Thursday, July 23, 2009

Enterprise Software Buyers' Bill of Rights and Pricing

There has been a great series of analytical posts resulting covering the topic of what rights customers should demand from their vendors when buying enterprise software. Ray Wang kicked off the series with his seminal analysis, which was reviewed and extended by Mike Krigsman, and commented on by Dennis Howlett, and extended by Vinnie Mirchandani. These four treatments are great analysis, and every buyer should read it. Every vendor should read it as well.

Customers should also think about why vendors behave the way vendors do. Is vendor behavior driven by greed? To an extent. Is
vendor behavior driven by fear (of litigation, bad press, or other horrors)? To an extent. Is vendor behavior driven by altruistic concern over what it will take to make a customer successful? To an extent. Is vendor behavior driven by customer behavior? 100 per cent.

All of which is to say, vendors behave the way vendors do, because customers drive them to do so. Vendors want customers' money now, and in the future, and they will do what they have to do to get customers to hand over money to them. Vendors want what they consider to be their fair compensation for the intellectual property (IP) they offer, and the work they do on behalf of the customer.

Still, many customers feel that they are being "taken advantage of" by vendors. From a vendor perspective, this is hard to understand. After all, if you don't like the product or its associated services, then as a buyer you can switch to a different vendor/supplier. If there is no alternative, or the switching costs are high, then why should the vendor lower its price? Customers are able to hire experts (like the aforementioned Ray, Mike, Dennis, and Vinnie) to learn from the experiences of other customers. Customers are able to network, demand references from vendors, and read industry news and analysis to understand what they're getting into. And no customer should make a major purchase without undertaking such efforts.

How products and services are priced

Over the years, I developed a theory of pricing that is based on economics and psychology (but let's be realistic, economics is macro-psychology -- the psychology in aggregate of some group of people). My theory goes like this: the maximum price (Pmax) a vendor can get a customer to pay is equal to a fraction (b) of the customer's benefit from the product or service (B), multiplied by the probability the customer perceives that the customer can achieve that benefit (s), multiplied by the perceived competitive differentiation of the offering (d). Written symbolically:

Pmax = bsdB

Put into words another way: a customer is willing to share some portion of its benefits with the vendor who made those benefits possible. The amount the customer is willing to share is based on how much the customer thinks is fair to share, how likely it is that the project will be successful, how many competitors or substitutes are there out there, and the total benefit expected. Prices will go down if the customer doesn't treat a vendor as a partner, expects that the project is risky, believes that there are many alternatives (competitors, or entirely different ways of spending budget to achieve shareholder value), or doesn't expect to achieve a lot of benefit from the project. Conversely, the price will go up if the customer views the vendor as a partner, believes the project will be successful, understands that there is a meaningful and valuable difference between the vendor's offering and any other market alternative, and has reason to believe that a significant benefit will accrue to the customer as a result of the vendor's offering.

The factors

b, the customer's willingness to share their benefits with the vendor, ranges from 0 to 1; 1 means the customer believes it is fair to give all its benefits to the vendor. Most commonly this number would be something between 1% and 50% (the customer would share 1% to 50% of their benefit with the vendor). This factor has little to do with any vendor or customer actions, but is really based on the customer's culture; a more arrogant culture will want to share less of their benefits (perhaps as little as 1% or even less). At customers with a culture where vendors are truly considered to be partners, the customer may be willing to share more of the benefit with the vendor (perhaps as much as 25% to 50%).

s, the customer's perception of the probability of the project's success in achieving the customer's desired benefits, ranges also from 0 to 1; 1 means the project is guaranteed to achieved the desired benefits. Most commonly, for IT projects, the probability of success should never be estimated above 50%; however, this factor is the customer's perception that the project will succeed. This factor can be artificially lowered or raised by the actions of the customer and the vendor. For example, a start-up will generally be considered a riskier partner; when offering the same product, this factor will be about 3 times lower for a start-up acting alone, as compared to the same exact product when sold by or bundled in by a large, established vendor. Vendors can increase "s" by providing evaluation copies, demonstrations, customized demonstrations, case studies, responses to objections ("objection handling"), customer reference calls, user group meetings (with happy users!), transparency about uptime (e.g. as Salesforce.com does), by offering various services to ensure project success or solution completeness, by creating a fixed-price bid, and in many other ways.

