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Software innovations are disrupting entire industries in ways that were once unimaginable. New technologies, tools, business models, and licensing models are facilitating these changes and at the same time creating a more complex playing field than software development teams have ever known. Not all organizations are prepared to deal with the changes.

The shift from on-premise licenses to SaaS, though obvious these days, is not absolute. What’s less obvious are the nuances of what that shift represents and what the likely implications are in the near future.

As business models and therefore software licensing models evolve, so must the thought processes of the people developing and delivering commercial software, because customers’ expectations are changing. Many software providers will find themselves in discussions with customers about usage-based pricing (a twist on user-based pricing), licensing in virtualized environments, or the effect of microservices and Docker containers, if they haven’t already. Interestingly, the common thread among such discussions is the notion of value, which can take some non-traditional directions.

SaaS is not absolute
More software providers have moved to SaaS models, but traditional licensing models persist, especially among some of the older, more established players. There are also hybrid models that combine on-premise and SaaS-like features.

“We’re seeing a shift to a subscription-based model that looks exactly like the cloud except the product remains on premise,” said Laurie Wurster, research director in the technology and service provider research area at Gartner. “It has a lot of the benefits of the cloud, but the control of when the updates are deployed can be delivered to the on-premise data center. The vendor can’t control the deployment the way they can in the cloud. They’re adding service together with the license. It’s one price, a subscription that could be paid quarterly, yearly, monthly, or in advance depending on what the customer wants and what the vendor’s billing structure is.”

(Related: Are you paying too much for software?)

Making the move to SaaS hasn’t been an easy one for companies that have sold products in the traditional way, namely a large upfront investment complemented by a maintenance contract. SaaS offerings combine all of that in the subscription model. The bad news is, companies making the move to SaaS see changes to their revenue models that can be very scary. According to Mathieu Baissac, vice president of product management at software licensing and compliance company Flexera, it takes an average of three-and-a-half years to achieve the same run rate.

“[The question is] when do you start making more money from subscriptions as opposed to perpetual licenses. You’re going to lose money the first and second years,” said Baissac. “Our observation is about three-and-a-half years. You start to see recovery just before the third year.”

In the meantime, customer expectations are changing, which is also having an impact on pricing models and licensing.

“People want more flexibility on the pricing side, on the subscription side, so matching payment against the value received,” said David Rowley, Chief Revenue Officer of software licensing company Nalpeiron. “A lot of our customers have deployed models that are server-based software, desktop-based software, mobile-based software and embedded devices. People are really wanting to pay for any service or product on an ongoing, pay-as-you-go basis.”

The business value of software is somewhat more evident in SaaS solutions because of the insight they provide, and their ROI can be measured faster. Every time the software comes up for renewal, the customer will buy or not buy the product based on its perceived or demonstrated value.

“Some SaaS providers really understand the business value that they deliver to customers and focus their organization around that,” said Duncan Jones, vice president and principal analyst serving sourcing and vendor management professionals at Forrester Research. “The older, more established vendors struggle with that little bit. If we look at the SAPs and Oracles, they’re used to dancing around value and selling a vague vision that a customer will buy, but the customer will never call them on [the fact the vendor said] ‘I would cut my inventory by this much, but I didn’t.’ There isn’t that continual feedback between the value proposition that was put in at the start and the actual value that’s being delivered three or four years later.”

User-based pricing evolves
User-based pricing isn’t a new concept, and it has evolved with the proliferation of mobile devices. The implication is that the user is no longer assumed to be using a single device within the walls of his or her company. Now, he or she likely has multiple devices: a smartphone, a tablet, and a laptop or desktop, which affect revenue models and licensing.

“One difference is person versus device. You originally paid to download the app and then if you change your phone, you have to download and pay for the app again,” said Jones. “That didn’t go over so well, so there had to be a shift toward per-user rather than per-device [pricing]. Big vendors like Microsoft had to accept that if a user had four devices, they weren’t going to pay four times for the right to use Microsoft Word, so Microsoft had to change to per-user licensing.”

Another evolving concept is the concurrent or floating license. One can no longer assume that the development team is in one location since more development teams are global. Globalization can have licensing implications because laws and their enforcement differ from country to country. It may also impact the number of licenses that need to be purchased and their pricing.

