By Paul DeGroot [bio]
Posted: Mar. 22, 2004

• Chart: Software Assurance Benefits

The following is the full text of an article published by Directions on Microsoft, an independent research firm focused exclusively on Microsoft strategy & technology. Each month we make one or more key articles available to non-subscribers.

Thousands of Microsoft customers face an important deadline in mid-2004, when Software Assurance (SA) upgrade rights purchased during a major promotion campaign in mid-2002 come up for renewal. In the short term, customers can save money by not renewing their upgrade rights, but they will give up the opportunity for discounted upgrades in the future. Microsoft expects that most of these customers will not renew SA, a decision that will impact Microsoft's revenues and reduce adoption rates for future products. In an effort to encourage customers to keep their upgrade rights, the company might sweeten the program, or modify it more radically.

The SA Transition Period

The large batch of SA contracts up for renewal in 2004 is an echo of the transition from Microsoft’s previous upgrade programs to the SA offering in 2001 and 2002. The company introduced SA partly to simplify a confusing array of upgrade options for customers in its Open and Select volume licensing programs. (Enterprise Agreements, used by large customers to license Microsoft desktop OSs, applications, and client access licenses [CALs] on all their PCs, already had terms that are very similar to SA.)

SA replaced all other upgrade options, including the most popular form of upgrade, the version upgrade. SA offers the right to upgrade to any new release of a licensed application during the term of the customer’s volume licensing agreement. In exchange, the customer pays a fee, based on an annual rate of 29% of a desktop license, or 25% of a server license, for upgrade rights. At the end of the volume licensing agreement, the customer must renew SA for one to three years (depending on the type of agreement) or the right to upgrade to future releases is lost, and the customer must purchase a new license to use these releases.

In general, SA is only available at the time a new license is purchased. However, adhering to this rule when the program was introduced would have made it impossible for customers to buy SA on existing licenses. Thus, Microsoft instituted a transition period, ending July 2002, during which SA could be purchased for existing licenses. During that time customers could use an older upgrade option, Upgrade Advantage (UA), which conferred the right to upgrade to any new version for two years, to purchase upgrade rights for the older products they already had installed (e.g., Office 97).

About 200,000 customers took advantage of the transition program to purchase UA for existing software, but those two years of upgrade rights come to an end no later than July 2004. Customers who want further upgrades for those licenses can renew those rights only by purchasing SA in a current or new volume license agreement (unless they have more than 250 seats, which would allow them to participate in an Enterprise Agreement instead).

(Some customers have longer to wait, but may still have to renew SA to get important upgrades planned for 2005, such as SQL Server 2005. These are customers who, rather than purchase UA, signed Select 6 agreements or Enterprise Agreements and purchased SA on SQL 2000 during the transition period. Those agreements start to expire in Oct. 2004, and by July 2005, all will have expired. They have the option of then renewing for either one year or three years.)

Renewals: A Difficult Choice

UA customers now face a difficult choice. If they don’t renew SA they lose the following advantages:

• The right to upgrade existing licenses to future releases
• A broad range of enhancements that Microsoft has added to SA, including training material, discounted software for employees’ home use, and various technical support options, ranging from TechNet subscriptions to telephone support.

(For a list of SA benefits, see the chart "Software Assurance Benefits".)

The reasons for not renewing include the following:

• Customers who purchased two years of UA in 2002 on major products such as Windows Server, Windows Server CALs, and Office already have rights to the latest versions of those products
• Customers who can wait until the second half of 2007 to upgrade to the next major versions of Windows Server or Office (upgrades that may not arrive until 2007 anyway) will probably find it cheaper to buy new licenses than to pay for upgrades through SA
• Many benefits (apart from upgrade rights) that are similar to the SA enhancements are available outside of the SA program for less than the cost of SA
• Customers who wait might be able to take advantage of additional benefits or incentives added to SA, reduced prices on licenses or SA, or substantial modifications to the program that Microsoft might introduce in an effort to make SA more attractive.

Why Significant Changes to SA Are Likely

Statements from senior Microsoft executives suggest that the company is considering substantial changes to SA to make it more appealing in the face of the big wave of UA-to-SA expirations. Among other issues that affect Microsoft’s thinking are SA’s impact on the company’s annuity revenue and its competitive position.

