We had a client many years ago that was struggling with how to bring a new software offering to market, specifically how to price it. Their core product was equipment used in manufacturing processes and the associated parts and accessories. The equipment was a large capital purchase for their customers, but they made most of their money of the ongoing purchase of parts and accessories (think razor blades). Their new software would help their customers design and optimize their manufacturing process and choose the best mix of parts and accessories. The challenge lay in the fact that, although the software would create tremendous value for their customers, it had the unfortunate side effect of frequently reducing the number of parts and accessories that they needed to buy. The leadership team was stuck with some wanting to postpone the software release indefinitely and others wanting to price it very high to make up for the potential lost parts revenue – and no one really thinking about customer value.
Software pricing can be complicated and confusing, but it need not be a reason to panic – even for organizations that are more comfortable pricing hardware. The primary thing to keep in mind is that all the rules of customer value still apply. Below are several of the pitfalls that we see customer fall into when pricing software, and some thoughts on how to avoid them.
Pitfall: Not being able to measure value
Too many software packages over-promise and under-deliver – think ERP implementations. As a result most customers are skeptical of software-based solutions where they have not used them before. To overcome this, you should strive to measure value in a way that is believable and demonstrable. In this case, our client got it right. They gave away 50 beta versions of the software and compared the results at those plants to 50 matched plants that continued current practices. This gave them an accurate and credible way to estimate the value for future customers (and gave them critical insight into how and where to improve the software).
Remedy: Strive for an independent and objective way to measure value, do not assume the customer will accept ‘trust me’ as evidence
Pitfall: Using the wrong reference point to measure value
It is critical that you understand the reference point of value from the customer’s perspective, which is their next best alternative. In the case of the equipment manufacturer, they had been thinking that they needed to price the software to overcome the reduction in sales of parts and accessories. That was an internal reference, not a customer reference. While it was true that the customer would see value in the reduction of those costs, the bigger value was in the optimization of their manufacturing process (e.g. less downtime, higher throughput, etc).
Remedy: Always start with the next best alternative (from the customer’s perspective, not yours, when measuring value.
Pitfall: Failing to anticipate the next best alternative
The software world moves quickly, with start-ups and spin-offs launching new products all the time. For this reason, it is even more critical to anticipate what the customer’s next best alternative might be, not just what they do today. In this case, if our client failed to release the software to extend machine life, it is likely that someone else eventually would. Remember: if there is a better way to solve a customer’s problem, someone will find it. Your job is to make sure that someone is you!
Remedy: Think broadly about next best alternatives and honestly ask “how hard would it be for someone else to do this?”
Pitfall: Ignoring the drivers of value
Another important factor to consider when pricing software is the source of the value, and more specifically one or two metrics that correlate to value in such a way that you can use them to set your price. The equipment manufacturer came in thinking that they were going to price their software based on a seat license per user. Although that is a very common way of pricing software, the number of users had very little correlation with the value that the customer could receive. A single user could be using the software to optimize anywhere between 1 and 50 pieces of equipment or production lines. The metric that mattered was the number of production lines.
Remedy: Dig deep to understand the underlying source of the value and identify a metric that correlates with that value when choosing what metric drives your price.
Pitfall: Not linking price to the goals of the business
We typically say that the goal of value pricing is to optimize the earnings impact on the business. If your goal as a business is to grow a profitable, self-sustaining business, then that statement is absolutely true. Although with software, too many companies get it wrong.
Not that long ago, it was common for companies to give away software to sell more hardware, because selling more hardware had always been the business goal. While this may have been historically true, it is clearly short-sighted. Over time it generally gets harder to differentiate on hardware alone, but software and analytics become more important – a balanced pricing approach that aligns price with where the long-term value is created is more likely to succeed.
In the pure software world, many smaller companies have a different goal: to maximize the valuation of the business for an equity event (sale or IPO). Valuation is often driven by metrics such as growth in subscribers, low customer churn, and/or growth in Annual or Monthly Recurring Revenue (ARR). The fundamentals of value still apply, but the decision on pricing to that value is often driven to optimize those metrics rather than purely profitability. In the end though, there still needs to be a path to profitability. Smart investors will look at the whole package, and if there is not a path to sustainable profit, they will stay away no matter how good one of these metrics may appear.
As an example, one of our clients had a goal of having a million users of their software, so they literally gave it away. Even so, only about 50 percent of customers ever used the software and those who used it never relied on it for a regular part of their business. As of this writing, they hit their goal of a million users, but are still struggling to create ANY revenue from the software offering.
Remedy: Start by confirming what you are trying to achieve as a business and have a clear and aligned set of expectations and goals for your software that are linked to long-term value creation.
Pitfall: Overcomplicating pricing
Because software is so configurable, it is far too easy to overcomplicate your pricing. You can have different levels (e.g. free, standard, pro), different modules, different add-ins, etc. While that flexibility can provide you the power to price-differentiate for customers who can self-select what they need (their segment), it also gives them the ability manipulate your pricing in their own best interest (as they should). Trying to “trick the customer” into buying something they don’t need usually ends poorly. In the case of the equipment manufacturer, their simplest and best pricing metric was based on the number of pieces of equipment being managed.
Remedy: Start with the simplest pricing model that you can construct that links to the driver(s) of value. You can always expand it over time (if expanding looks like it will deliver value over your first, simple approach).
Pitfall: Using the wrong business model
Some of the biggest business innovations over our lifetime have been business model innovations. Launching a new software offering provides a great opportunity to introduce, or at least explore, a new business model. Don’t get stuck in the mode of thinking business as usual.
In the case of the equipment manufacturer, they were initially thinking about per seat software license that was priced to try to overcome the anticipated lost sales in parts and accessories. What they launched was a price per piece of equipment model that had a built-in capability to directly place the order for the required parts and accessories per the design. What they achieved was a closer connection with their customer and increased sales for two reasons. First, it was easier for customers to order and they had a higher confidence in ordering the right part for their specific configuration. This slowed the penetration of third party parts and accessories. Second, and even more importantly, as the software-enabled ordering and tracking of parts became embedded in customers’ way of doing business, it helped our client in securing additional equipment sales.
Remedy: When launching a new software offering, step back and consider multiple business models, then pick the business model that both delivers the greatest life-cycle value to the customer and that allows you to capture the largest share of that value.
Although there are many pitfalls to avoid when setting your pricing strategy for a new software offering, but it is important to remember that the fundamental rules of customer value still apply. Taking time to evaluate your business goals for the software, value drivers, pricing structure, and business model options can help to avoid these traps and deliver improved business performance.