Is pay-per-use the next big wave?
If your company has moved to SaaS or you work for a native SaaS company, be advised that business models and therefore licensing models are not static. Consumption-based pricing may become the norm, like SaaS is now—or not.

“I was talking to a storage vendor that licenses based on capacity currently, which is a pretty traditional model for storage,” said Nalpeiron’s Rowley. “Now they want to grab usage data off those environments, flow that back and then do billing on actual usage against that capacity. They’re using licensing to enforce a cap on the usage.”

The same thing is starting to happen on the software side. Interestingly, the insight users get from SaaS solutions is driving the demand for consumption-based models. Because customers can see what their actual usage is, some of them may eventually inquire about a pay-per-use option.

“People don’t want to pay for cloud like they don’t want to pay for shelfware, so users are demanding consumption models,” said Gartner’s Wurster. “If I’m paying for payroll software I use twice a month, I don’t want to pay the same as someone who uses the software all the time. I want to pay for how much I use, not just having access to the product.”

In a recent pricing survey by Flexera, 42% of respondents said they wanted to add consumption-based models (per-for-use or pay-for-overage) within the next two years or sooner.

“I think most vendors can’t do pay-per use. We see a little of it among the API vendors and content vendors, but for software and hardware, it’s hard to budget for the IT community,” said Flexera’s Baissac. “It’s much more of a pre-pay for some type of capacity, and then you pay for exceeding that capacity, but from a licensing standpoint you’re not stopped.”

Value-based pricing is a big challenge
An even more controversial model—value-based pricing—is also being discussed. Instead of paying based on capacity or users, the idea is to pay the vendor based on the business value the software delivers.

“There’s more of an emphasis on really measuring the business value of whatever software you’re delivering,” said Forrester’s Jones. “The licensing has to reflect the way you measure value so that if a customer then changes the way they use the software, or the extent to which they’re using the software in such a way they get more business value, then you can go back and say, ‘You need to pay us some more money.’”

In the past, one might assume that software inherently delivers business value because of the high cost of the box it resided on. If the company could afford the box, it must be getting business value.

“There was an assumed correlation between processing power and value. When you look at software pricing per processor or per core or per server, it really has nothing to do with business value; it just assumes there’s a correlation,” said Jones. “As you get closer to SaaS, the people you’re selling to don’t know or care about the processing power underneath, so software vendors have had to move away from hardware-based metrics and find new metrics.”

It’s difficult to define what “value” means in a manner that’s acceptable to the software provider and its customers. Some vendors have a habit of defining value in terms of brochureware, and even if they don’t, their definition often differs from their customers’ definitions.

“The thing becomes how do you define value? How do you get the vendor to agree to that value?” said Gartner’s Wurster. “There’s going to have to be acceptable criteria that’s measurable in order to base anything on value. Both parties will have to agree to it and it will have to be in the contract, so you’ll probably have to get legal people involved. I think it’s something end users want. Vendors are going to want to avoid it because it’s hard to decide how you measure value.”

Nalpeiron has been known to price its licensing solution based on what it and its customers perceive as its value. Typically, it’s implemented as a small percentage of the overall revenue being driven through its platform.

“If we do our job right, we help them grow their business and support brand new business models that allow them to enter new markets and grow their revenue. We then participate as part of that as their revenue grows,” said Nalpeiron’s Rowley.

With enterprise software, the calculus is more complex. How much of a company’s revenue can be attributed to ERP, CRM, department-specific applications, etc.?

“If you’re a software company selling a solution, it’s extremely hard to map that value back and charge accordingly,” said Jon Gillespie-Brown, CEO of Nalpeiron. “The closest you get to that is metering which is more along the lines of consumption. At least you pay for what you use, whereas the ability to understand the value that a software product delivers probably could only happen in certain vertical markets where it’s clear if you plug this in you get that result.”

Odd as it may seem, some customers may try to approach software pricing from a value-based perspective, whether it’s as vague as “increasing revenue” in a complex enterprise setting, or as specific as reducing the cost of a shipment by a certain amount.

