Becoming SaaS: How CFOs Need to Manage the Transition from Perpetual to Subscription Models

December 18, 2018

The growing popularity of SaaS applications among end users, enterprise software buyers and investors creates tremendous pressure on traditional software providers to offer subscription versions of their applications. The business case for moving to SaaS is so strong that this business model is projected to dominate all software sales in the near term. According to Gartner Analyst Laurie Wurster, “By 2020, all new entrants and 80% of historical vendors will offer subscription-based business models.”

At FLG, we’ve worked with many native SaaS companies as well as technology companies that have transitioned to SaaS. As strategic advisors, we help companies manage the financial and operational requirements of the SaaS model.  One question we frequently hear from clients in transition is how to differentiate between perpetual (licensed) and subscription models.

Perpetual licenses charge customers an initial cost (to purchase the license), plus an annual subscription cost that entitles the owner to all updates and technical support. With subscription models, customers pay either a monthly, quarterly or annual price that includes software, all updates and technical support.

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:

  1. Right to Use the “Product” (or software to be sold)
  2. Physical Transfer of the Product
  3. Liability for the Product
  4. 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.

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 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 (often less than the term), a per-user (or per seat) 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 condition 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.”

Transfer of Product

Under the Perpetual Model, the Vendor has transferred physical possession of the asset to the customer. Software delivery should be straightforward and require no special production, modification, or authorization by the software vendor.

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 effects 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.

Liability for Product

Under the Perpetual Model, the Customer has the significant risks and rewards of ownership of the asset. The risk associated with ownership includes the requirement to maintain the systems necessary for the delivery of the product to users. Additionally, training will be required for the Customer to maximize the adoption and engagement among employees. For all of these services, the Customer can develop the skillset and organization internally or contract a third party to do so. The Vendor may even be (and in smaller companies, often is) the training provider.

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. Because of this risk/reward profile, only large companies now 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. Additionally, to avoid obsolescence, the Vendor is obligated to deliver upgrades and enhancements, usually on a fixed routine. The reduced operational risk makes subscription software licenses attractive to startups. Additionally, the per-usage pricing makes these deals more financially attractive. As Customers grow in size, their demand for this software can increase exponentially. However, since the Customers will purchase new subscriptions at prices commensurate to the higher value-add, which will likely be at higher rates, they will not enjoy outsized rewards.

Vendor Specific Objective Evidence (VSOE)

At a very high level, Vendor-Specific Objective Evidence, or 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.

Product and Service Bundling

For either perpetual or subscription business models, the Vendor’s ability to determine VSOE impacts the amount recognized as a subscription revenue.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, i.e., 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 is therefore recognized ratably over the term of the contract.

Do note 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.

Theory to Application: 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 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 Billings, Annual Recurring Revenue (ARR), Net Expansion, and unit economics such as ARPU (per month or per quarter), Lifetime Value (LTV), Customer Acquisition Cost (CAC) and related ratios.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.

Revenue Recognition

Finally, do not confuse these guidelines for revenue classification with the four-part test defined by the Financial Accounting Standards Board (FASB) for determining the recognition of revenue.

The core principle behind the FASB guidance is that recognition of revenue generally occurs at delivery if this four-part conjunctive test is met; “Software delivery should be straightforward and require no special production, modification, or authorization by the software seller (the Vendor)”.In the application of this core principle, a Vendor should therefore apply the following steps to determine if revenue recognition should be made at the time of delivery:

  1. Persuasive evidence of an arrangement exists
  2. Delivery has occurred, or services have been rendered
  3. The vendor’s price to the buyer is fixed or determinable
  4. Collectability is reasonably assured

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.This article originally appeared on FLG Partners.

Eric Mersch has nearly 20 years of executive finance experience, including twice serving in public company Chief Financial Officer roles.  Currently, he serves as Chief Financial Officer for Percolate, an Enterprise SaaS company delivering a Content Marketing Platform. He worked with SaaS companies in the Big Data, Advertising/Marketing Technology, Enterprise Data Warehouse, Mobile App and Website QA Subscription Services, Real-Estate Technology, Hospitality Technology & Payment Processing spaces.