Tuesday, May 16, 2006

Small Percentages make a Big Difference

I had the good fortune of having a very entertaining conversation about the economics of the software industry with a bright senior software executive this week. We were talking about the economics of a subscription model as compared to the economics of a perpetual license model, and she had all of the fundamentals down cold:

- R&D is cut in half (from 16% to 8% of revenue, on average) when you can bring all customers along with every bit of maintenance so there are no legacy platform or release issues.

- Renewal rates are higher when customers see the software vendor continuously delivering innovation that makes their application more valuable

- It is difficult to transition to a subscription model when you are so dependent on perpetual licenses for quarterly revenue

She explained to me that her company historically had a very high maintenance renewal rate of 90% compared to the industry average of 85%. I thought about those numbers and how they contrast with Red Hat's most recently reported renewal rates of nearly 100% for the top 100 customers, which I wrote about in a previous blog post. I decided that I wanted to do a little test of the power of subscription renewals for topline performance of a software company.

Let's take a hypothetical case of a company that books $100 in new subscription bookings each year, with some percentage of the prior years new bookings renewing each subsequent year. In year 2 and year 3, for example, the company bookings would be:

- Year 2 Bookings = $100 + (Year 1 Bookings)*X%

- Year 3 Bookings = $100 + (Year 2 Bookings)*X%

and so on for each subsequent year. Over a ten year period, how much more annual bookings would a company have if they are able to improve their subscription renewal rate from the average of 85% to 90%? to 95%? to 98%?

Here are the numbers and the percentage improvements for each case relative to the industry average of 85%:

- 85% renewal yields $555 in Year 10 Bookings, base case

- 90% renewal yields $686 in Year 10 Bookings, 24% improvement

- 95% renewal yields $862 in Year 10 Bookings, 55% improvement

- 98% renewal yields $996 in Year 10 Bookings, 79% improvement

I was shocked to discover that a mere improvement of 13 points on renewals yields a topline improvement of nearly 80% over 10 years. Then again, I think it was Albert Einstein who claimed "The most powerful force in the universe is compound interest." Why should I be suprised when Einstein is proven correct yet again?


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