I D C T E C H N O L O G Y S P O T L I G H T

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1 I D C T E C H N O L O G Y S P O T L I G H T S t r a t e g i es for Optimizing Recurring Reve n u e M o dels in the Softw are Industry November 2013 Adapted from The Coming of the 3rd Platform and What This Means for Business Models by Amy Konary, Robert Mahowald, and Vanessa Thompson, IDC # Sponsored by NetSuite The proliferation of 3rd Platform solutions is rapidly disrupting software business models, resulting in an increase in new software business models. Various subscription models are now growing much faster than traditional license models. IDC expects to see more adoption of consumption-based models including pay per use and subscription plus usage approaches that scale up or down according to actual utilization of resources, and as this progresses, SaaS delivery will significantly outpace traditional software product delivery. However, the transition to subscription will not necessarily be an easy one. The current software industry shift from up-front, inflexible license contracts to subscription, consumption-based models is shining a spotlight on the shortcomings of systems that were designed around the way that the software business ran 20 years ago. Software companies are evaluating whether the systems that support their business will be up to the challenge of subscription licensing or consumption-based pricing models. In addition, the lack of systems that support usage-based pricing models for the purposes of real-time assessment and billing represents a major barrier to the adoption of usage-based pricing. There is a clear need in the software industry for commerce, ERP, and billing solutions that will help support the dynamic business of software. This Technology Spotlight examines these trends and the role that NetSuite's cloud-based business software plays in this strategic market. Introduction The information and communications technology (ICT) industry is in the midst of a major shift to a new technology platform for growth and innovation. IDC calls it the "3rd Platform," and it is built on the interconnected technologies of mobile devices and applications, cloud services, broadband networks, big data analytics, and social networks. The 3rd Platform, with cloud at its core, will serve as the primary growth driver of ICT over the next decade. According to IDC research, it will be responsible for 75% of new growth as worldwide ICT spending moves from $3.7 trillion in 2013 to more than $5 trillion in In the interim, the number of new products and solutions built on the 3rd Platform will explode, and they will see rapid adoption in emerging markets. The proliferation of 3rd Platform solutions and new customer expectations is rapidly disrupting software business models and, in fact, is changing them forever. As a result, IDC is seeing an increase in the use of new software business models that align more closely with actual user experience and are priced on the basis of various subscription models. Given the undeniable momentum of these trends, subscription models are now growing much faster than traditional license models. Virtually all software vendors are at various stages of a seminal transition with respect to how they build, sell, and deliver their products as services, hoping to generate more revenue and improve customer satisfaction. In fact, IDC's Key Trends in Software Pricing and Licensing Survey of 123 software publishers found that 42% of respondents made changes to their pricing and licensing strategy in the past months with the intent of generating more revenue and improving customer satisfaction. IDC 1603

2 Trends in Subscription-Based Business Models The business of software is changing rapidly, creating opportunity but also putting a strain on software operations. In this new environment, growth and innovation are increasingly centered on applications delivered via a subscription model. Subscription software licensing has grown from being an interesting approach taken by only a few daring companies to a mainstream model representing nearly $65 billion in worldwide revenue. 67% of the top 100 software vendors worldwide had subscription revenue in 2012, up from 57% in In this new environment, start-ups aren't the only ones offering subscription license models. Subscription accounts for more than 50% of revenue for 16% of the top 100 software vendors. IDC expects to see more adoption of consumption-based pricing models. These include both pay per use and subscription plus usage approaches that offer the ability to scale up or down according to a company's actual utilization of services and resources. New business models that align more closely with business outcomes and customer experiences and are priced via subscription are becoming the norm. Going forward, software business models must support dynamic, elastic, mobile, global, and virtual software deployment and usage all 3rd Platform characteristics, many of which are related to new cloud computing models. According to IDC data, up to 82% of new commercial applications are being built specifically for cloud delivery in By 2016, nearly $1 of every $6 spent on packaged software and $1 of every $5 spent on applications will be consumed via the software-as-a-service (SaaS) model. This shift is being driven by the trend whereby SaaS delivery will significantly outpace traditional software product delivery, continuing to grow nearly five times faster than the software market as a whole and becoming the significant factor driving growth for all software markets. At the same time, developers of business applications are focusing innovation on ways that companies can take advantage of end-user connectedness and mobility, with some companies developing applications for mobile access instead of not in addition to client devices. A combination of factors are driving the adoption of the 3rd Platform, including lower cost and ease of use. Unlike the 2nd Platform, 3rd Platform applications will be designed for the consumer and enhanced for the enterprise (as opposed to being designed for the enterprise first). Consumer-like expectations for ease of acquisition and access, simplicity, and transparency will dictate pricing models and payment terms. Overall, the 3rd Platform is driven by end-user desire for more flexible pricing models that align cost more closely with actual consumption. Positioning Subscription with Customers and Other Stakeholders Many vendors cite the desire to respond to customer demands for more flexible delivery and pricing options as a key reason for migrating to a new approach. Applications that are well-suited to subscription include those that are updated on a frequent basis and for which the ultimate value of the software is not recognized unless these updates are applied. An application that isn't frequently updated, or one for which the updates aren't meaningful to most customers, is not as good a candidate for subscription. That said, a customer situation may dictate that a subscription model is the preferred approach, even if the application isn't entirely well-suited. In today's environment, many businesses are cautious about making capital investments in purchases such as enterprise software. Companies typically use operating expenditure (opex) for the day-to-day running of their organization, while capital expenditure (capex) is used for the purchase of assets that have a relatively long life. Subscription allows customers to shift software spending from capital to operating budgets IDC

