Enterprise Software Vendors Now Vulnerable to Maintenance Payment Reduction

The current downturn has given rise to numerous pieces of fundamentally good analysis on software company valuations that use software maintenance payments as a basis for valuing a business. Comments like “this company sells at only 2X or 3X its maintenance revenue stream” have popped up in numerous conversations with tech investors and sell side analysts. In fact, in better times, comments like these would send most investors to the trading desk. Software maintenance are the fees that software users pay to enterprise software providers to keep their products current, get enhancements, bug fixes and obtain all kinds of support. That is the theory.

In the real world, the actual maintenance arrangements are typically a lot more complex and involve numerous terms and conditions, price increase clauses and caps, differentiation between renewable and perpetual contracts and many more highly-legalese terms designed in some cases to protect the users and in others to insure that the enterprise software vendors do not go out of business. Part of the reality is also that many software vendors treat maintenance as a right to collect 15-20% of the current list price of their product every year and in advance, but in return forget to actually provide many enhancements or quality support. In good economic times, users tend not to bother with this issue too much. Thus, most investors tend to feel that the maintenance payments are a safe bet - sort of a high-margin economic “sacred cow” in technology.

Make no mistake, as analysts we are big fans of those fat recurring maintenance payments that users have little choice but to pay especially for software products that benefit from high degree of integration into customer environment and are very difficult to get rid of.

The experience of the 2001-2002 tech downturn has taught us many lessons, but one of the most important ones is that sacred cows like software maintenance can become hamburger meat if users feel enough of a budget pressure. We do feel that a similar scenario may unfold in the current economic cycle, especially if the recession lasts longer than the end of 2009. Thus, a valuation based on a multiple of software maintenance, especially during the times of low or no growth needs to take a more conservative view towards software maintenance renewal rates. We do not feel that we have yet entered an environment in which IT users are aggressively slashing budgets with a chain saw – so far it has mostly been a “freeze for now and use a scalpel later” environment.

But again, the longer the recessionary mood, the more likely it is that maintenance payments will be slashed, re-negotiated, cancelled, re-negotiated again and otherwise reduced. Companies with perpetual software licensing models are particularly vulnerable to this risk factor. During 2002 we saw numerous examples of users calling vendor bluff on maintenance and dropping support – which they claim was not worth much anyway. Some of the companies affected by such aggressive user negotiating are no longer with us, e.g. Manugistics. This can happen again and on a bigger scale, especially as it applies to smaller companies with low values MGI Index (MGI-X). SaaS companies are definitely less vulnerable to this specific risk factor for they tend to charge a monthly per seat fee. But they have their own issue: How do you grow the seat base when the client company is laying off 10% of its workforce. Reduced per seat pricing with advanced payment options covering 2-3 years was in the past often the solution of choice to this dilemma, but given the credit crunch it seems very unlikely as a way forward.

Bottom Line: There are no sacred cows in technology.

Comments

[ITman:]

I have worked over 25 years in IT. I agree that many vendors do not offer quality support. But many of us would say that customer service exists only in name for nearly every industry - software vendors do not deserve special recognition here.
I would take great exception to the statement "[M]any software vendors treat maintenance as a right to collect..., but in return forget to actually provide many enhancements..." I have worked for IT companies that sold commercial products, and for companies that consumed such products. I have witnessed from both sides the reluctance of clients to accept/install/use standard product enhancements/bug fixes/upgrades. Unless your vendor is a fly-by-night company (caveat emptor!), it probably has software advancements available - and it will be like pulling teeth to get many customers to install them. (I do not speak here of custom software development, which would ordinarily not be covered by maintenance agreements.)
So yes, just drop your maintenance agreement in order to save money on your budget. The next time you \really\ need a newly added feature or bug fix, the vendor may charge you a tidy sum for something that your now-expired agreement would have covered.
The bio for MGI Research says, "Our analysts have on average over 15 years of industry experience, and must have held a C-level job with a technology company before joining our firm." What job? CFO? These guys must have never been through the experience of unsupported/desupporte... software.

2008 Nov 18 06:25 PM

[Jackson999:]

50-70% of tech companies revenues come from maintenance (M&E) fees. There is commonly less revenues from new sales than many believe. M&E is the principle driver of tech business and development, not new sales revenues.

The fact that so much revenue is dependent on maintenance streams is why some large companies will give you their whole software suite for free in exchange for a 5 year M&E lock in (old Computer Associates, Oracle, etc).

List price M&E typically ranges from 17-22%. But most companies will go down to an 8-10% M&E rate for a 3-5 year lock-in if you negotiate hard. That isn't a bad deal since you are not just getting support but also upgrades w/o charge.

I would recommend that companies always get a contract in place that limits their M&E to the PRICE THEY PAID for the software, not the current list price, which is what most customers who don't know what they are doing agree to, either explicitly or implicitly. When company product sales are on the decline, companies will often raise the list price of their products so that they can milk more M&E revenue out of existing customers.

There is a tipping point where companies will try to renegotiate M&E or threaten to drop it. But dropping M&E (or skipping payments) isn't a good idea if you plan to stay with the software because most contracts specify that you have to make up missed M&E if you want the current product or support. Whenever I start a new sales job, I pull the contracts and histories for existing customers and ensure that they are all up-to-date on their M&E. I have made some good money doing this.

Customers need to read and understand what they are signing! At a prior company I worked for, they actually had a clause in the contract which let THEM cancel the contract on 30 days notice, for any reason whatsoever. This of course, effectively negates anything the customer negotiated originally (for instance if the company was acquired and got new management). I was amazed at the number of companies that left themselves exposed by signing off on a contract with this clause without any question.

2008 Nov 20 05:56 PM