Software License and Maintenance Pricing Principles Best Practices and Case Studies

Walter Baker and Homayoun Hatami

SoftSummit Conference, Santa Clara, CA October 18, 2004
Copyright 2004 McKinsey & Company

TODAYS DISCUSSION

Why pricing is important and why superior pricing

performance is hard to achieve

Examples of software license and maintenance pricing

issues and best practices

PRICING IS BIGGEST LEVER AFFECTING PROFITABILITY

Average economics for ISVs between $100 million and $10 billion in sales
Raising price by 1% increases profit by 7% Improve by 1% yields operating profit improvement Percent True nature of price/ volume tradeoff Percent

101

15
1

Price

26 100

Operating profit

Volume

COGS Fixed costs

59

Price change Volume change required to breakeven on profit basis

-5

COGS Sales Fixed costs

How many resources are dedicated to reducing costs or increasing volume vs. improving pricing?

Do price reductions drive sufficient incremental volume?

Source: CompuStat, 2002; McKinsey analysis

NUMEROUS CASES SHOW SUBSTANTIAL UPSIDE POTENTIAL EXISTS FROM IMPLEMENTING PRICING BEST PRACTICES
Improvement in return on sales (within 12 months of implementation) Percentage points
10

DISGUISED EXAMPLES

Case example Enterprise software Storage systems (hardware, software, and services) Computers (servers and software)

Telecom (hardware and software) Enterprise software

Pricing impact is usually greater in situations with: Complex product lines Many transactions Broad customer base High switching costs Weak current pricing capabilities

3
Source: McKinsey engagement experience

EVEN SO, MANY TECHNOLOGY COMPANIES FEEL THEIR PRICING MANAGEMENT SKILLS ARE "BASIC"
Pricing excellence skill level Deficient Basic Very good (1) (2) (3) Strategic pricing

Companies in top quartile Companies in bottom quartile

Superior (4) Lifecycle and industry level pricing abilities are key differentiators

Proactive management of industry

conduct Systematic lifecycle pricing Product differentiation to optimize margin capture

Structural pricing

Quantification and communication

of value proposition Exploitation of alternative pricing schemes Ability to quantify and communicate value is weak across the board

Transactional pricing

Understanding/quantification of
discount elements Creating discipline on discount management

Pricing process, organization, tools, and enabling devices

Optimizing bid process Decision support tools Transaction based monitoring

systems Skill building and training Pricing coordination across units Impact on incentive system Average score: 1.8 2.7

Wide variation in capabilities across core elements of pricing enablers and infrastructure 4

Source: Survey and interviews of 120 senior executives from technology companies, 2003

SUPERIOR PRICING IS CHALLENGING IN GENERAL

Top management attention focused elsewhere (e.g., growth, cost

Focus and dedication reduction) Limited investment in pricing function and infrastructure Few dedicated, capable pricing resources

No transparency into actual net (pocket margin) pricing

Visibility into opportunity performance across deals, customers, products, markets Size of prize and potential improvement opportunities not fully appreciated and prioritized along with other initiatives

Poor understanding by frontline decision makers of fundamental

Frontline pricing performance tradeoffs and implications Incentives not aligned to drive improved pricing performance (e.g., sales focused on closing deals every deal is a good deal)

Share or volume growth aspirations dominate sales strategy

Strategic direction instead of profitable growth Price not value seen as primary competitive weapon Fear of embracing price leadership

 AND EVEN TOUGHER FOR TECHNOLOGY COMPANIES, ESPECIALLY SOFTWARE BUSINESSES Frequent innovation and short product lifecycles Steady growth in feature functionality with often decreasing Dynamic
environment price/performance ratios

Potential for high user switching costs, network effects, and

Winner takes all mindset emergence of de facto standards drives push to establish presence Discipline lost in rush to get to market

Value delivered is hard to quantify and communicate (e.g., for

Communication of value new innovations, software, and services) Marginal costs perceived to be at or near zero for software leading to extreme discounting

Complexity over lifecycle

Myopic view of pricing strategy and tactics over product lifecycle Multitude of alternative pricing models and approaches available
many degrees of freedom (e.g., across license/services)
6

TODAYS DISCUSSION

Why pricing is important and why superior pricing

performance is hard to achieve

Examples of software license and maintenance

pricing issues and best practices

COMPONENTS OF SOFTWARE LICENSE AND MAINTENANCE PRICING

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segment based value pricing strategy