d, the customer's perception of the competitive differentiation of the product offering, also ranges from 0 to 1; 1 means there is no substitute for the offering. Now, there is always a substitute for any offering - the "do nothing" option (and often the "build it ourselves" option) - in corporations, this might also be considered to be the "do something else with the same budget" option. Although "d" is hard to quantify, it sometimes seems to be as simple as the reciprocal of the number of direct competitors (including "do nothing") - when there are two competitors, "d" might be 1/3 (two competitors plus "do nothing" = 3). Vendors can increase the perceived competitive differentiation in many ways. Vendors can offer a different business model (e.g. prepaid phones, freemium model, subscription pricing, open source, guarantees), complementary services (e.g. 24x7 monitoring, backstop service to ensure your SI is following best practices, annual user conferences, iTunes store, technical white papers, demonstrations, customer testimonials), or differentiated features (e.g. better UI, high availability, faster performance). However, no matter how the product is differentiated, none of that matters unless the customer sees the product as differentiated! The better UI must be demonstrated, certified by some authority (another customer, an analyst, an award of some type), and included in the evaluation checklist by the customer, or the vendor will be unable to increase "d" and thus capture a higher maximum price.

B, the customer's expected benefit, is a financial measure of the customer's net benefit (total benefits converted to currency, minus total costs converted to currency). How much would it be worth to the customer to have that benefit? Vendors, by virtue of working with many customers and speaking to many experts, often know of benefits the customer may not. Vendors and customers work together to identify "B," generally through some ROI study. Vendors can influence "B" by creating a good process for capturing benefits customers expect across various industries, geographies, and enterprise sizes, and then sharing these benefits with customers (and trying to get them onto evaluation checklists). Testimonials, expert estimates, studies, and other validating techniques help a vendor to establish the highest possible "B" with the customer. "B" is a "net benefit" figure, so any costs associated with the offering will reduce "B" - these can be switching costs, the cost of the evaluation process undertaken with the purchase, long-term costs, and implementation ("go live") costs.

All this, b times s times d times B, yields the maximum price the customer is willing to pay for the offering, or Pmax (pretend the "max" part is a subscript). Vendors may choose to settle for a lower P < style="font-weight: bold;">Example application of this theory


This pricing model is a model, or a theory. Let's apply it to an example case (or two) to see if it makes sense in a real-world context.

Let's consider a company who would like to implement a new customer service system, such as a customer community system. This system might offer benefits to the company including better customer satisfaction due to faster problem resolution, cost avoidance due to fewer calls to the call center, cost avoidance due to creation of a better knowledge base for problem resolution, increased revenue due to upsell and cross-sell opportunities, and perhaps other benefits (Lithium is one such system). In aggregate, the company expects to achieve $5 million in net present value (NPV) from the sytsem (using their weighted average cost of capital, etc.) - so B = $5 million. This customer tends to treat vendors somewhat as partners, so b is 0.3. The customer believes that the system has an 80% probability of achieving desired goals, given that it is a SaaS system with little technical risk, and given that many other companies are successful with this supplier, so s = 0.8. Finally, the company has identified 4 vendors in total who have such systems (perhaps not all as well-implemented and well-conceived as Lithium), and the ability to build a system on their own, so d = 1 / (4 competitors + do it in-house) = 1/5 = 0.2. In this example, Pmax = (b = 0.3) * (s = 0.8) * (d = 0.2) * (B = $5M) = $240,000. Fair enough, seems like a very reasonable price. The customer may be looking at this systems costs and benefits over a five year period in this example, and the customer and vendor negotiate this price.

However, what happens if this system stays in place after that period, or if the customer realizes that additional modules are required? Let's say the customer is looking at a new "knowledge base" module, which is only available from the original vendor. If the benefits of this module are $5 million in savings due to reduced call center costs, better customer satisfaction, etc., what is Pmax? Well, b is still 0.3. s is probably very high, since the major implementation is completed - maybe 0.9. The number of competitors is 0, so d = 0.5. Pmax is now $675,000, for the same $5 million benefit.

Dilettante industry observers will now tell the customer that the vendor is ripping them off due to "vendor lock-in" and "switching costs," but nothing could be further from the truth. Risk and competition for the second deal are now lower, so the price should be higher!
Both sides are acting in their own interest, and neither is being cheated.

