McKinsey BakerHatami

7/30/2019 McKinsey BakerHatami

1/35

Software License and Maintenance

Pricing Principles Best Practicesand Case Studies

SoftSummit Conference, Santa Clara, CA

October 18, 2004

Copyright 2004 McKinsey & Company

Walter Baker and Homayoun Hatami


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1

TODAYS DISCUSSION

Why pricing is important and why superior pricingperformance is hard to achieve

Examples of software license and maintenance pricingissues and best practices


3/35

2

PRICING IS BIGGEST LEVER AFFECTING PROFITABILITYAverage economics for ISVs between $100 million and $10 billion in sales

59

26

14

100

increases

profit by 7%

15101

Sales Fixedcosts

COGS

Operating

profit

Raising price

by 1%

Source: CompuStat, 2002; McKinsey analysis

2

4

5

7

yields operating

profit improvement

Percent

Improve

by 1%

Price

Volume

Fixedcosts

COGS

True nature of price/

volume tradeoff

Percent

7

-5

Pricechange

Volumechangerequired tobreakevenon profitbasis

How many resources are dedicatedto reducing costs or increasingvolume vs. improving pricing?

Do price reductions drivesufficient incrementalvolume?


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3

10

7

5

4

2

NUMEROUS CASES SHOW SUBSTANTIAL UPSIDE POTENTIAL

EXISTS FROM IMPLEMENTING PRICING BEST PRACTICES

Pricing impact is

usually greater in

situations with:

Complex product lines Many transactions Broad customer base High switching costs

Weak current pricingcapabilities

Improvement in return on sales

(within 9-12 months of implementation)Percentage points

Enterprise software

Storage systems

(hardware, software,and services)

Computers (serversand software)

Telecom (hardwareand software)

Enterprise software

Source: McKinsey engagement experience

Case example

DISGUISEDEXAMPLES


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4

EVEN SO, MANY TECHNOLOGY COMPANIES FEEL

THEIR PRICING MANAGEMENT SKILLS ARE "BASIC"

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

Understanding/quantification ofdiscount elements

Creating discipline on discountmanagement

Optimizing bid process Decision support tools Transaction-based monitoring

systems

Skill building and training Pricing coordination across units Impact on incentive system

Proactive management of industryconduct

Systematic lifecycle pricing Product differentiation to optimize

margin capture

Quantification and communicationof value proposition

Exploitation of alternative pricingschemes

Transactionalpricing

Pricingprocess,organization,tools, andenablingdevices

Strategicpricing

Structuralpricing

Deficient(1)

Basic(2)

Very good(3)

Superior(4)

Pricing excellence skill level

2.7

Companies in top quartileCompanies in bottom quartile

1.8Average score:

Wide variation incapabilities acrosscore elements ofpricing enablersand infrastructure

Lifecycle andindustry levelpricing abilities arekey differentiators

Ability to quantifyand communicatevalue is weakacross the board


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SUPERIOR PRICING IS CHALLENGING IN GENERAL

Top management attention focused elsewhere (e.g., growth, costreduction)

Limited investment in pricing function and infrastructure Few dedicated, capable pricing resources

Focus and

dedication

Poor understanding by frontline decision makers of fundamentaltradeoffs and implications

Incentives not aligned to drive improved pricing performance (e.g.,sales focused on closing dealsevery deal is a good deal)

Frontline

pricing

performance

No transparency into actual net (pocket margin) pricingperformance across deals, customers, products, markets

Size of prize and potential improvement opportunities not fully

appreciated and prioritized along with other initiatives

Visibility into

opportunity

Share or volume growth aspirations dominate sales strategyinstead of profitable growth

Price not value seen as primary competitive weapon Fear of embracing price leadership

Strategic

direction


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AND EVEN TOUGHER FOR TECHNOLOGY COMPANIES, ESPECIALLY

SOFTWARE BUSINESSES

Frequent innovation and short product lifecycles Steady growth in feature functionality with often decreasing

price/performance ratios

Dynamic

environment

Value delivered is hard to quantify and communicate (e.g., fornew innovations, software, and services)

Marginal costs perceived to be at or near zero for softwareleading to extreme discounting

Communication

of value

Potential for high user switching costs, network effects, andemergence of de facto standards drives push to establish presence