Standard
license pricing Discounting policy and practice Channel pricing

Warranty Update/
upgrade

Ordering
and delivery

Payment
terms

Renewal
pricing

License
management

Revenue
deferral

Lifecycle
pricing

Support
Pricing model Discounting policy and practice

License and
maintenance compliance

Internal
transfer pricing

Special License
structure Model (e.g., perpetual vs. subscription) License metrics License scope license pricing Volume based models Enterprise level agreements

Maintenance
offering

Promotion
and demo pricing
8

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segment based value pricing strategy

Standard

Warranty

Ordering
and delivery

Payment
terms

Renewal
pricing

License
structure Model (e.g., perpetual vs. subscription) License metrics License scope

license pricing Update/ Discounting upgrade policy and Common issues Support practice Channel Pricing One size fits all product/pricing pricing model architecture Discounting Special policy and license practice pricingvs. benefit not assessed at Price segment level Volume based models License metrics not aligned with Enterprise customer value perception level agreements

License

Revenue

Lifecycle

management deferral pricing Best practices License and Internal Unbundle transfer maintenance software suites as appropriate to better address compliance pricing underlying segment needs

Analyze differences in value

perception by segment and set pricing strategy accordingly

Align license scaling metrics with

fundamental customer impact parameters (within constraints imposed by ease of administration)
9

Maintenance
offering

Promotion
and demo pricing

IMPACT OF UNBUNDLING SOFTWARE SUITES

Percent
11 100 -20 7 15 8 120

DISGUISED EXAMPLE

Money left on the table due to unsophisticated differentiation model Current revenue Want base only (80% existing) Want func tionality (20% existing) Convert losses to wins Price sensitive mid tier Func tionality seekers Expected revenue with base/module price structure

20% increase from unbundling software suite

Current customers Modules* Base only 0 Base+2 modules Base only 20

New customer segments Base Base+1 only module 10 10

10

Assumptions Percent change in number of deals

* Base now priced at 75% of original price; incremental modules each priced at 30% of original base price

OPPORTUNITIES TO ADDRESS DISTINCT VALUE PROPOSITIONS IN CUSTOMER SEGMENTS

No product purchase strategy Segment 1

DISGUISED EXAMPLE Clear product purchase strategy

Company A Value disadvantage Competitor B

Value advantage

1 3 1

 

Moderate or nonsoftware users

Segment 4

Segment 3 Competitor C Value disadvantage Value advantage

1

Company A Competitor B

Value advantage

 

Value disadvantage

Heavy software users

Company A Competitor B

Segment 2

Company A Competitor B ~15%

Competitor C Value disadvantage Value advantage

Value pricing opportunity

1

11

CHOOSING WRONG LICENSING METRIC CAN LEAD TO HEAVY DISCOUNTING OR BELOW VALUE PRICING
Company Pricing parameter Alignment with perceived value Capacity Poor Competitor Ports High

DISGUISED EXAMPLE Competitor price lower Company price lower ?

Ratio between client and competitor list prices Number of ports Capacity 1 2 4 6 8 10 15 20 8 1.2 1.4 1.7 2.0 2.3 2.6 3.3 4.1 16 1.0 1.1 1.4 1.7 1.9 2.2 2.8 3.4 32 0.8 0.9 1.1 1.3 1.5 1.7 2.2 2.7 64 0.6 0.6 0.8 0.9 1.0 1.2 1.5 1.9 128 0.4 0.4 0.5 0.6 0.7 0.7 1.0 1.2 256 0.2 0.2 0.3 0.3 0.4 0.4 0.6 0.7 Company price far exceeds competitor price and perceived value, forcing sales force to discount heavily 12 Perceived value Competitor Company Perceived value Competitor Company

Company undercuts competitor and does not fully capture value

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segmentbased value pricing strategy

Standard
license pricing Discounting policy and practice Channel pricing

Warranty Update/
upgrade Common issues

Ordering
and delivery

Payment
terms

Renewal
pricing

License

Special License
structure Model (e.g., perpetual vs. subscription) License metrics License scope license pricing Volume based models Enterprise level agreements

management Support Lack of frontline discounting Pricing License and discipline (e.g., at end of quarter) model maintenance Discounting compliance policy and practice Target discount structure does not differentiate by segment

Revenue Lifecycle Best practices deferral pricing Establish discount floors and exception management Internal transfer processes with incentives tied to pricing measurable performance Differentiate target discounts by
segment based on underlying value differences

Special license agreements are

all one-off deals

Standardize volume/ELA deal

T&Cs and centralize approval process to ensure consistency

Maintenance
offering

Promotion
and demo pricing

Enterprise license agreements

used with smaller accounts

Set rigorous account criteria to

qualify deals for ELAs
13

WIDE VARIABILITY IN FRONTLINE PRICING

Deal level analysis
License discount Percent of list price Why do smaller deals receive such large discounts?

