Wednesday, July 29, 2009

When (and Why) to Accept Less Than Pmax

In my first blog entry on enterprise solution pricing, I described a model for understanding the drivers of pricing, from the customer's point of view (but for the benefit of vendors). I also introduced some ideas that may help vendors obtain a higher price from customers - and hopefully, deliver more real value to customers in the process.

But, just because a customer is willing to pay a certain amount for an enterprise solution, does that mean the vendor would be stupid to take less?


In fact, the model itself shows the seeds of ideas for why a vendor should almost always be willing to offer customers a lower price - in exchange for something more valuable than (immediate) money.

As a reminder, the pricing model I suggested for enterprise solutions goes like this: the maximum price a customer is willing to pay is based on four key factors:
  • the fraction of the customer's benefit that this particular customer is willing to pay to any vendor (aka whether the customer considers vendors to be opponents or partners),
  • the customer's perception of the probability of success of the project to implement the solution,
  • The customer's perception of the competitive differentiation of the vendor's solution as compared to substitutes (including direct competitors, DIY, and "do nothing), and
  • the net benefit available to the customer as a result of implementing the vendor's solution (total benefit less implementation and evaluation costs).
The lower any of those four key factors, the lower the price the customer is willing to pay.

So, why should the vendor be willing to offer the customer a lower price than the maximum the customer is willing to pay? After all, you won't often find customers willing to pay a vendor more!

Some things are more valuable than money

Simply put, some things are worth much more to a vendor than to a customer. In the transaction itself, the money is worth more to the vendor than to the customer - at least to the actors in the transaction. The enterprise solution salesperson is usually compensated not at a fixed salary, but instead on an accelerating commission basis. If the salesperson achieves say 0% to 80% of their quota (target for sales, usually on a quarterly or annual basis), they often get paid a very low base salary and a very small commission. From 80% to 100% of quota, the salesperson gets an "accelerator," giving her a higher commission rate for those sales. At 100% of quota, the salesperson is paid their "target comp" (target compensation) - the compensation amount in their contract or offer letter. After 100%, things get interesting, with many companies offering the salesperson a "kicker" for higher sales. If an account does business with the company after a change in salesperson responsible for the account, generally the prior sales rep will get no commission for the sale. Things are a little more complicated in most comp plans, but - trust me - your salesperson is highly motivated to close the deal this quarter. And this motivation goes straight to the top of the company.

But - and this is a big one - some things are more valuable to the company than your money. Remember, the maximum price the customer is willing to pay is based on four factors. On the customer's perception of those four factors. A vendor will often be willing to accept a lower price in exchange for help in closing more deals with other customers, faster, at a higher price. Any customer can help the vendor to accomplish this goal - by offering to provide some kind(s) of testimonial(s), case study(ies), sales reference(s), or even to help better understand the benefits of the vendor's solution(s). By providing this help, the customer helps the vendor to raise Pmax in other deals. This kind of help can raise other customers' expected probability of success, their expectations about the net benefit available, and even the perceived competitive differentiation of the vendor's solution, thus raising the price other customers are willing to pay.

Think of it another way, for those "mathy" folks out there. The vendor is trying to maximize EBITDA (within certain constraints, such as stability of sales and earnings, acceptable levels of risk) over the long run - or at least that's what their legal, fiduciary responsibility requires of them. Assume "P" in these articles is the price paid adjusted for the time value of money. Let's call the price paid by each customer P(i) (read "P sub i"), and the costs associated with that customer C(i). The vendor wants to maximize the sum over i of [P(i) - C(i)]. If a lower P paid by a particular customer can be made up by and overcome by a higher P paid by other customers, then the vendor should be willing to reduce P so that it is less than Pmax - if the vendor believes the customer will follow through on the commitment to help, and if the vendor believes the customer's help will actually raise P for other customers, and if the vendor believes this customer's help will be less costly and/or more beneficial than trying to get the same help from another similar customer.

The time value of money

In economics, we are taught to understand a concept that was clearly understood by Popeye's friend J. Wellington Wimpy, who famously said "I will gladly pay you on Tuesday for a hamburger today." Money is worth more to someone who has none, than to someone who has enough. This is known as the time value of money, and is something generally understood by anyone who has ever had to calculate the net present value of something, or who multiplied their monthly mortgage bill by 360 to see what their house really is costing.

As we established above, the salesperson is the person who is put under the most pressure by the time value of money. Any customer who offers to accelerate a deal into the current fiscal period for the vendor is likely to earn a substantial discount for his trouble. Most enterprise software business is closed in the last few weeks or days of the fiscal quarter, and nearly half of the license sales part of the business (for traditional, non-SaaS vendors) is done at the end of the fiscal year's last quarter. Subscription pricing, and the compensation plans for sales reps in most SaaS companies, discourages this type of deep time pressure and its attendant discounts, but customers working with more traditional vendors can use the end of a fiscal quarter or year to obtain a lower price.