Discipline lost in rush to get to marketWinner takes

all mindset

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)Complexity

over lifecycle


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7

TODAYS DISCUSSION

Why pricing is important and why superior pricingperformance is hard to achieve

Examples of software license and maintenancepricing issues and best practices


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8

COMPONENTS OF SOFTWARE LICENSE AND MAINTENANCE PRICING

Product/pricing

architecture

Featurebundles

Segment-based valuepricingstrategy

Licensestructure

Model (e.g.,perpetual vs.

subscription) License

metrics License

scope

Maintenance

offering

Offering

Standardlicense

pricing

Discountingpolicy andpractice

Channelpricing

Speciallicense

pricing

Volumebased

models Enterprise

levelagreements

Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management

Orderingand delivery

Licensemanagement

License andmaintenance

compliance

Revenue

operations

Paymentterms

Revenuedeferral

Internaltransfer

pricing


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9

COMMON ISSUES AND BEST PRACTICE EXAMPLES

Product/pricing

architecture

Featurebundles


Licensestructure



metrics License

scope

Maintenance

offering

Standardlicense

pricing


Channelpricing

Speciallicense

pricing

Volumebased

models Enterprise

levelagreements

Promotionand demo

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Renewalpricing

Lifecyclepricing

OfferingLicense

pricing

Renewal and

end-of-life

pricing

Maintenance

pricing

Delivery and

management

Revenue

operations


Licensemanagement


compliance

Paymentterms

Revenuedeferral

Internaltransfer

pricing

Common issues

One size fits all product/pricingarchitecture

Price vs. benefit not assessed atsegment level

License metrics not aligned withcustomer value perception

Best practices

Unbundle software suites asappropriate to better addressunderlying segment needs

Analyze differences in valueperception by segment and setpricing strategy accordingly

Align license scaling metrics withfundamental customer impactparameters (within constraintsimposed by ease of administration)


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10

IMPACT OF UNBUNDLING SOFTWARE SUITESPercent

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

20%

increase

from

unbundling

software

suite

Expectedrevenue withbase/moduleprice structure

120

20 10 100AssumptionsPercent change in

number of deals

Money left on the table

due to unsophisticateddifferentiation model

Convertlossesto wins

Pricesensitivemid-tier

Func-tionalityseekers

New customersegments

118

15

Baseonly

Baseonly

Base+1module

Baseonly

Base+2modules

Modules*

Wantbase only(80%existing)

Wantfunc-tionality(20%existing)

Current customers

7

-20

Currentrevenue

100

DISGUISEDEXAMPLE


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11

OPPORTUNITIES TO ADDRESS DISTINCT VALUE

PROPOSITIONS IN CUSTOMER SEGMENTS

Heavy

software

users

Moderate

or non-

softwareusers

No product

purchase strategy

Clear product

purchase strategy

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7 8 9 10

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7 8 9 10

Competitor CCompetitor B

Company A

Valueadvantage

Valuedisadvantage

Competitor B

Company ASegment 2Segment 1

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7 8 9 10

Competitor B

Company A

Segment 4

0

1

2

3

4

5

6

7

8

9

10

0 1 2 3 4 5 6 7 8 9 10

Competitor B

Company ACompetitor C

Segment 3

DISGUISEDEXAMPLE

Valueadvantage

Valuedisadvantage

Valueadvantage

Valuedisadvantage

Valueadvantage

Valuedisadvantage

~15%

Value pricing

opportunity


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CHOOSING WRONG LICENSING METRIC CAN LEAD TO

HEAVY DISCOUNTING OR BELOW VALUE PRICINGCompetitor pricelower

Company pricelower

Ratio between client and competitor list prices

1

2

4

6

8

10

15

20

Capacity 8 16 32 64 128

1.2 1.0 0.8 0.6 0.4 0.2

1.4 1.1 0.9 0.6 0.4 0.2

1.7 1.4 1.1 0.8 0.5 0.3

2.0 1.7 1.3 0.9 0.6 0.3

2.3 1.9 1.5 1.0 0.7 0.4

2.6 2.2 1.7 1.2 0.7 0.4

3.3 2.8 1.0 0.6

4.1 3.4 1.2 0.7

Number of ports

2.7 1.9

Company Competitor

Capacity PortsPricing parameter

Poor HighAlignment withperceived value

Company undercuts competitor

and does not fully capture value

Perceived

value

Com-

petitor

Company

?

