Subscription Software Is Changing the Rules

Years after Microsoft(MSFT Quote) popularized the phrase "software as service," its latest incarnation -- dubbed "on demand" -- is finally taking off.

The result: More software vendors, ranging from big-caps Siebel Systems(SEBL Quote) and Red Hat(RHAT Quote) to smaller companies such as Ultimate Software(ULTI Quote) and IPO-bound Salesforce.com, are collecting revenue on a subscription basis.

Although that means more predictability for investors, the subscription model also requires a change from the traditional way of evaluating software firms' financials. Questions over how to value subscription sales are certain to arise in coming weeks as software companies release their quarterly results.

"We believe that 2004 will be the year the software industry will hit a critical inflection point and move closer to being consumed as an 'on demand' service," Merrill Lynch analyst Jason Maynard wrote in a lengthy note about software on demand last month. "For the investor, the changes in the software business model have deep consequences," he continued. "Normal valuation metrics such as price-to-earnings and price-to-sales may not be appropriate." ...