Annuity Income Impact

Last-minute purchases of UA during the transition period boosted unearned revenue (the revenue category through which Microsoft recognizes revenue from SA and other annuity payment programs) by about US$1.8B in the 2003 fiscal year. However, SA purchases quickly lost momentum, and SA’s contribution to unearned revenue has dropped. In the first quarter (ending Sept. 30, 2003) of its 2004 fiscal year, unearned revenue dropped US$768 million compared with Microsoft’s estimate of a drop of US$200 million to US$300 million. In the second quarter (ending Dec. 31, 2003), it dropped another US$395 million.

By June 2004, the last of that UA revenue will have been booked, and Chief Financial Officer John Connors expects only 10% to 30% of customers to renew SA. Part of the reason is the customers themselves: Connors says many of those who bought upgrade rights in 2002 were "opportunistic license-only" buyers who saw their last chance to purchase discount upgrades, but who have little interest in Microsoft’s maintenance program.

(For more information about Microsoft’s annuity sales channel, see "How Customers Buy Microsoft Products".)

Competitive Disadvantages

Another concern (about which company executives have not commented) is SA’s effect on Microsoft’s competitive position. Because other forms of upgrades were eliminated when SA was introduced, the price for sticking with Microsoft products among the majority of Select and Open volume customers, who have not purchased SA, has gone up.

For example, before fall 2002, Windows NT customers could buy (through volume licensing) a version upgrade to Windows 2000 Server for about US$370, or 50% of the price of a full license. Now, Windows NT customers who do not have SA upgrade rights will pay about US$740 for the same product. That price increase, coming just as Windows NT support ends, has effectively increased Linux’s price advantage over Windows.

Even among customers who aren’t considering a competitor, resistance to SA creates a barrier to rapid adoption of new versions. For example, adoption of Office versions beyond Office 2003 could be significantly retarded by the US$420 average volume price of new Office licenses for customers who let their SA lapse in 2004. In a move that reflects a similar concern, the Office team in February removed one set of SA enhancements—access to "solution accelerators" based on Office—and made them available to all Office customers, whether or not they had SA.

Microsoft could improve its competitive position and boost adoption of future applications, such as Office, by reducing the price of full licenses. However, SA customers have already paid for upgrades based on a percentage of the original license price, and they will be penalized if Microsoft lowers prices. Microsoft could provide rebates or other special benefits to SA customers, but this would create a costly fulfillment headache.

As Microsoft CEO Steve Ballmer, speaking to partners in Toronto in Feb. 2004, summed it up: SA is not having much impact on Microsoft’s revenues, and the licensing changes in 2002 have been "a big pain in the neck for some of our customers."

What Changes Might Be Made

For these and other reasons, Ballmer hinted in February at radical changes to licensing to resolve some problems with the current program and to make "maintenance" licensing more attractive and easier to customers.

Ballmer and other Microsoft executives have so far offered no concrete ideas about how Microsoft might change SA, but Directions on Microsoft’s analysis, based on our review of Microsoft’s licensing programs and of past Microsoft actions, suggests that the company’s primary options include changing the price of SA, changing the terms under which it can be purchased, offering additional enhancements to the program, or replacing the program with a different type of maintenance offering.

Changing the Price

By reducing the price of SA, Microsoft would bring it more in line with competitive offerings and would align the cost of upgrades more closely to actual upgrade schedules.

Even with its enhancements, SA is relatively expensive compared with what competitors offer. Typical enterprise pricing for both upgrades and vendor support is about 20% a year, according to market analyst IDC. SA is more costly, at 29% a year for desktop products (for which most customers don’t purchase vendor support) and 25% a year for server products.

Because the technical support included in SA is not comparable to Microsoft’s regular support offerings, customers who want 24/7 support still require an additional support contract, pushing the total cost even higher.

Also, if Microsoft fails to ship an upgrade during a customer’s three years of SA, the customer must renew for another two or three years; most customers who don’t get an upgrade during an SA contract would have paid less for their upgrade if they had simply bought a new license four or five years after the purchase of their original license rather than buying SA.