1.52.2Company price far exceeds competitor

price and perceived value, forcingsales force to discount heavily

Perceivedvalue

Com-petitor

Company

256

DISGUISEDEXAMPLE


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13


Product/pricing

architecture

Featurebundles


Licensestructure



metrics License

scope

Maintenance

offering

Offering

Standardlicense

pricing


Channelpricing

Speciallicense

pricing

Volumebased

models Enterprise

levelagreements

Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management


Licensemanagement


compliance

Revenue

operations

Paymentterms

Revenuedeferral

Internaltransfer

pricing

Common issues

Lack of frontline discountingdiscipline (e.g., at end of quarter)

Target discount structure doesnot differentiate by segment

Special license agreements areall one-off deals

Enterprise license agreementsused with smaller accounts

Best practices

Establish discount floors andexception managementprocesses with incentives tied tomeasurable performance

Differentiate target discounts bysegment based on underlyingvalue differences

Standardize volume/ELA dealT&Cs and centralize approvalprocess to ensure consistency

Set rigorous account criteria toqualify deals for ELAs


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14

WIDE VARIABILITY IN FRONTLINE PRICING

0

10

20

30

40

50

60

70

80

100 1,000 10,000 100,000 1,000,000

License discount

Percent of list price

Deal size

Dollars

Deal level analysis

What is justificationfor such widelyvarying discounts forsimilar sized deals?

Why are there so

many deals (evenmedium ones) at fulllist price?

Why do smallerdeals receive suchlarge discounts?

Can sales

behavior bechanged tolimit discountsat standard

levels?

DISGUISEDEXAMPLE


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15

OFTEN INDICATES OPPORTUNITIES TO IMPROVE

FRONTLINE PERFORMANCE

0.9

2.9

7.6

4.5

1.5

11.0

18.8

11.1

3.82.7

21.6

1.0 0.72.0

0.2

8.0

1.30.3

85

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

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

Discount bandPercent of list price

DISGUISEDEXAMPLE


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16

POOR MANAGEMENT OF EXCEPTIONS MAKES IT EASIER TO

NEGOTIATE INTERNALLY THAN EXTERNALLY

100

7050

3

2

5

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

Approval/rejection of exceptional discount for deals

Number of deals

Managers rarely rejectescalated deals

Sales reps are not afraidto request high levels ofdiscount

Sales reps do not suffer

any consequences fromoffering excessivediscounts

Discountapproved

Discountrejected

Salesmanager

Area VP VP Sales

105

72

53

DISGUISEDEXAMPLE


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17

IMPACT OF IMPROVING END-OF-QUARTER BEHAVIOR

First 11weeks

Last 2weeks

45%

44

56

37%

Initial situationPercentage of total deals100% = 220

Average discount

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

14% profitimprovement

28

72

First 11weeks

Last 2weeks

After 1 yearPercentage of total deals100% = 263

43% 28%

Change initiatives

Marketing role expanded to include Competitive intelligence Price negotiation support

Sales incentives Mid-quarter quota targets Price realization incentives and

penalties

Commitment to change behaviors CEO approval for EOQ deals

over Area VP discount authority

Internal and externalcommunication strategy

DISGUISEDEXAMPLE

SCO G O C S S O C C S


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40

38

68

58

58

56

46

44

DISCOUNTING POLICIES SHOULD REFLECT DIFFERENCES IN

CUSTOMER SEGMENT VALUE PERCEPTIONS

Academic

Government

Pharmaceuticals

Professional services

Utilities

Packaged goods

Manufacturing

Financial services

License discount


30% 40% 50%

One-size-fits-alldiscount floors

Traditionally higherdiscount segments

Discount policies should betighter in those segments wheresoftware titles are of intrinsicallygreater value

DISGUISEDEXAMPLE



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Product/pricing

architecture

Featurebundles

Segment-based value

pricingstrategy

Licensestructure



metrics License

scope

Maintenanceoffering

Offering

Standardlicense

pricing


Channel

pricing

Speciallicense

pricing

Volumebased

models Enterprise

levelagreements

Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management


Licensemanagement

License andmaintenancecompliance

Revenue

operations

Paymentterms

Revenuedeferral

Internaltransferpricing

Common issues

Concessions at time oflicense sale can delay

maintenance revenuestream

Excessive discountingof maintenanceservices

Choosing betweenpercent of list vs.

percent of net

maintenance pricing

Best practices

Enforce strict criteriaand require approval

for nonstandard terms

Establish tight discountpolicies and practicesfor maintenance (e.g.,sales commission

carve outs)

