Dhaval Moogimane and Amy Fletcher, West Monroe Partners
Technology companies are continuing their shift to As-a-Service (XaaS) models -– and for good reason: they’re lucrative, popular with investors, and allow software companies to deliver better service with more scale.
This trend was clear in a West Monroe Partners survey distributed last year, in which 40 percent of private equity respondents said that between 50% and 70% of their tech portfolios sold and delivered products and services as a subscription.
But there is a lot that companies should consider as they maximize their XaaS or subscription models. They especially need to think about customer centricity and scalability. In other words, it is way more than just a change in the billing model.
The market is growing
If you need more convincing that the XaaS model is here to stay, consider this: Over the next half-decade, SaaS subscription services, a category within XaaS, are projected to see a compound annual growth rate of 12 percent, according to research from Gartner. Salesforce, a leading SaaS provider, reported revenue of $5.82 billion in the fourth quarter of 2020, up 20% year-over-year. The cloud communications company RingCentral reported a 32% increase in total revenue for the first quarter of 2021 to $352 million, in addition to a 34% annual increase in subscription revenue.
Meanwhile, valuations for software companies employing a XaaS model have skyrocketed. Last year, Insight Partners paid $5 billion for the cloud management platform Veeam Software; Clayton, Dubilier & Rice bought Epicor Software from fellow private equity firm KKR for $4.7 billion; and the Canadian buyout manager Onex paid New Mountain Capital $2.65 billion for the employee benefit platform OneDigital.
Focused customer centricity
The benefits of employing XaaS models are not limited to the valuation. To retain subscribers over time, companies using these models must continuously engage with their customers. If done well, this activity can make those customers “stickier,” empowering them as your advocates and increasing retention rates.
Companies have tended to operate in a stovepipe, with customers invariably “handed-off” from one department to another. However, companies need to understand the importance of recognizing moments that matter and learn how to drive value at those critical stages of the journey. Roles and responsibilities must be clear so that each customer engagement builds on the prior one.
Customer acquisition cost is a key metric that most tech companies closely manage. Typically, the cost to retain or grow a customer is a fraction of the cost to acquire a new one. That said, companies need to be cautious not to underinvest in retention and expansion -– and a smart investment includes deep analytics to understand customers, digital workflows to guide value-oriented engagement, and frictionless service and support.
Product design also has an integral role to play in this process. Traditional B2B software product investments tend to focus on building the next best feature. These efforts need to be balanced with investments in data-driven customer engagement to maximize usage and adoption.
Companies that can orient themselves to place customers and users first will thrive in the subscription model. Of course, it is easier said than done.
It’s not for everyone
There is constant debate on the merits of the pay-per-use model versus the subscription model. The predictability of the subscription model has its allure. Management teams and investors certainly like it, and even customers find it easier to budget. However, depending on a company’s products and customers, as well as its maturity and competitive dynamics, a pay-per-use model may make more sense and also might disrupt the market.
For instance, a startup company marketing an entirely new genre of application could have difficulty enticing customers to subscribe. With a totally new kind of software, how are consumers going to know the product is worth the recurring expense?
In that case, a pay-per-use model makes sense as the startup introduces itself to the marketplace and customers begin to learn the value of its products. Then, as customers come to understand the vendor’s unique value proposition, the company can explore longer-term subscription commitments.
While t the investment community likes the revenue predictability of the subscription business, they likely wouldn’t dismiss a smart pay-per-use company with a high customer retention rate. In fact, investors might be attracted to such a company if they saw a clear opportunity for growth with a pivot to a subscription model.
A major transition
Companies transitioning from pay-per-use models to subscriptions should not underestimate the changes needed to be successful. Beyond the basics of designing thoughtful pricing strategies, a careful consideration of the customer and user journey is needed.
On the pricing front, companies need to consider their customer’s usage patterns and supplement that with a deep understanding of their cost structure to design appealing subscription packages. Let’s say Netflix had a pay-per-use option charging $1 per movie. If a user averages six movies a month, they will likely not be inclined to move to $9.99 per month for unlimited access. However, they might be tempted with a $7.99 per month option. Defining the pricing breakpoints for a subscription requires a solid understanding of the customer value drivers and competitive dynamics. In addition, it also necessitates a fundamental understanding of the cost structure of delivering the service. Netflix would need to determine what the costs are to deliver the service for $7.99 per month.
Outside of pricing, the customer engagement model also needs to be carefully designed. Companies must know when to offer the subscription to the customer that is buying on a per-use basis. Additionally, there needs to be a focus on ensuring continuous value to these customers. Netflix’s recommendation engine and email prompts are examples of engagement to ensure consistent renewals.
It’s not just about the money — it’s about the customer
Moving to subscription and XaaS models is far more than pricing changes and valuation, in part because a successful subscription business is centered around customer value.
Deep understanding of the customer and their value drivers is key, and designing an engagement model and workflow to guide the customer to achieving those value drivers is even more important.
This is a significant change for some organizations. Implemented thoughtfully with the customer always top of mind, these models can make a company smarter, faster, and more responsive to the needs of its users -– transforming it into a more successful business.
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