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Moving from licensing software to selling subscriptions is a company-wide transformation that requires rethinking procedures, people and policy, according to new research from EY. David Padmos, EY Americas TMT leader, and Ken Englund, EY Americas Technology Sector leader, wrote the report: “What to know when adopting subscription or consumption business models.”

The financial implications of this shift are clear. IDC estimated in a 2020 report that software subscription revenues will grow by 16.6% while licensed software revenues will shrink by 6.1% between 2020 and 2024, based on a compound annual growth rate.

SEE: Do you need a SaaS platform to manage your “SaaS sprawl”? (TechRepublic)

This transformation typically takes five to seven years, according to EY. The report identified four common challenges that software companies face during the transition from one business model to another:

  1. Determining pricing and bundling strategy
  2. Managing sales transformation and customer incentives
  3. Managing the operating model change
  4. Defining key performance indicators, accounting and revenue management

Englund said the executive team has to plan out the transition over several years and decide which products will be the first to move to the new model.

“You have to think about how the market is going to treat you as you make the transition because there may be a gap in revenue,” he said

The transition requires revamping operations, products and sales strategy as subscription revenue starts out as a minor revenue stream and evolves to a major one, Englund said.

How to manage the SaaS transition

Here are three crucial steps to making the transition as well as a prediction for what the next phase of software sales may look like.

1. Elevate the customer success team

As software companies move from a licensing model to a subscription model, it’s important to give the customer success team a seat at the executive table. Englund said that a key part of building long-term relationships is standing up a customer success organization.

“In very successful companies, they have as much authority and direction as the sales team,” he said.

Englund said customer success is different from customer satisfaction. Customer success is proactive and measures how well a customer can use a product to achieve their own goals. Customer satisfaction is more about efficiency and solving short-term problems.

2. Develop new pricing strategies

One of the first changes to manage is to set new pricing strategies. The EY report found many enterprise technology companies have not done a customer segmentation analysis to select the most profitable markets and products. The report recommends making customer segmentation a central part of strategic road maps.

Englund said the conversation is shifting from a debate about the merits of the SaaS model to how to make that move.

“Subscriptions may provide more consistency with fewer peaks and valleys but you still have to decide to move away from a really good profitable business,” he said. “It’s also not a foregone conclusion that a client will shift to a subscription product,”

Another important element of pricing strategies is to phase out discounts over time, according to the EY report. Sales teams need to move away from a “sell things” mindset to one that’s more focused on building long-term relationships.

“It really is incumbent on the vendor to make sure the customer is using the product and using it well,” he said.

SEE: The new SMB stack (ZDNet/TechRepublic special feature) | Download the free PDF version (TechRepublic)

3. Set new key performance indicators

Company leaders also have to reset key performance indicators to support a successful SaaS transition. Englund said it is best to have two or three top KPIs and get those right first before adding other metrics.

There are two common metrics for the SaaS model: annual recurring revenue and net revenue retention. ARR is the value of the contracted recurring revenue elements of term subscriptions normalized to a one-year period. SaaSOptics explains that most ARR calculations exclude one-time fees and subscription consumption or variable fees.

NRR is the percentage of recurring revenue retained from existing customers in a defined time period, which includes expansion revenue, downgrades and cancellations. Revenue management firm Paddle sees NRR as a good way to measure success because it shows how much a business could grow based on existing customers alone.

It’s crucial to make sure all departments are using the same KPIs and that incentives are aligned as well, he said.

SaaS companies also should track renewals and customer churn Englund said.

From subscriptions to consumption

The authors of the EY report suggest that the next phase in this evolution of software products is a “by the drink” approach. Instead of buying a monthly subscription to use software, customers would pay a fee for a single use of the software, a fee structure similar to microtransactions.

“It’s a pure consumption model which we see as the next step in the evolution of the ecosystem,” he said.

This transition will require software companies to instrument products differently and make sure products have features that customers really use.

“There is no reason customers shouldn’t have a much better immediate and native view of how the software is being used,” he said. “Instrumentation will let people buy smaller pieces of software or at least have a better product.”