Either practice can beviable provided there issufficient discipline

SOFTWARE WARRANTY/MAINTENANCE CONCESSIONS CAN

DISGUISED


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20

SOFTWARE WARRANTY/MAINTENANCE CONCESSIONS CAN

REDUCE ANNUITY OPPORTUNITY

Effective warranty/maintenance period due to

concessions given away at time of license salePercent of licenses

45

25

5

25

0-3 3-6 6-9 9-12 12-15 15-18 18+18+

Standard industry practicefor warranty (90 days)

Coverage periodMonths

Due to forward sale or

shelfware customernot ready to use software

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

DISGUISEDEXAMPLE

NET EFFECT OF SOFTWARE MAINTENANCE DISCOUNTS CAN DISGUISED


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21

NET EFFECT OF SOFTWARE MAINTENANCE DISCOUNTS CAN

BE SIGNFICANTMaintenance revenue, indexed to revenue = 100

DISGUISEDEXAMPLE

List value ofrevenue

Discounts attime oflicense sale

Discounts atrenewal

Customersatisfactionand otherhiddendiscounts

Net revenue

35

25

175

15100

MAINTENANCE SERVICES CAN BE DISCOUNTED MUCH LESS DISGUISED


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22

License

MAINTENANCE SERVICES CAN BE DISCOUNTED MUCH LESS

THAN LICENSE SALES

Share of list revenue

Percent

69 10 10

6

16 15

9 811

Average ~50%

0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100

DISGUISEDEXAMPLE

Discount


0-10 10-20 20-30 30-40 40-50 50-60 60-70 70-80 80-90 90-100

Maintenance Average 3%

75

1015

0 0 0 0 0 0 0

(all at 0)

Maintenance discounts were rarelyallowed

Sales reps were required to sellmaintenance with license and were

penalized if they discounted it

License discounting rulesoften violated

Licenses in biggest dealsalmost given away

THERE IS NO DOMINANT SOFTWARE MAINTENANCE 2001 DATA


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THERE IS NO DOMINANT SOFTWARE MAINTENANCE

PRICING MODEL

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

Software maintenance pricing model

Percent, N = 24 companies

Percent of license

net price BMC HDS Clarify

DEA IFS Network Associates Oracle SAP

Mixed models

Veritas HP Caldera Linuxcare Microsoft NCR Sybase

Percent of license

list price Novell Peoplesoft Progress

CA Sun IBM EMC Filenet Legato

33

29

38

There is no rightanswer either modelcan be viable

Mix of models used byindustry

Can usually realizeany given absoluteprice point under eithermodel

Best choice of model

depends on salesobjectives, incentives,frontline discipline, andsometimes tacticalfactors (e.g., systems)

2001 DATA



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Product/pricing

architecture

Featurebundles

Segment-based value

pricingstrategy

Licensestructure


subscription) Licensemetrics

Licensescope

Maintenanceoffering

Offering

Standardlicense

pricing


Channel

pricing

Speciallicense

pricing

Volumebased

models Enterpriselevelagreements

Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management


Licensemanagement

License and

maintenancecompliance

Revenue

operations

Paymentterms

Revenuedeferral

Internal

transferpricing

Common issues

Inadequate licensemanagement tools

result in lack ofinstalled base usageinformation

Entitlement check andenforcement practices

for license andmaintenance are weak

Best practices

Use electronic licensemanagement tools to

facilitate registration,trial usage, purchase,and customer softwareasset management

Entitlement systemscan limit unlicensed

usage and createopportunity formaintenance renewal/up-sell

ELECTRONIC LICENSE MANAGEMENT CAN HELP ENFORCE DISGUISED


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ELECTRONIC LICENSE MANAGEMENT CAN HELP ENFORCE

ENTITLEMENT RIGHTS

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

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

80%

20%

DISGUISEDEXAMPLE

Entitled tosupport

Notentitled



27/35

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Product/pricing

architecture

Featurebundles

Segment-based value

pricingstrategy

Licensestructure



Licensescope

Maintenanceoffering

Offering

Standardlicense

pricing


Channel

pricing

Speciallicense

pricing

Volumebased


Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management


Licensemanagement

License and


Revenue

operations

Paymentterms

Revenuedeferral

Internal

transferpricing

Common issues

Prepaid or earlypayment terms often

generous beyondsound give and get

Service giveaways andconcessions lead tomisaligned sales vs.