In fact, many customers try to include a "standard discount" in their negotiations, just so they can avoid paying this kind of fair price later for their benefits. Vendors respond to this as expected, by creating new products (instead of adding features), or by reselling third party products, or by jacking up prices. In this case, instead of trying to creat win-win scenarios, the vendor and customer are locked in a "zero-sum game" (at best), and everyone loses out on the possibility of synergistic wins.

Industry observers, and customers as well, should remember this: any vendor who strives to raise Pmax will be working in the customer's interest - by reducing risk, creating differentiated solutions, and adding new benefits to their solutions. Obviously, some vendors also work to reduce the number of competitors to raise Pmax, but that is why we have anti-trust laws and occasional enforcement.

Customers should want to be good partners for their vendors. Customers should also strive to raise the value of their projects (Pmax), in a sense - they should also be striving to remove risk from projects and to increase the benefits obtainable. However, customers should also act in their own interest, by being aware of all relevant competitors, not introducing risk into a project, not overestimating probability of success, thinking into the future thus hedging risk and growth, and not expecting unrealistically high benefits from projects.

Any thoughts on this? Any good examples you'd like to share?

6 comments:

  1. Dennis,

    Great post and equation! You raise some perceptive points about vendors chasing customer behaviour. We see a lot of this in today's market.

    However, with less competition in the market and a return to better economic scenarios, vendors in oligopoly situations will be in the position to drive policy with less regard for customer requests.

    We'll just have to see if customers will still have any leverage in these new models.

    Warmest regards

    R "Ray" Wang
    Software Insider's POV
    http://blog.softwareinsider.org

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  2. Dennis,

    I enjoyed your post. Vendors are motivated by customer behavior, no doubt. However, I think it's important to note that vendors can change the terms of the debate by altering their behavior. Certainly, pricing and licensing can all be tweaked in an effort to meet customer needs, but what about more fundamental changes to allow for a customer warranty or guarantee that the solution will be successful according to pre-defined terms by both vendor and customer.

    This warranty approach requires the vendor to put their "product" where their mouth is, so to speak. It also requires the customer to define realistic success criteria in advance and stick to that definition for the lifetime of the license.

    Just a thought, but it's something that we've done at InnerWorkings to good effect.

    Best regards,

    Brian Finnerty
    www.innerworkings.com

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  3. Brian-

    All good points.

    Software vendors are generally unwilling to share (or fully bear) the downside risk, because they don't believe customers are willing to limit themselves to "best practices" likely to achieve success, and because customers are unwilling to share the upside benefits of success with the software vendors. Customers have been burned and harmed by such deals as well, as the fully spec'ed out approach leads to a severe disincentive to disruptive innovation, leaving the customer at a competitive disadvantage in the market.

    Good ideas - thanks!

    - Dennis

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  5. Dennis,

    Thanks for a great post. The pricing question is one that requires a lot of thought - I found your insights to be very helpful in approaching the issue for my own company.

    I thought your comment on customers treating vendors as partners was interesting. I agree, but it's often the case that customers don't do this. In fact, in my experience, the vast majority of customers view their vendors as something closer to enemies! I wonder why this is, given that often times it's in the the interest of customers to have a friendly relationship with their vendor.

    Homepage.

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  6. Brett -

    The relationship dynamics between customers and vendors are complicated - maybe worthy of another blog. If there were only one person at the customer and one at the vendor involved, I'm sure each would see the benefit of partnering more. Instead, there are multiple people on each end involved, and this makes it difficult to keep a partnership relationship in place unless there is executive commitment on both sides and a behavior within both firms to follow through on that commitment.

    Think about the people involved. At a customer, there may be a variety of users (IT, line of business), a number of divisional "deciders" (finance, sales, IT, marketing, International), someone in purchasing who negotiates some of the terms of the deal, and a budget owner. The chances that all these people will have a consistent agenda is very low, especially over time (e.g., when the old CIO is fired after 2 years).

    Similarly, on the vendor side, there is a cast of characters: the original sales person, the original pre-sales person, the contracts person, all the people in consulting and tech support who get involved, the sales exec who shakes the buyer's hand, etc., and these people change jobs frequently too. Remembering the promises of the former sales guy can be pretty hard for some vendors as well.

    Game theory explains how this conflict can come about even when there are only two participants: http://en.wikipedia.org/wiki/Prisoner%27s_dilemma . Without strong leadership, a partnership relationship is unlikely.

    - Dennis

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