Varonis Systems (VRNS -0.02%) is a small-cap cybersecurity company that is making big changes to its business model. The company, which provides software for protecting unstructured data (emails, spreadsheets, documents, etc.), announced it will transition from a software licensing model to a software as a service subscription model (SaaS).

The change is expected to have an impact on which software packages customers buy and how they will be billed. Does this business model transition make sense?

A man using a computer in the dark.

Image Source: Getty Images.

The rationale for changing the business model

When Varonis was founded in 2004, it had a more limited use case for its cybersecurity software. Today, the company sells 24 different software licenses, complicating the sales process for both the company and its prospective customers.

Under the current software licensing model, Varonis sells the customer a perpetual right to use a version of the software. Under the SaaS model, customers purchase a one-year or multiyear subscription to use the software.

The key difference from the customer's point of view is that the licensing model requires a large upfront payment to purchase software for a "lifetime" term. With the SaaS model, the customer pays a much smaller monthly rate, making it more affordable to purchase a larger bundle of applications upfront. Also under the subscription model, the customer is entitled to receive the most updated version of the software.

On the fourth-quarter 2018 earnings call in February, when Varonis announced the SaaS transition, CEO Yaki Faitelson said:

We see much available market and room for platform adoption both through the adoption of new customers as well as the expansion in the existing customer base. ... We also recognize that we need to make it easier for our customers to adopt more of the platform earlier in the journey with us and make it smoother for our sales teams and partners to sell the full platform, which will ultimately drive accelerated increases in total customer and lifetime value.

In other words, Varonis is betting that a SaaS model will encourage customers to spend more money over the term of their subscription as the lower upfront cost leads to their buying more. Customers will also influenced to stay subscribed longer because subscribing to a larger software bundle for a lower upfront and monthly cost will make the customer feel as if they are receiving a better overall value from Varonis.

The reality is also that Varonis needs to make this change because the market has moved in this direction. Many customers prefer to spend on software incrementally without multi-year commitments, and competitors already offer their software as a pay-as-you-go subscription.

Breaking down the financial implications

Although Varonis expects the change to a SaaS model to have financial benefits over the long term, the transition will be a short-term negative to revenue and cash flow because instead of paying a lump sum upfront, customers will pay over time. During a recent conference call, the company disclosed that the SaaS model would "break even" with the licensing model around the three-year mark. Which means that it will take three years to recoup in monthly fees what could have been collected upfront under the licensing model.

There is uncertainty over to what degree the top and bottom lines will be impacted, for two key reasons. First, the company will go back to its customers in an attempt to convert preexisting licensing deals into subscription plans, and it is unclear how many customers will convert. If customers are happy with their current plan, Varonis will let them stay put.

Second, the company has made some assumptions about how many customers will upgrade to larger bundles based on a pilot program the company did with a limited set of customers in 2018. There could be an upside if many customers upgrade to larger software packages, but there could be a downside if they do not bite. 

Varonis will likely benefit financially in the long run, but the road will be bumpy. Renegotiating deals is messy and could result in some short-term disruption, negatively impacting near-term growth prospects. However, once Varonis is on the other side of this transition, the company may see revenue per customer rise and benefit from a stickier customer base that generates a more predictable revenue stream as opposed to a series of lumpy sales "deals."

Investor reaction

Investors were immediately negative. Varonis stock was down more than 10% on the day the transition was announced in February. This reaction came even though the company reported better-than-expected earnings for the fourth quarter.

VRNS Chart

VRNS data by YCharts

It makes sense that investors were negative about the announcement. It came as a surprise, and the headline impact was a hit to the company's guidance. Furthermore, the business model transition creates uncertainty and potential short-term disruption.

A few weeks after the initial announcement, Varonis executives appeared at a Morgan Stanley conference where they provided significantly more detail regarding customer adoption expectations and financial assumptions. For example, before the Morgan Stanley conference, Varonis had not disclosed any insight into the pricing differences between the SaaS and licensing model. However, at the conference, the company described the three-year "break even" on revenue per subscription.

The stock is still trading below its pre-announcement level, however, investors appear to be coming around as they assess the longer-term impact.

Does the transition to a SaaS model make sense?

The SaaS transition makes sense for Varonis. Selling dozens of different software packages sounds like a logistical nightmare for a smallish company. Subscription models play to how customer buying behavior has evolved and how many other (if not most) software companies now package their products.

Not to mention the financial benefits the company will likely realize, as the switch amps up its ability to cross-sell products and potentially improves customer retention. The temporary headwind is manageable for a company like Varonis, which grew sales over 20% last year and has no debt.