“Customers generally measure themselves based on some type of cost per widget,” said Charlie Li, senior vice president and Chief Cloud Officer at Capgemini North America, a management consulting company. “It doesn’t matter whether that widget is a computer, a claim, or a mortgage. If I tell a customer we can reduce the price of a claim from US$1 to $0.50 using digital and cloud as enablers of that, clients are happy. But when you peel the onion, what constitutes that dollar for the claim?”

In Li’s scenario, the costs included in the one-dollar cost of a claim might include SAP software, Windows servers, and claim-processing solutions, all of which have different licensing schemes. To offer a coherent solution to a client, Capgemini has to negotiate with multiple vendors as well as consider the cost of people and change management to deliver what he calls “business-as-a-service.” The biggest challenge is negotiating with the software providers who want to stick to their tried-and-true revenue models.

“They want the systems integrator to take all the risk,” said Li. “In the next three to five years, I think you’ll see the market change even more where the software vendors will be pushed to have more skin in the game in terms of solving business problems or being able to provide business as a service licensing models.”

Capgemini has been able to negotiate with hardware and software vendors to create a unique business model and pricing model, but because it’s a one-off contract, it takes months to negotiate.

Virtualization: Problem not solved
Virtualization has been a source of angst for software providers and their customers. Software providers want to get paid for the use of their software, whether non-compliance is intentional or not. Conversely, customers hate audits and fines.

“There’s no great solution there. It’s still a problem, particularly because the older, established software companies have so much inertia that they can’t abandon their obsolete models, and so virtualization really shouldn’t be an issue. But it is,” said Forrester’s Jones. “I don’t have an easy answer for that, really, but one answer is SaaS. This whole argument about virtual machines and counting physical processors and virtual processors should be a discussion between the SaaS provider and the infrastructure software [provider].”

One issue with virtualization is the ability to distinguish between an original app and a clone of it running elsewhere.

“Most of the traditional vendors I talk to say we know it’s a problem and we’re kind of ignoring it,” said Flexera’s Baissac. “We have a number of interesting solutions around that.”

Specifically, Flexera is tracking the fact that a copy was made, alerting the software producer and letting him or her decide to do with the information.

“It’s really hard to know which [copy] is the legitimate one, and on top of that, what if it’s critical software and you decide to kill one of those VMs because [it’s] out of compliance? That’s a really bad thing, potentially,” said Baissac.

Nalpeiron considers virtualization—specifically, the ability to detect and manage virtualized environments—a big part of what it does.

“You need to be able to distinguish between an app running in one virtualized container versus the clone of that running elsewhere and make sure the developer gets paid appropriately for all the instances that are being run,” said Nalpeiron’s Rowley. “That’s something of great interest to our customers.”

Don’t try this at home
Virtualization, microservices, containers, globalization, and evolving business and pricing models collectively suggest that software licensing complexity is growing and that perhaps building one’s own solution isn’t the best idea, especially when there are companies out there that, for a reasonable price, are willing not only to manage all the details, but also provide a path that makes the adoption of new business models faster, easier, and less of a mystery than if an organization tried to do the same thing itself.

“All of our customers have tried to offer licensing on their own,” said Baissac. “They end up coming to us because it doesn’t scale or they didn’t think about virtual machines or a new licensing model. They think of licensing as a prevention mechanism. I see it as an opportunity for innovation.”

Nalpeiron suggests that its customers take advantage of its analytics capabilities so they can make more informed decisions about changes to their products and licensing models.

“The amount of data we generate on a customer is phenomenal—everything from individual feature use to the types of operating environments they’re running in, any errors generated, geolocation, so all manner of fine-grained analytics,” said Rowley. “We tie into back office systems like Salesforce, CRM, and ERP environments.”

In short, the software landscape has become more complex over time, and the trend is going to continue, likely at an accelerated rate. For now, don’t get too comfortable with your favorite SaaS model because alternative models will continue to compete with them or even replace them.

Although value-based pricing may turn out to be a non-starter because “value” is too difficult or too time-consuming to define for most software providers, pay-per-use or consumption-based pricing is expected to take off in the coming years, fueled by the Internet of Things.

About Lisa Morgan

Lisa Morgan is an analyst at Strategic Rainmakers.