DISGUISED EXAMPLE

6 5 4

What is justification for such widely varying discounts for similar sized deals?

Can sales behavior be 1 changed to limit discounts at standard levels?

Why are there so many deals (even medium ones) at full list price?

1
Deal size Dollars

1
14

 OFTEN INDICATES OPPORTUNITIES TO IMPROVE FRONTLINE PERFORMANCE

Distribution of deals by discount level Percent of sales Maximize upside potential Set list prices competitively and fairly Avoid additional automatic discounts (e.g., volume discounts) Focus marketing program and executive visits

DISGUISED EXAMPLE

Tighten range of discounting Create disciplined pricing/escalation processes Align sales force incentives to reduce discounting Create tools to track and support frontline pricing performance

21.6 1 .8

11.0 .6 .5 .9 0.9 <5 5 10 10 15 15 20 Discount band Percent of list price 1.5 20 25 25 30 30 35

11.1 8.0 .8 2. 1.0 35 40 40 45 45 50 50 55 55 60 0. 60 65 65 0

2.0 0.2 0 5 5 80

1.3 80 85

0.3 >85
15

POOR MANAGEMENT OF EXCEPTIONS MAKES IT EASIER TO NEGOTIATE INTERNALLY THAN EXTERNALLY

Approval/rejection of exceptional discount for deals Number of deals Discount rejected 1

DISGUISED EXAMPLE

Managers rarely reject

escalated deals Sales reps are not afraid to request high levels of discount Sales reps do not suffer any consequences from offering excessive discounts Area VP VP Sales

Discount approved

Sales manager

Quotes from sales force interviews Managers are no deterrent, they approve everything We never walk away from deals These big deals with huge discounts only get done because of senior management approving them
16

IMPACT OF IMPROVING END-OF-QUARTER BEHAVIOR

Initial situation Percentage of total deals 100% = 220 After 1 year Percentage of total deals 100% = 263 14% profit improvement Change initiatives

DISGUISED EXAMPLE Average discount

72

56 44
2

Marketing role expanded to include

Competitive intelligence Price negotiation support

Sales incentives
Mid-quarter quota targets Price realization incentives and penalties

First 11 weeks 45%

Last 2 weeks 37%

First 11 weeks 43%

Last 2 weeks 28%

Commitment to change behaviors

CEO approval for EOQ deals over Area VP discount authority

Internal and external

Impact Shift in deal volume away from end-of-quarter Reduced discounting on largest deals Improved profitability (on higher deal volume) communication strategy

17

DISCOUNTING POLICIES SHOULD REFLECT DIFFERENCES IN CUSTOMER SEGMENT VALUE PERCEPTIONS

License discount Percent of list price Academic Government Pharmaceuticals Professional services Utilities Packaged goods Manufacturing Financial services
8 8 8 8

DISGUISED EXAMPLE

Traditionally higher discount segments Discount policies should be tighter in those segments where software titles are of intrinsically greater value

One-size-fits-all discount floors % % %

18

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segmentbased value pricing strategy

Standard
license pricing Discounting policy and practice Channel pricing

Warranty Update/
upgrade

Ordering
and delivery

Payment
terms

Renewal
pricing

Support
Pricing model Discounting policy and practice

License Lifecycle Common issues Revenue practices Best management deferral pricing Concessions at time of Enforce strict criteria license sale can delay License and Internal and require approval maintenance transfer for nonstandard terms maintenance revenue compliance pricing stream Excessive discounting
of maintenance services

Special License
structure Model (e.g., perpetual vs. subscription) License metrics License scope license pricing Volume based models Enterprise level agreements

Establish tight discount

policies and practices for maintenance (e.g., sales commission carve outs)

Choosing between
percent of list vs. percent of net maintenance pricing

Either practice can be

viable provided there is sufficient discipline
19

Maintenance
offering

Promotion
and demo pricing

SOFTWARE WARRANTY/MAINTENANCE CONCESSIONS CAN REDUCE ANNUITY OPPORTUNITY

Effective warranty/maintenance period due to concessions given away at time of license sale Percent of licenses
45

