees now kicking in, the company has no time to transition to a new system. The CIO at that company, who had not been involved in the original deal, is now scrambling to negotiate with the vendor to limit the price hike, but he has very little leverage.

Attorneys advising clients on subscription deals encourage them to seek as much price protection as possible; some say to ask for seven years of price caps in any subscription licensing deal.

Most vendors won't give price protection forever, however, so software buyers need to be sensitive to the approaching end of a protection period, says attorney Overly. A year ahead of such an expiration, he says, CIOs should start exploring options with the current vendor and others to minimize the risk of the subscription agreement. Instead of getting stuck with little time to change systems, CIOs should start renegotiating while they still have time to look for possible replacements.

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It's a Numbers Game

Whole Foods' Clifford contends that with his new subscription licence with Retek, he is able to better predict his software costs. To do so, he has analyzed his usage carefully and negotiated a system in which he pays a fixed fee for every user above the initial agreement. Clifford encourages CIOs, even those not interested in subscription licences for software, to explore all options and talk to vendors about pricing and licensing before they select a product. "You won't get the best deals if you talk about functionality before pricing," he says.

To convince his CFO that a subscription licence with Retek was the way to go, Clifford walked him through some real-life examples that highlighted the problems with perpetual licences. He explained how he could better manage risk by being able to walk away if the software wasn't producing value and how the arrangement would motivate the vendor to make it work. For the moment, Whole Foods' subscription licence with Retek is the first one for the grocery chain, but Clifford is on the lookout for new opportunities. For example, he is currently struggling with a PeopleSoft system for financials that he inherited. He considers the PeopleSoft licence "too expensive per user", especially since it includes "outrageous maintenance costs". If a good subscription offer comes along for financial software, he says, he is more than ready to jump ship and abandon PeopleSoft.

Jerry Dolinsky, senior vice president of worldwide sales at Retek, says he is in talks with several other customers who are considering moving to a subscription licence. But unlike his dealings with Whole Foods, much of the interest is coming from company CFOs, who are intrigued by the idea that they can move software expense from the capital to the operating expense side of the ledger and gain flexibility.

Dave Mahler is one of those CFOs. As head of finance for Jacobs Management, Mahler was looking for a replacement for payroll systems that served 5000 employees at sister company Genmar Holdings, a large boat manufacturer. He had been unhappy with poor service and a lack of reporting from a hosted provider. Working with his CIO, Mahler looked at a couple of hosted payroll services and also considered buying a perpetual licence and doing payroll in-house. In the end, Mahler chose a subscription hosted payroll service from Ultimate Software. With a very small IT department and decentralized systems, Mahler found that the cost of paying a subscription would be similar to buying a perpetual licence and paying maintenance costs. "But when I added up the headaches of doing it in-house, it became a no-brainer," he says, noting that a perpetual licence would have meant adding to his IT staff. Mahler figures that the $225,000 he paid to set up the system will be quickly covered by the $100,000 a year he will save by avoiding maintenance fees plus the money he has saved by changing providers. And even though he will be paying Ultimate roughly $300,000 a year for the hosted service, he won't be adding to his IT department. "From my perspective, there are fewer risks, internal costs and hassles," Mahler says.

Mahler believes that corporate executives have considerable leverage with software vendors right now, but they need to do the maths for themselves to see what works best for them.

For his part, Clifford hopes more software vendors will offer subscription licences. "Not many software vendors out there are enlightened," Clifford says. "I would say that those not open to the subscription option need to watch their backs because a lot of us CIOs want to do deals this way."

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SIDEBAR: A Bitter Aftertaste

How one CIO's experience with Microsoft soured him on subscription licensing

Larry Shutzberg, CIO at packaging maker Rock-Tenn, has bitter memories of the day in May 2001 when Microsoft announced it was changing the way companies would pay for its software. The plan, known as Volume Licensing 6.0, replaced confusing upgrading rules and options with a maintenance plan called Software Assurance (SA). Under the new plan, customers would pay for the original licence and a yearly fee and would be covered for all upgrades. Shutzberg baulked at the new arrangement because, among other things, he calculated he would have to pay an additional 29 percent each year for the desktop software maintenance.

He was not alone. A significant number of CIOs said no to Microsoft that year. Since then, Shutzberg says he has gone "cold turkey", by declining almost all upgrades to Microsoft Office desktop software over the past two years. "The goal is to only upgrade when we absolutely have compelling business drivers," he says.

Microsoft defends its licensing plan and says that it has added to its package, which now has 14 benefits, including training vouchers and home use support. And the company says that up to 35 percent of SA's customers are expected to renew their subscriptions. According to a Microsoft spokesperson, that number is "in line with company expectations". Microsoft also has a wide variety of subscription licensing plans for its software but says customers usually go with perpetual licences.

Shutzberg says he won't be tempted by Licensing 6.0, although he has a good relationship with his Microsoft sales reps, because he dislikes any licensing agreement that charges maintenance fees for Office software. When the time comes to upgrade on Office software, he will negotiate the deal on its own merits. What's more: The experience with Microsoft has soured him on other forms of subscription-based software pricing, at least for the moment. He says he will continue to pay maintenance fees on his perpetual licences for enterprise software "as long as we see value". When a vendor can show him the business case for a subscription licence, he says, then he might be inclined to try it.

Five Tips on Negotiating Subscription Licences

1.If you're new to subscription licensing, start with an application that you plan to use for two to three years.

2.If you plan to use the software for a longer period, negotiate protection from sharp price increases for as long as possible. Try for seven years.

3.Make sure your contract allows for user growth at a reasonable rate.

4.Estimate how long you think you will be using the software, and do the maths to compare costs over the long run with a perpetual licence plus yearly maintenance fees.

5.Start negotiating with your vendor one year before your price protection ends to avoid getting stuck with little time to find a replacement if the subscription price goes way up.