The flip side of this is that vendors really do not like to take less money than they believe is fair for a solution, and the sales team is compensated on total revenue (and sometimes profitability), so the vendor is also dis-incented from making pricing concessions. Generally, the vendor would prefer to offer additional "seats," products, or services to maintain the price of the deal. There are internal control mechanisms, like forecasts for each deal and deal reviews and approval processes, that also aim to discourage discounting. After all, if one customer earns a discount, then Ray Wang will learn of it and every customer will ask for an even steeper discount in the future!

Market share

A really smart professor, Subi Rangan of INSEAD, advised some colleagues and I on a project about pricing models once. He advised that companies that can command a pricing premium often will offer products at a lower price for one or both of two reasons: to increase market share, or to grow the market. When a vendor can offer a product in a competitive market with a hard-to-copy way of offering a greater benefit, less project risk, or an important competitive differentiation, that vendor can increase market share by offering their product at a price below Pmax.

One last thought

One idea that has not been well thought through by me (or by others I've found) is the notion of the benefits that can be created when the customer and vendor work together in partnership. Every customer says they want vendors to be their partner, but few will fairly share the rewards or benefits the vendor brings. Similarly, every vendor says they want to be the customer's partner, but few will fairly share the costs and risks, at least in the enterprise solutions space. I hope that someday, in this industry, vendors and customers, salespeople and purchasing people will walk hand in hand in partnership, raising the prices paid by customers, but greatly - disproportionately - increasing the benefits obtained by the customer. Perhaps not as inspiring as the Revered Dr. Martin Luther King, Jr., but a lofty goal for us all, nonetheless.

As always, your thoughts, issues, ideas, critiques, and contributions are greatfully welcomed.


  1. Unfortunately, it's like a Middle east bazaar where neither side speaks the same language, where vendors assume tourists are suckers, and tourists have heard of huge bargains. Completely misaligned expectations and lots of hand waving.

    Best thing is to set up a Google or Zoho spreadhseet and have both sides collaboratively fill out a 10 year TCO to include license, maintenance, training, SI, upgrade every few years, ops cost, hosting etc

    we need realism in the overall planning - then negotiations can have some semblance of reality

  2. Dennis, I think you summed it up in your conclusion as far as where I personally would like to see the industry headed - true collaboration between enterprise vendors and customers when it comes to mutually defining value. Perhaps this is unrealistic in an era where "putting customers first" is almost always lip service and "putting shareholders first" is the undeniable reality. Or maybe it's a matter of making it clear to shareholders that short term gains based on milking customers leads to long term instability of investment.

    There are some rare examples of enterprise vendors and customers working together to define "value," I'd like to see much more of this, for example, in the SAP space, I blogged recently about defining tiered support models based on true customer needs (and contributions) to SAP's online communities. Like you, I think the market needs a lot more of this, well beyond what any vendor is doing today.

    - Jon

  3. Thanks, Vinnie and Jon. Jon, could you provide a pointer to your mentioned blog? Thanks ...

  4. While many vendors might want you strung up for heresy, there are some that would welcome stability and mutual benefits in exchange for the jousting contest that happens during price negotiations, renewals, etc. To reach your promised land there needs to be an honest, mutually agreed accounting of benefits and an evolution in the vendor/customer relationship. The good news is that the technology exists and altruistic vendors who might sign up.

    Determining maximum price is onerous, because an accurate quantification of value is nebulous in enterprise software. Vendors are throwing darts when they try to calculate the value of benefits, because customers are loathe to disclose the true value the solution. Customers can not calculate value, because they don’t know the breadth and depth of the application considered and its hidden benefits. So for the conversation to start on the right foot, quantifying value has to be an honest process, which will only happen when there is a high level of trust.

    But, dare to dream. Let’s assume boy meets girl and the Vision is to be made real. Advances in technology, particularly cloud computing, enable metering and actual usage and could provide a transparency to the benefits reaped (then to be shared). Beyond the technology advances, there is evidence of an evolution of business practices and the vendor/customer relationship. Agribusiness is giving way to locavores (look at Slow Food – Carlo Petrini). Investing has ceded some space to social entrepreneurism (look at SoCap ’09). Could enterprise software embrace the [insert buzzword here] partnership you describe? Dennis, you may be a dreamer, but you are not the only one.

  5. Nice thoughts, Carl! A few comments:

    1. While it may be hard to determine actual Pmax, vendors should realize how to increase Pmax - by developing partnering relationships (offering to share risk, for example), increasing probability of success (lowering implementation scope and costs, for example), increasing competitive differentiation (building in industry-specific functionality, for example), and increasing overall benefits to the customer (adding closed-loop analytics, for example).

    2. As to calculating value, today it is hard because we vendors are far too focused on automating business processes and recording business activities, and not focused on delivering transformational systems that deliver new business benefits ...

    There is a great song covered by Robert Gordon, Rockabilly genius, originally by Marshall Crenshaw, called "Someday, Someway" - part of the lyrics goes: "Someday, someway, maybe you'll understand me - You've taken everything from me, I've taken everything from you." Perhaps I am a dreamer, but I think we on the vendor side have the opportunity to transform this from a discussion of price ("Someday, Someway") to a discussion of business results ("Imagine").