How vendors think about licenses: marginal price

CRN recently ran a story summarizing a Forrester Research study (sorry, I don't have the link - hopefully, someone will provide it in the comments) which revealed certain vendor practices which are stirring up resentment among CIOs. There is a lot within this report that our industry needs to take to heart, but there are a few items in there in which CIOs appear to want to have their cake and eat it too.

One item is based on a significant difference between how vendors view license fees for marginal users, versus customers viewing those fees (years after the contract is written) based on average price. Let's eavesdrop on a typical enterprise software sale to see the roots of this later dispute.

"So, I think I will need about 1000 users licensed for your CRM product this year, and then the population will grow by about 500 users next year, 1200 call center agents the year after, and then all international users in year four, which would be around 2500 additional users," said Carol Cio.

"I don't know if I'll still be on this account next year, let alone in four years," thought Sam Salesguy to himself. "Let's see if I can move this deal into this quarter."

"I'll tell you what," said Sam Salesguy, this time out loud. "How about if we do all 5200 licenses this year. If you can move that through procurement, I think can get you an additional 40% discount overall, and we'll phase in the maintenance on those licenses according to your schedule."

"I don't know if I'll still be in this job next year, let alone in four years," thought Carol Cio to herself, "but getting such a great concession from this vendor will improve my chances, make the CFO happier, make budgeting for the next few years easier, and will leave a little money on the side for us to bring that tablet roll-out for executives into this budget year."

"Let's do it," said Carol to Sam. "I'll push this through the CFO and procurement, as soon as you get approval from your sales management on the discount."

Later, Vince Veep said to Sam, "If we can pull in the deal this year, we can do the increased discount because we'll have reduced costs of administering contracts, we'll be sharing the risk with the customer, and because you and I will both be getting paid more for the deal." Vince thought to himself, "Of course this is what the company wants, because that's how they write our comp plans. If they wanted something else, they would compensate us differently. And it totally makes sense to share the risk with the customer, taking less money overall in exchange for a contractual commitment now by the customer. If the customer only wanted 1200 licenses now, they would pay more now for those licenses per user, and they would also pay more later for the other 4000 users. I would never offer this discount if the customer wanted an "out" clause, because then there is no shared risk. In fact, my friend Ed Economist would point out that the marginal price for the last 4000 users is lower than the unit price for the first 1200, so of course the maintenance price for those 4000 users is also lower. If the customer ever wanted to negotiate a cancellation of those last 4000 users, we'd have to go back to the higher price, plus we'd have to somehow be compensated for the commissions we already gave out and can't get back, plus also get compensated for the extra costs we have in contract administration and perhaps other areas of the company."

Perhaps I'm exaggerating what is going through Vince Veep's mind, but you get the point. To the customer, in economic terms, the marginal utility of a license in the future is about the same as the marginal utility of a license in the present, so that customer feels like she is getting a real bargain by getting that future license at a greatly reduced price, and often doesn't stop to think that there is a contract - that must be honored - underneath that price.

To the sales rep, the marginal utility of a deal in the future, when he may not have this account any more, is close to zero, so he would like to pull the largest check possible into this quarter, regardless of the interest of the vendor. The vendor's interest is enforced by a contracts and discount policies process, ensuring that the sales rep doesn't give away the farm, and that the customer gets a reasonable discount for taking on the risk of acquiring additional licenses.

If the customer needs to return those licenses in the future, the customer may be thinking about the average price of those licenses, but most likely the vendor is thinking about the marginal price of those licenses, plus a "restocking fee."

Obviously, in this short blog post, I'm oversimplifying a lot of things, and I'm not trying to fully represent the buyer's point of view, since that is widely covered elsewhere (e.g. at Constellation Research Group). I just want to communicate why it might be worthwhile to think about the marginal, rather than the average, price when thinking about license returns or exchanges. After all, understanding how your vendor is thinking might help you to better negotiate the best possible outcome for you and your enterprise.

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?

No.

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.

Enterprise Software Pricing

How should vendors and customers think about vendor pricing when it comes to pricing? 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 some fraction (b) of the customer's benefit from the product or service (B), multiplied by the customer's perception of the probability 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 far less than 1 (no customer will participate in a transaction where they expect to gain nothing!).  The "Ultimatum Game" experiment shows that psychology overcomes logic when dividing up benefits, but - in the real world - business sense generally prevails.  Customers are willing to share some portion of the benefits with vendors who bring them solutions; in my experience, this factor is generally between 0.25 and 0.5, depending on the urgency behind solving the customer's problem.

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 0.5; 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 access (as in product-led sales approaches), demonstrations, customized demonstrations, case studies, responses to objections ("objection handling"), customer testimonials and 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) or 1/4 (two competitors, do nothing, and built it ourselves). 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, dedicated advisor, active user community, 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.

Example application of this theory

This pricing model is just 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 contact 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. In aggregate, the company expects to achieve $5 million in additional revenue annually at a cost of $2.5 million, and a one-time implementation cost of $500K - so B = $5M - $2.5M - $0.5M = $2M. 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 3 vendors in total who have such systems, and the ability to build a system on their own, so d = 1 / (3 competitors + roll our own + do nothing) = 0.2. In this example, Pmax = (b = 0.3) * (s = 0.8) * (d = 0.2) * (B = $2M) = $96,000/year for a one-year subscription price. Fair enough, seems like a very reasonable price.  Assuming these figures stay the same, over a three year period the maximum price per year would be higher, given the implementation cost is a one-time investment (Pmax = 0.3 * 0.8 * 0.2 * $7.5M = $360K, or $120K per year).

What happens if the customer wants additional modules? Let's say the customer is looking at a new "generative AI" module, which is only available from the original vendor. If the benefits of this module are $2.5 million in savings due to reduced contact center costs at a one-time implementation cost of $100K, 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, since no alternative exists that works with the vendor's customer community system, so d = 0.5. Pmax is now $324,000, for the same $2.5 million benefit.  So the community system is worth $120K per year according to this model, but the AI system (with the same expected annual benefit) is worth $324K.

Industry analysts may 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 create 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?