3 Customers also like the low up-front cost of the subscription model as well as the enhanced ability to build a relationship with the software provider that they pay on an ongoing basis. Licensing approaches that enable customers to purchase via subscription have attracted brand-new customers for some vendors. Many of these customers could never have practically afforded the software products if they were licensed under the traditional perpetual model. Others could afford a perpetual license but would prefer to purchase another way. Customer perceptions about subscription licensing models vary widely; therefore, vendors should be prepared to offer customers a portfolio of options. This does not mean that vendors need to create several versions of their software. It should be the same software, just licensed and delivered in different ways for the customer. IDC does not believe that subscription will always be the preferred model of customers by default, but in many situations, subscription will make more sense for customers and vendors. IDC expects that subscriptions will still make up the minority of software license revenue for the next several years, but that growth will accelerate. From the customer perspective, the main concern with subscription licensing is that it will most likely cost more in the long term to purchase software via subscription rather than using perpetual arrangements. The break-even point for license and maintenance is typically somewhere between three to four years. After that, subscription will likely cost more than buying a comparable product via a perpetual license. At the same time, some customers have a preference for paying for software purchases from capital budgets, and others prefer to "own" the software license a concept that is not an aspect of subscription. Advanced Approaches Technologies exist today that enable granular packaging of software as well as usage-based pricing. However, only a small percentage of vendors and customers are using these technologies for the purposes of usage pricing. Since the majority of customers are not currently collecting granular and frequent usage statistics, it will be difficult for them to ascertain the impact of usage pricing and manage the complexity of granularity. The lack of systems that support usage-based pricing models for the purposes of real-time assessment and billing represents a major barrier to the adoption of usage-based pricing. Most existing systems, on both the customer side and the vendor side, do not meet the requirements and complexities of a usage-based model. Third-party systems are available and suitable but are not widely deployed. It is important to note that most traditional IT asset management systems do not provide detailed enough data on actual software usage to assist customers with a usage-based pricing scheme. Several IDC studies have revealed a market need for tools to improve the level of intelligence that customers and vendors have on how, what, when, why, and where software is used. This intelligence could be used to give customers better visibility into their software purchase decisions and help vendors appraise the value of offerings to customers. There is always the temptation in the software industry for companies to build this capability internally. Unfortunately, for most software companies, a "build" strategy results in inflexible systems that are costly to maintain IDC 3

4 Key Metrics for Tracking Success As software companies transform themselves, many will be managing hybrid environments, including a mix of subscription and usage-based models. They will need to pay attention to business metrics that they have focused on in the past, as well as new metrics. The key metrics that companies are using to measure the success of their subscription businesses include: Average revenue per user (ARPU) Churn Monthly and annual recurring revenue (M/ARR) Recurring profit margin Retention rate Customer lifetime value Customer acquisition cost Growth efficiency (a measure of net recurring profit compared with net-new ARR) Another element that companies are keeping an eye on is usage. If the customer is a heavy user of the subscription service, it is a key sign that it will probably renew. Challenges and Opportunities with Subscription The transition to subscription will not necessarily be an easy one. The current software industry shift from up-front, inflexible license contracts to subscription, consumption-based models is shining a spotlight on the shortcomings of systems that were designed around the way that the software business ran 20 years ago. The business model transitions that software companies are attempting today will take place over the course of many months or years. One of the most common issues that software companies face is determining how to enable flexibility when relying on systems that have been built to support up-front perpetual license sales. Software companies are evaluating whether the systems that support their business will be up to the challenge of subscription licensing or consumption-based pricing models. Oftentimes, they are not. Most software publishers that have developed or are developing subscription offerings will continue to support traditional perpetual license businesses. These companies also face the difficulty of managing a hybrid business model scenario. They will also need to determine issues such as: How to price a subscription relative to existing perpetual licenses How to sell the subscription offerings and how to compensate sales Whether they should enable a migration path to or from subscription and perpetual models Whether customers can mix and match perpetual and subscription licenses in the same engagement These policy decisions are often impacted by cultural, competitive, investor/financial, and customer needs. However, they may also be driven, or limited, by systems capability IDC

