Subscription myth busters: What it takes to shift to a recurring-revenue model for hardware and software

Excerpts from the article by By Kevin Chao, Michael Kiermaier, Paul Roche, and Nikhil Sane on McKinsey & Co

Migrating your business from an up-front to a recurring-revenue model can seem a daunting challenge that may take years to yield benefits. High-tech vendors often embark on massive projects requiring large investments in new offerings, such as multitenant cloud solutions or managed-service ones with multiyear lead times. By focusing only on the long term, high-tech companies miss out on an opportunity to adapt their business model quickly to the new way customers like to purchase software and hardware: flexibly, without big up-front investments, and with costs reflecting the business value they derive.

Satisfying latent demand for flexible subscription pricing not only allows companies to capture significant additional lifetime value from existing customers but also unlocks previously untapped customer segments, which can include business units that prefer operating rather than capital expenses or companies whose cash constraints prevent them from making big advance investments (Exhibit 1). What’s more, companies that aren’t willing to make a full commitment but do value flexibility might be open to experimenting on a subscription basis. Further, subscription pricing helps high-tech vendors reduce the end-of-quarter “fire sales” that pervade up-front models.

Vendors that don’t adapt to this new market reality tend to see their traditional models come under increasing pressure. The demand for discounts on large up-front deals is rising as customers shift their software and hardware purchases from capital to operating expenses and as expectations for lower year-one costs for high-tech purchases rise. For all these reasons, the move to a subscription business model is no longer optional for most high-tech vendors.

Five myths

The many successful business-model transitions in software, printing, and even aircraft engines show that there’s enough “case law” in the market to prove the value of subscription pricing. Still, in our work with companies, we find that they often misunderstand critical aspects of the transition. Here we dispel the five myths we observe most frequently.

Myth 1: You must move to the cloud to make the transition

Many companies use the terms “cloud” and “subscription” synonymously. However, distinguishing between the deployment model (cloud versus on premise) and the business model (perpetual versus subscription) is critical to seizing the recurring-revenue opportunity. There is undoubtedly increasing demand for cloud solutions in the market, and a portfolio shift toward software as a service is the right long-term strategy for most software companies. But one particular kind of demand from customers outstrips even the demand for the cloud in most market segments: flexible subscription offerings. For example, we find that the preference for on-premise software subscriptions has increased to 82 percent, from 63 percent, over the past several years (Exhibit 2). The simplicity and flexibility of the subscription model are the main reasons cited for this shift.

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