DISGUISED EXAMPLE

Due to forward sale or shelfware customer not ready to use software

25

Due to previous deals or concurrent sales (e.g., hardware) with customer

25

0-3

3-6

6-9

9-12

12-15

15-18

18 18

Standard industry practice for warranty (90 days)

Coverage period Months

20

NET EFFECT OF SOFTWARE MAINTENANCE DISCOUNTS CAN BE SIGNFICANT

Maintenance revenue, indexed to revenue = 100

DISGUISED EXAMPLE

175

35 25 15 100

List value of revenue

Discounts at time of license sale

Discounts at renewal

Customer satisfaction and other hidden discounts

Net revenue

21

MAINTENANCE SERVICES CAN BE DISCOUNTED MUCH LESS THAN LICENSE SALES

Share of list revenue Percent License

DISGUISED EXAMPLE

License discounting rules

Average ~50%

1 9

often violated Licenses in biggest deals almost given away

16 6
0-10

10 6

11

10-20 20-30 30-40 40- 0 Average 3%

0-60 60-70 70-80 80-90 90-100

Maintenance

Maintenance discounts were rarely

allowed Sales reps were required to sell maintenance with license and were penalized if they discounted it

7 (all at 0)

10
0-10

1 0 0 0 0 0 0 0
22

10-20 20-30 30-40 40- 0

0-60 60-70 70-80 80-90 90-100

Discount Percent of list price

THERE IS NO DOMINANT SOFTWARE MAINTENANCE PRICING MODEL

Software maintenance pricing model Percent, N = 24 companies Percent of license list price Novell Peoplesoft 33 38 Progress CA Sun IBM EMC 2 Filenet Legato Mixed models Veritas HP Caldera Linuxcare Microsoft NCR Sybase Percent of license net price BMC HDS Clarify DEA IFS Network Associates Oracle SAP

2001 DATA

There is no right
answer either model can be viable Mix of models used by industry Can usually realize any given absolute price point under either model

Best choice of model

depends on sales objectives, incentives, frontline discipline, and sometimes tactical factors (e.g., systems)
23

Source: Gartner 2001 software support portfolio (October 2001); IDC 2001 support services for enterprise-level applications; Company website; McKinsey analysis

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/

Standard

Warranty

Ordering
and delivery

Payment
terms

Renewal
pricing

pricing license architecture pricing Update/ Feature Discounting upgrade Best practices Common issues bundles policy and Use Support Segment- license practice electronic license Inadequate based value Pricing management tools to management tools Channel pricing pricing facilitate registration, model result in lack of strategy purchase, trial usage, Discounting installed base usage Special and customer software policy and information License license asset management practice structure pricing Volume Entitlement systems Model (e.g., Entitlement check and perpetual vs. based can limit unlicensed enforcement practices subscription) models usage and create for license and License Enterprise opportunity for maintenance are weak metrics level maintenance renewal/ License agreements up-sell scope Promotion Maintenance and demo offering pricing

License
management

Revenue
deferral

Lifecycle
pricing

License and
maintenance compliance

Internal
transfer pricing

24

ELECTRONIC LICENSE MANAGEMENT CAN HELP ENFORCE ENTITLEMENT RIGHTS

DISGUISED EXAMPLE

Breakdown of software related customer service support calls Percent

20% of calls were not entitled to support

Significant support cost reduction opportunity Opportunity to upsell/renew maintenance contracts

20% 0%

Not entitled

Electronic license management tool,

combined with entitlement system can: Bring visibility to compliance issues Clamp down on unlicensed usage Lower cost of managing support entitlement

Entitled to support

25

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segmentbased value pricing strategy

Standard

Warranty

Ordering

Payment
terms

Renewal
pricing

license and delivery pricing Update/ Discounting License Best practices Common issues upgrade policy and management practice Prepaid or early Support Ensure business Channel License and payment terms oftenPricing objectives and logic pricing maintenance generous beyond model underlying prepaid or compliance early sound give and get Discounting payment terms Special policy and justify margin reduction License license practice structure pricing Service giveaways and Reducing or eliminating Model (e.g., Volume service giveaways and concessions lead to perpetual vs. based concessions can help misaligned sales vs. subscription) models reinforce and clarify corporate finance License Enterprise overall corporate deferral methodologies metrics level deferral guidelines License agreements scope Promotion Maintenance and demo offering pricing

Revenue
deferral

Lifecycle
pricing

Internal
transfer pricing

26

COMMON ISSUES AND BEST PRACTICE EXAMPLES

License pricing Maintenance pricing Delivery and management Revenue operations Renewal and end-of-life pricing

