By Reed Stevenson

SEATTLE (Reuters) - Microsoft Corp. MSFT.O is about to complete the biggest change in five years in the way that it sells its software to businesses with a system of locked-in upgrades and fixed payments that promises steadier revenue but has also rankled some smaller customers.

By Wednesday, the world's No. 1 software maker will have fully implemented the change in the way business customers pay for the right to use the latest versions of its software.

Chief Executive Steve Ballmer admitted that the shift in Microsoft's complex volume licensing practices, which it introduced five years ago, had sown some confusion.

"The fact that our customers probably didn't understand our licensing as well they might have earlier makes the transition and the perceived pain higher than it actually is," he told analysts at the company's Redmond, Washington headquarters last week. "So we're smarter for the experience, that's for sure."

Microsoft hopes to stabilize its income through multi-year contracts that promise to deliver regular updates through the new "Software Assurance" program.

Up to now, customers bought a license -- the right to use software -- and usually made one-time payments for an upgrade, often for a reduced price.

Under the new scheme, software buyers must decide whether to pay regular installments for the right to upgrade to the latest software at any time, or opt out of the plan and pay full price for a full-version software license later.

The change, closely watched by Microsoft's large customers, partners, investors and competitors, will mainly affect businesses that buy software in bulk, not consumers buying Microsoft products off the shelf or with a new computer.

Even so, the move has drawn complaints at a time when information technology budgets are under pressure and smaller firms are reluctant to upgrade to the latest Windows operating system, server system or desktop application, such as Office.

Most business customers will end up paying more for upgrades whether they sign on with the new program or not, "a reality that has drawn heavy fire from both customers and critics," said Paul DeGroot, an analyst at Directions on Microsoft, an independent research firm.

HIGHER HURDLES

The changes have already had an impact on Microsoft's income structure, but analysts appear split over whether the shift will improve future visibility -- at a time when investors are demanding greater transparency in corporate bookkeeping.

At the close of its June-ended business year, Microsoft had $7.7 billion in unearned revenue, up from $5.6 billion a year earlier, which represents sales billed upfront. So far, 20 percent of this year's projected sales, mainly from multiyear agreements, has been booked as deferred revenue.

"It gives them a predictable revenue stream, something that a lot of other software vendors out there wanted for a long time," said Dwight Davis, an analyst at Summit Strategies.

Others say that there's a risk that the unearned revenue could be more volatile than investors expect.

"You shouldn't expect that unearned revenue balance to grow anything close to what it did this year," Microsoft's Chief Financial Officer John Connors told analysts last week.

At the same time, analysts said the move would put a strain on Microsoft's resources since the software giant will have to deliver more timely updates -- a goal it has had some trouble with in the past.

"Software Assurance puts the pressure on Microsoft to deliver at least one 'must have' upgrade to key products such as Office during any three-year period," said DeGroot.

DISCOUNT OFFER ENDS

Microsoft has been encouraging customers to sign up for Software Assurance by offering favorable terms before the transition period ends on Wednesday.

But customer confusion over the new policies along with smaller IT budgets sparked a slew of complaints that forced Microsoft to delay the original deadline twice.

"The most common misunderstanding would be that customers felt that Software Assurance is a requirement," said Rebecca LaBrunerie, Microsoft's Licensing Program Manager.

"It's a choice," she said, adding that Microsoft has spent $20 million in the last three months to promote the program.

While large enterprises have signed on, rivals say some smaller businesses have opted for source software, such as Linux, which can be used and modified freely.

Demand for Linux "has just gone through the roof in recent months," said Diane Hagglund, Director of product management & marketing at Freshwater Software. Freshwater makes a Linux version of its Web system monitoring software.

Sun Microsystems Inc. SUNW.O , which began selling a competing product to Microsoft's Office suite, also reports some improving demand for its StarOffice product.

But Peter Houston, Director of Business Strategy at Microsoft's Windows Division, argues that the cost of maintenance and keeping up with industry standards would prove too costly for open-source users.

"We've asked people to take a deeper look and consider life-cycle costs," he said. "We're not seeing any significant movement away from Microsoft software."