At a lower price, say 15% a year, SA customers could be more confident that SA would save them money. If Microsoft takes four or five years to ship an important upgrade (as will likely be the case with the next Windows desktop OS and with SQL Server, for example), SA customers would still pay less than the full license price.

Guaranteeing an Upgrade

Recent slips in the schedule for SQL Server 2005 have raised the ire of customers who purchased two years of SA on SQL Server and will now have to commit to two to three more years of payments to get the next version. Asked a similar question about what Microsoft would do for customers who purchased SA on Windows if the release date for Longhorn slipped (as it subsequently did), Platforms Group Vice President Jim Allchin told an interviewer in the fall of 2003 that Microsoft would "do right by customers."

This raises the possibility that Microsoft could guarantee an upgrade to the next version of the software for SA customers. For example, the company could give customers who have paid for at least three years of SA a license to upgrade to the next version of the software, even if it ships four or five years later. That would ensure, at minimum, that customers who purchase SA would not be penalized because of Microsoft’s delays. Customers who did not renew SA after three years might not be eligible for technical support and other SA benefits, but they would receive the core benefit, a future upgrade.

However, Allchin never gave any additional detail on what "doing right by customers" would mean, and the company has not announced any specific plans to guarantee upgrades.

Changing Purchase Terms

Microsoft could give customers more flexibility regarding when they purchase SA. Customers today must purchase SA at the same time they pay for the license, which means they often pay for an upgrade years before it becomes available and long before they know what features it contains. In earlier volume licensing programs, customers usually waited to pay for an upgrade until they actually upgraded (as is still the case for Microsoft products sold through retail channels). Ironically, Microsoft’s best customers, early adopters, take the biggest risk that their SA agreements will expire before the next version of their covered software is released.

By giving customers the right to purchase a two- or three-year upgrade contract at any time, Microsoft would give customers greater certainty that they would get an upgrade for their money. While this would shift some of the risk from customers to Microsoft, more certainty about upgrades would significantly improve the appeal of SA, resulting in greater annuity revenue and faster adoption of new releases.

Additional Enhancements

In an effort to make SA more attractive, Microsoft has added benefits to the program since it was first introduced, such as user training, technical support, and discounts for employee purchases of software. SA customers are also eligible for discounted upgrade paths, such as step-up licenses to move between Standard and Enterprise Editions of products, or other paths when the usage model or billing details for a specific product changes (e.g., when Project moved from a stand-alone desktop to a client-server model, or when Microsoft began charging Windows XP Professional customers for Terminal Services CALs). Microsoft has also offered price breaks, such as reductions in SA payments for volume purchases of Office 2003.

Microsoft could add even more inducements to the program in an effort to build a larger package of benefits and privileges around it—for example, by increasing the amount of support that Microsoft provides directly. However, this approach would be costly, it could reduce the company’s revenue from regular support programs, and it assumes that all customers who want upgrade rights also want more technical support.

New Maintenance or Subscription Offerings

Microsoft could also change the way it sells software to offer customers a choice of one-time payments for a permanent license or ongoing subscriptions for temporary licenses. One-time purchasers would not be eligible for upgrades; subscription purchasers would automatically receive all new upgrades and enhancements as long as their subscription remained current.

Microsoft has tested subscription programs in the past in some markets (a subscription version of Office was marketed in Australia, for example), but those tests have not inspired the company to expand its subscription efforts. One of the problems is pricing: in return for giving up permanent rights to their software, customers may demand subscription prices that are lower than Microsoft is willing to charge.

One alternative already being explored by some large customers is self-hosting. Microsoft’s license terms for hosted applications permit organizations to pay on a monthly basis for each application used by each employee, which gives customers considerable flexibility and control over which employees use which applications. In contrast, Enterprise Agreements require customers to license all covered software for every PC in their organizations, even though many of those licenses might not be used by every employee. However, organizations that pursue the hosting route must set up their own hosting company.

Microsoft could make it easier for customers to pay for their software in the same way that hosters charge, thus giving customers licenses that closely track their actual software use and providing Microsoft with an annuity revenue stream at the same time.

Terminate SA

A final option would be to launch a revised licensing program that replaces SA with more traditional upgrade offerings, such as version upgrades.