Offering

Product/
pricing architecture Feature bundles Segmentbased value pricing strategy

Standard
license pricing Discounting policy and practice Channel pricing

Warranty Update/
upgrade Common issues

Ordering
and delivery

Payment
terms

Renewal
pricing

License Revenue Best practices

Lifecycle
pricing

Special License
structure Model (e.g., perpetual vs. subscription) License metrics License scope license pricing Volume based models Enterprise level agreements

management deferral Support Provide sales incentive Inefficiencies in Pricing Internal renewal process License and can to renew contracts well model maintenance expiration and void and delay renewal before transfer Discounting compliance pricing opportunity support reps with policy and efficient renewal practice process (e.g., inside sales support)

Discount policies are

same for maintenance deals at both time of license sale and renewal

Tighten discounting
policies for renewal and enforce discipline in renewal negotiations

Maintenance
offering

Promotion
and demo pricing
27

INEFFICIENCIES IN RENEWAL PROCESS CAN VOID OPPORTUNITY

Renewal opportunities Indexed to total opportunity 100 15 10 <10 <5 Sales not pursuing all renewal deals (lack of sales priority/capacity) 60

DISGUISED EXAMPLE

Best practice renewal rate for software is 8595%

Sales not closing all renewal deals (lack of productivity or skill)

Total opportunity

Cancelled for admin reasons

Forgone opportunity

In quote or pending customer response

Cancelled by customer

Renewed

28

 AND ALSO DELAY OPPORTUNITY CAPTURE

Percent of renewal opportunity value

DISGUISED EXAMPLE

28

Best practice is to send renewal quote and P.O. 90 and 30 days (respectively) before contract expiration to lock in renewal Long renewal process teaches customers that renewal decisions can wait
14 9 6 4

Average = 29
16 16

Before expiration

1-30

30-60

60-90

90-120

120-150

150+

Time to renewal beyond contract maintenance expiration Days

29

MAINTENANCE RENEWAL SALES CAN BE DISCOUNTED MUCH LESS THAN AT TIME OF LICENSE SALE
Software maintenance discount Percent of list price

DISGUISED EXAMPLE Time of license sale Renewal

At time of renewal
Fewer competitive options are available to customer (e.g., third-party or self-maintenance not always viable for mission critical applications) Renewal approval is scrutinized less than initial license deal, often by different buyers
0

Q1
30

Software companies should:

Have tighter discounting policies for renewal sales Hold line in renewal pricing negotiations

Same discount floors in place at time of license sale and renewal

30

31

NO DEFINITIVE LICENSE/PRICING MODEL

Pricing model Perpetual Pros Cons

Customers can predict

expenditures Payments can be capitalized

End-of-quarter pressures
result in deep discounting One-time payment could be relatively large and can be focus of customers price reduction efforts

Subscription

Lessens impact of end-ofquarter pressures Can facilitate customer adoption due to lower upfront costs and shorter commitments

Transition to new revenue

model may not be welcomed Risk of renegotiation before end of contract More difficult for customers to capitalize payments
32

BEWARE OF ASSUMPTION THAT MARGINAL COSTS ARE ZERO

Percent, indexed to configured list price
Standard customer volume/ tier discount 25 Installation/ maintenance services 20 Giveaway professional services/ customization 5 Application/ feature functionality software 55 40 Feature functionality stuffing/ giveaways 30 5 5 2.5 2.5 40 20 Rebate/ old version or credit/ peripheral giveaways Payment delays (e.g., A/R, acceptance criteria) Competitive negotiated discretionary discount

DISGUISED EXAMPLE

100 Professional services 10

15

COGS/ effective transfer price*

Core operating software

Giveaway install/ integration and maintenance/ support services

10 10 Actual service costs**

Configured list price

Invoice price

Pocket price

Pocket margin 33

* Includes sales costs, allocated R&D acquisition/goodwill, royalties, license fees ** Including professional, installation/integration, and maintenance/support services

BUNDLING OF SOFTWARE INTO HARDWARE SALES

Distribution of deals by type Percent of deals 1 %=5

DISGUISED EXAMPLE

Weighted average discount of deals Percent 55

Hardware 4 only 3

3 Hardware with software Hardware with software Software only

5 Software only

Wrapping software into hardware deals can result in heavy

discounting (to sweeten the deal)

Software is often bundled with hardware because of desire to

maximize product revenue may need to correct incentives
34