Wednesday, March 29, 2006

Red Hat Demonstrates Subscription Power

Red Hat announced full results for FY06 yesterday, and the results were very impressive. The most notable statistic, in my opinion, was the strength of the renewals. 25 of the top 25 customers and 99 of the top 100 customers up for renewal in 4Q06 renewed their subscription contracts with the company. These renewals are not for some percentage of an initial license sale, but for the full value of the subscription. In most cases, it was probably higher due to an increasing footprint within each customer.

The important lesson here for the rest of the software industry is that getting your product in the door at a reasonable price (i.e. a "pay as you go" subscription) leads to a great business model if you continue to fulfill on the value of the product over time. I was on a call yesterday with Jason Maynard, a CSFB equity analyst, where Jason declared that he was seeing a definite transition to the "pay as you go" subscription model. He claimed that the pendulum of negotiating power was swinging toward the customer, and software vendors are reacting by accepting some of the risk of software success by changing the license terms from perpetual to subscription.

During the early days at Red Hat, it was difficult to sell the customer on the notion that the payment each year was the total subscription value instead of a bigger payment in year one for a license and lower payments in subsequent years for "maintenance." The logic that ultimately prevailed with the customers was that a subscription to the total value of the supplier provides a healthier foundation for a relationship. Customers can consume the technology that works best for them independent of the "version" or "release" because the subscription entitles the customer to the total value stream for a particular product line. Additionally, the supplier has to "earn the value" everyday or be faced with the prospect of cancellation at the end of the subscription term.

One final lesson for the software vendors that are still addicted to the adrenaline rush of the perpetual license model - customers do not replace software that works for them. The switching costs are too high. Lower the barrier to entry, get in the door, do a good job, and maybe you too can build a model that looks as good as RHAT.

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