corporate financedeferral methodologies

Best practices

Ensure businessobjectives and logic

underlying prepaid orearly payment termsjustify margin reduction

Reducing or eliminatingservice giveaways andconcessions can help

reinforce and clarifyoverall corporatedeferral guidelines



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Product/pricing

architecture

Featurebundles

Segment-based value

pricingstrategy

Licensestructure



Licensescope

Maintenanceoffering

Offering

Standardlicense

pricing


Channel

pricing

Speciallicense

pricing

Volumebased


Promotionand demo

pricing

License

pricing

Renewalpricing

Lifecyclepricing

Renewal and

end-of-life

pricing

Warranty

Update/upgrade

Support Pricing

model Discounting

policy andpractice

Maintenance

pricing

Delivery and

management


Licensemanagement

License and


Revenue

operations

Paymentterms

Revenuedeferral

Internal

transferpricing

Common issues

Inefficiencies inrenewal process can

void and delay renewalopportunity

Discount policies are

same for maintenancedeals at both time oflicense sale andrenewal

Best practices

Provide sales incentiveto renew contracts well

before expiration andsupport reps withefficient renewalprocess (e.g., insidesales support)

Tighten discounting

policies for renewaland enforce disciplinein renewal negotiations

INEFFICIENCIES IN RENEWAL PROCESS CAN VOID DISGUISED


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INEFFICIENCIES IN RENEWAL PROCESS CAN VOID

OPPORTUNITY

Renewal opportunities

Indexed to total opportunity Best practice renewal

rate for software is 85-95%

Sales not pursuing allrenewal deals (lack ofsales priority/capacity)

Sales not closing allrenewal deals (lack ofproductivity or skill)

EXAMPLE

Totaloppor-tunity

Cancelledfor adminreasons

Forgoneoppor-tunity

In quote orpendingcustomerresponse

Cancelledby cust-omer

Renewed

15

10

100

60


30/35

29

Percent of renewal opportunity value

28

16 1614

9

6

4

Beforeexpiration

1-30 30-60 60-90 90-120 120-150 150+

Time to renewal beyond contract maintenance expiration

Days

Average = 29

Best practice is to send renewal

quote and P.O. 90 and 30 days(respectively) before contractexpiration to lock in renewal

Long renewal processteaches customers thatrenewal decisions can wait

EXAMPLE

MAINTENANCE RENEWAL SALES CAN BE DISCOUNTED MUCH DISGUISED


31/35

30

LESS THAN AT TIME OF LICENSE SALE

25

30

50

55

Q1

Q2

Software maintenance discount


Renewal

Time of license sale

At time of renewal Fewer competitive options are

available to customer (e.g., third-partyor self-maintenance not always viablefor mission critical applications)

Renewal approval is scrutinized lessthan initial license deal, often bydifferent buyers

Software companies should: Have tighter discounting policies for

renewal sales

Hold line in renewal pricingnegotiations

Same discount floors inplace at time of licensesale and renewal

EXAMPLE


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NO DEFINITIVE LICENSE/PRICING MODEL


33/35

32

Perpetual 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 befocus of customers price

reduction efforts

Subscription Lessens impact of end-of-quarter pressures

Can facilitate customeradoption due to lower up-front costs and shortercommitments

Transition to new revenuemodel may not be welcomed

Risk of renegotiation beforeend of contract

More difficult for customersto capitalize payments

Pros ConsPricing model

BEWARE OF ASSUMPTION THAT MARGINAL COSTS ARE ZERO DISGUISEDEXAMPLE


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Configured

list price

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

Professionalservices

Installation/maintenanceservices

Application/featurefunctionalitysoftware

Coreoperatingsoftware

Invoice

price

Pocket

price

Pocket

margin

100

Percent, indexed to configured list price

15

25

5

5

20

10

40

20

10

10

2.52.5

55

40

5

30

Actualservicecosts**

COGS/effectivetransferprice*

Paymentdelays(e.g., A/R,acceptancecriteria)

Rebate/old versionor credit/peripheralgiveaways

Giveaway install/integration andmaintenance/support services

Giveawayprofessionalservices/customization

Featurefunctionalitystuffing/giveaways

Competitivenegotiated

discretionarydiscount

Standardcustomervolume/ tier

discount

EXAMPLE

BUNDLING OF SOFTWARE INTO HARDWARE SALES DISGUISEDEXAMPLE


35/35

34

45

30

25

Distribution of deals by type

Percent of deals100% = 500

Softwareonly

Hardwareonly

Hardwarewith software

55

30

Hardware

withsoftware

Software

only

Weighted average discount of deals

Percent

Wrapping software into hardware deals can result in heavydiscounting (to sweeten the deal)

Software is often bundled with hardware because of desire tomaximize product revenue may need to correct incentives

EXAMPLE

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