Such measures would have to be done carefully, however, to avoid reintroducing the complexity that SA was designed to fix. Furthermore, the company would need another transition program to ensure that customers who purchased SA are not penalized by the change.

Another Possibility: No Change

Another possibility is that the SA program as it stands today is more attractive to Microsoft than any possible change. SA has the following attractions for the company:

It generated substantial increases in revenue that helped tide the company through a down period in technology spending, and although its contribution to revenue is falling, customers will eventually need to upgrade, either by purchasing SA or by paying full price. Microsoft wins either way.

Increasing annuity revenue is a long-term goal for the company and will be particularly important as product development cycles lengthen. In 1999, Steve Ballmer said the company wants to move more toward "software as a service," and he suggested then that it would take a few years for the company to move to a model where a large proportion of its revenue came from annuity revenue streams. Tweaking the current model may be more attractive than going back to square one.

EAs received a boost when Microsoft introduced SA, for two reasons: the company reduced the number of seats required for an EA from 500 to 250, and the features of the SA program drove some customers to look at their upgrade options and sign an EA rather than go with SA. That additional EA revenue is a side benefit of the SA program.

Time Is Short

If it does intend to change SA, Microsoft will need to act in the next few months to avoid changes that upset a large number of existing contract holders. The expiration of the large batch of 2002 transition-period UA contracts in June 2004 gives Microsoft one of its better opportunities for change: it is much easier to begin a new contract, with new terms, than to amend an existing one.

However, because some customers bought two-year UA contracts and others bought three-year SA contracts in 2002, the first large batch of SA contracts will in fact be expiring between the summer of 2004 and the summer of 2005. Any special concessions to build support for SA will need to be factored into Microsoft’s plans for the coming year and will have to meet a variety of different customer renewal schedules, licensing needs, and support requirements.

Deciding Whether to Renew

Regardless of whether Microsoft changes SA, customers who are currently participating in the program will soon have to make a choice: renew or not. In choosing whether to renew, customers will need to consider the following:

The roadmap for current products. The value of SA going forward will depend on the particular products that are covered and the likelihood of significant updates.

For example, those who are considering renewal of their UA upgrades must decide whether Microsoft will release compelling upgrades within the next three years. Purchasing three years of SA in 2004 for these products offers only a modest discount off the full price (25% off for servers, 13% off for desktop applications)—assuming that the upgrades ship before the customer’s SA agreement expires. However, if the customer loses this bet and products are released after their SA expires, those customers will end up paying 50% to 74% more than customers who did not renew.

Given the recent release of Windows Server 2003 and Office 2003, and the current schedule for the Longhorn client release (2006, although any interim updates for current versions of Windows could push this to 2007), these products are not good candidates for SA renewal. However, server products, such as SQL Server, Commerce Server, MS Customer Relationship Manager, Systems Management Server (SMS), and Microsoft Operations Manager, are likely to see upgrades by 2006, which makes them better candidates for SA renewal.

Hardware compatibility. Purchasing upgrade rights on the client OS will have little value if he Longhorn OS will not run on a customer’s current PCs. These customers should wait until the Longhorn hardware requirements are clear and until the Longhorn release schedule is firmer, and then purchase SA on the PC OS when they purchase new Longhorn-compatible PCs within two years of the Longhorn release date.

The uncertain future of SA. Microsoft has sweetened the offer for SA several times since 2002, and could do so again, which could tip the balance in favor of SA renewal. However, Microsoft has not yet released details of any such improvements, which makes renewal for this reason highly speculative.

Given hints of more radical changes to Microsoft’s maintenance licensing model, many customers will be justified not renewing, but simply waiting to see what emerges. If Microsoft makes significant changes to its licensing rules, the company is likely to launch a transition program (as it did in 2001) to attract those who sat out its previous maintenance program; the transition period will give customers ample opportunity to decide whether they want to participate in SA's successor.

Resources

Release schedules for Microsoft’s business products are outlined in the Directions on Microsoft "Enterprise Product Roadmap".

Microsoft’s licensing models, volume licensing programs, and SA are discussed in detail in the Dec. 2003 Research Report, "Understanding Microsoft Licensing."