5 The subscription model also introduces challenges to finance in the form of new metrics to track and processes to manage. For example, as companies rev up their subscription businesses, they often find that existing ERP and billing systems are not well equipped. Accordingly, they are looking to determine whether they should adapt their existing systems that have been built over the years to support a perpetual license business and whether to look to the marketplace at point solutions provided for billing and financial management. There is a clear need in the software industry for commerce, ERP, and billing solutions that will help support the dynamic business of software. Considering NetSuite's Approach to Subscription Management NetSuite is a provider of cloud-based business management software, founded in 1998 and headquartered in the Silicon Valley. NetSuite products are designed to help companies manage core business processes with a single, fully integrated system covering ERP/financials, CRM, ecommerce, and inventory. The company offers industry-specific solutions for the professional services, software, wholesale distribution, manufacturing, and ecommerce sectors. According to company sources, more than 800 software companies use NetSuite's cloud-based ERP/financial solutions to manage their businesses. NetSuite is keenly focused on vertical markets, recognizing that several industries can exist within a vertical such as manufacturing and that the needs of these industries are very different. One such vertical where the needs are quite broad is software. As the software industry experiences dramatic changes in business models, companies are trying to adapt by injecting speed and agility into their systems and processes, including ERP. Start-up firms are looking for flexibility from the start, and the cloud approach that NetSuite offers provides several benefits. Established firms already have systems in place, but they are struggling to figure out how to get these systems to support their businesses as they move forward with flexible business models. NetSuite's cloud approach and integration story appeal to these firms. There is also an opportunity for NetSuite to step up and support software publishers that must keep a foot in both worlds traditional software and the software industry of the future. Traditional ERP systems are poorly suited to the job of managing software businesses in general and subscription SaaS businesses in particular. This inadequacy extends to billing capabilities. This represents another focus of the company that should appeal to software firms, especially those that are moving toward subscription or other flexible pricing models and managing recurring revenue streams. NetSuite offers a unified billing platform, including a common billing engine that supports evergreen subscriptions, multicurrency, usage-based billing, and parent/child billing. The company has identified recurring billing as a key area for continued investment and has indicated that it is seeing a strong interest in replacing point billing solutions. Professional services also plays a key role in NetSuite's focus on software businesses, given the broad needs of these companies. One area of focus here may be integration between new and old ERP for companies that must maintain legacy business models (and systems) as they make the transition forward. Challenges To meet future needs and grow footprint within the software industry, NetSuite will need to prove that its solutions can support large, hybrid software businesses and the complex order, billing, and payment scenarios that these companies require currently and going forward. The company will also need to demonstrate that its solutions can add value while coexisting with legacy ERP systems, 2013 IDC 5

6 billing technologies, and other systems that will continue to meet a need within the software business even as they support new models. It needs to further demonstrate that its solutions do not require a large up-front investment in time or money for enterprises to start realizing ROI value. Conclusion The 3rd Platform is not just a technology revolution; it's also a customer revolution. As a result, the industry is seeing the rapid rise of new software business models that align more closely with business outcomes and customer experiences. Growth and innovation will be increasingly centered on applications delivered via a subscription model, and software business models must support 3rd Platform attributes that are dynamic, elastic, mobile, global, and usage based. The momentum toward subscription approaches will continue as more software vendors look to augment traditional models or shift entirely to subscription approaches. As a result of these powerful trends, the business of software is changing rapidly, not only creating opportunities and adding value but also adding pain points to existing software operations and procedures. In this environment, software companies are evaluating whether the systems that support their business will be up to the challenge of subscription licensing or consumption-based pricing models. There is a clear need in the software industry for commerce, ERP, and billing solutions that will help support the dynamic business of software. NetSuite is addressing this need, and to the extent that it can address the challenges described in this paper, IDC believes the company will be well positioned for success in this market. A B O U T T H I S P U B L I C A T I ON This publication was produced by IDC Custom Solutions. The opinion, analysis, and research results presented herein are drawn from more detailed research and analysis independently conducted and published by IDC, unless specific vendor sponsorship is noted. IDC Custom Solutions makes IDC content available in a wide range of formats for distribution by various companies. A license to distribute IDC content does not imply endorsement of or opinion about the licensee. C O P Y R I G H T A N D R E S T R I C T I O N S Any IDC information or reference to IDC that is to be used in advertising, press releases, or promotional materials requires prior written approval from IDC. For permission requests, contact the Custom Solutions information line at or gms@idc.com. Translation and/or localization of this document requires an additional license from IDC. For more information on IDC, visit For more information on IDC Custom Solutions, visit Global Headquarters: 5 Speen Street Framingham, MA USA P F IDC