Marketing Expert's Corner

This article written in 2004


Pricing and Licensing

"Step right up...just 2 dollars...the Large Print giveth and the Small Print taketh away...just one dollar...step right up!" 

Tom Waits captured the huckster side of commerce (click image at right to hear an excerpt of this song).  To make money, every business must come up with a price and terms that are reasonable for the customer, highlight where the company adds value, and provide enough margin to keep things running. 

But every company has a price list, so no problem -- right?  Keep laughing. 

I'm going to start this section with a bit of heresy: don't be too creative or spend a bunch of time on pricing or licensing.  It's the wrong side of the equation to solve:  it's more important to focus on value -- what you give to customers -- and on increasing the uniqueness of the value you provide.  Learn from luxury items like Dom Perignon or deBeers or Apple.  Sustainable value-add, differentiation, and reputation will do more to make you profitable than any pricing scheme.  (Unless, of course, you're a Redmond-based ISV with monopoly power.)

That said, pricing is a signal you send to the market, and an indication of your value, and that goes double for services.  So it pays -- literally -- to set your pricing right.

There are three basic mechanisms for pricing:  cost plus, channel driven, and value based.  Cost-plus pricing makes the most sense with commodities, and bases the price on your underlying costs plus a fixed percentage.  Channel-driven pricing starts with the needs of your channel (whether retailers or direct sales reps) and determines price points from there (whether "shelf space means a $49.95 price" or "a rep can't make money with $25 K deals").  Neither of these mechanisms puts much emphasis on the customer or perceived value.  In contrast, for software, pharmaceuticals, medical equipment, services, and non-commodity hardware, value-based pricing is most appropriate because it starts with the customer's perceptions, and how much a solution to their problems ought to be worth.  Auction-based pricing is the latest twist in value-based deals. 

ValueFirst™ Methodology

It's a common mistake to choose price points too early.  Of course, you'll need an "average selling price" for your business case (whether for VCs or your own executives), but this average price is purely theoreticaland must never be thought of as a price point.  

My pricing methodology starts by quantifying the size of the customer's economic problem, and understanding which of their cost elements a product will resolve.  I pay attention to  the customer's decision horizon -- only the elements of value that are within their timeframe or "field of view" will be relevant to their willingness to pay.

Ironically, some of the hardest work in the ValueFirst methodology is figuring out who the customer is.  Remember, a customer is someone who pays you money and receives the economic benefit, not necessarily the user of your product or service.  Get this right, or you have to start over.

When you are creating a new product (unless it's a commodity item), you don't know what a reasonable price is, and neither does your customer.  So don't ask them yet.  Until the customer has actually used a  product mock-up, you can't measure benefits and they can't estimate value.  

The next step is to determine the pricing objective.  "To make a bunch of money real fast..." is not a usable pricing objective.  You need to identify the one thing from the list below that will be the most important driver for your business:

  • total revenues

  • total unit volume

  • market share

  • profitability per sale

  • total profitability

  • time-to-break-even

These items are interrelated, but each yields a different set of priorities and weighting factors for evaluating pricing models and price points.

The next step is to choose a pricing model.  Build on your understanding of the customer's perspective of your value to choose the metrics of how you will charge.  Pricing models are actually more important (and harder to change) than price points.  Pricing models are often intimately linked to business models, and your firm may use a combination of such models as:

  • ASP (application service provider) "rental"

  • Enterprise perpetual license

  • Enterprise timed license (or lease)

  • Per-use (or usage threshold)

  • Per user / per seat

  • Per system / per CPU

  • Dynamic (auction based) pricing

  • Shared-benefit ("I'll take 5% of whatever you save as a result of my product") 

  • Strategic pricing (near give-aways to preempt competitors)

It's OK to have more than one pricing model, but this will add operational complexity.  The most interesting pricing models (read: shared-benefit, the ultimate value-based price) are devilishly complicated to administer even in a direct channel and impossible through channels.  Unless you are in a really new product category, it is not a good idea to make up a completely new pricing model (it's too hard for your channel and just confuses the customer).  

There are a couple of pricing models that are essentially off-limits:  enterprise-wide licenses ("site deals") or all-you-can-eat licenses cause far more trouble than they are worth (just ask your CFO!).  Instead, create volume discounts ("5000 seats") with specific timeouts and thresholds that automatically trigger "recognizable revenue".

Only after all this is it time to come up with price points.  Look at competitors and substitutes, but know that customers rarely evaluate competitive prices the way you do.  First, they have different perceptions and understandings about the details of your product differentiation.  Second, they will prioritize elements of value differently than you.  Spend less time talking to your executive staff about price points, and more time talking with your sales rep, channel and customer.

Don't fall into analysis paralysis:  avoid the trap of academic or economist thinking.  Customers make irrational purchase decisions all the time, and even the best pricing has its share of emotional / intuitive / impressionistic "logic."  In fact, the price the customer is willing to pay may depend on the individual sales rep involved.

Do check with customers about prospective prices, but it's even more important that your channel -- whether direct sales or distributors -- be happy with the pricing model and price points.  Channel partners and sales management can shoot down pricing in very dramatic ways. 

Discounting - whether permanent volume schedules, upgrade / competitive offers, or temporary promotions - must be carefully designed to achieve specific behaviors.  The incentives must work equally well for the channel and the customer.  For promotions, think through the mechanics of your "coupon" and make sure to print an expiration date on all offers!

The final sanity check:  pricing must be simple to work.  A common mistake is to make price lists and enforcement mechanisms too complicated.  Price points should not be changed more often than once a year unless you are in a commodity market...and pricing models should last at least twice that long.  So get everyone to review the pricing for practicality and longevity before you launch any change.  Changing prices too often limits your credibility.

Product Licensing

Licensing -- the terms and conditions of your contract (or EULA) and any enforcement mechanism you build into the product -- is required to protect your intellectual property and your revenue stream.  Mistakes can be costly and long-lasting, so lawyers and even marketing consultants are a bargain here.

The licensing terms, conditions, and enforcement should be designed in conjunction with your pricing.  The units of pricing (e.g., $/CPU or $/use) and the pricing model need to match what your license and enforcement mechanism.  Think through how your license will get to the customer, how you will validate that the license has been accepted, and how you will authorize the user to continue using the product.  A lot of good work has been done by Microsoft on leveraging the web for this -- learn and even copy them.  

Pay a lot of attention to indirect channels -- how the partner will get license confirmations back to you -- and make sure that your license will work properly through distributors and international transactions.  Make sure to allow for free demos, limited time trials, and other "try then buy" mechanisms.  Generally speaking, "floating keys" for software license enforcement do not work.  

In some cases, you may be able to build gag orders into the license (e.g., "no benchmarking" or "no public comments about the product without company approval"), but these imply that you once worked for Oracle or otherwise have something to hide.  

The biggest mistake is to make your licensing so complex that it slows down the sales cycle, causes friction in your channel, or creates customer objections.  The KISS principle applies here.

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