The Risks of Value-Based Pricing

Think of this scenario: You’re shopping for a new home and instead of guiding you into a single-digit fixed-rate mortgage, lenders try to persuade you that an adjustable mortgage indexed to your income makes more sense. Structuring mortgages like that makes no sense, and it’s making less and less sense to purchase software that way.

Value-based pricing takes a percentage of total revenue or cost reduction attributable to the application and makes it payable to the vendor. If based on just 2 percent of incremental sales, that can amount to literally millions of dollars over the life of a contract. Like a bad habit, these value-based pricing arrangements are tough to break free of.

Total Cost of Ownership

Ironically, many vendors talk on the one hand of how their applications deliver superior total cost of ownership, especially in comparison to hosted applications. Yet on the other, they are now pushing a value-based pricing model, which is financially unpredictable on its impact to company’s expenses.

The truth is that value-based pricing only benefits the vendor, and further, it gives them a pricing ceiling they can enforce that protects their direct sales by making it too expensive for their channel partners, resellers and OEMs to go down market. Simply by cranking up the percentage of sales they request from their customers, these vendors are keeping an entire group of their targeted customers free from competition with their own resellers. It gets better.

Corporate Performance

Back when everyone believed the hockey-stick growth graphs of enterprise software, the concept of paying a percentage of a constantly ramping curve of revenue growth seemed fair.

It was also an era when debt, not profits, measured corporate performance, and the concept of value-based pricing fit right in. No more. For the companies that bought into that vision to the tune of millions of dollars, they are still paying a heavy price not only in the yearly dues, now in the millions, but also in the very difficult task of forecasting just what these payments will be.

Further, companies that have bought into value-based pricing often find there are two polarized political camps in their companies: those who are passionate about the benefits of the software and think any price is fair; and those who have to pay for it.

The conflicts that value-based pricing causes in companies are not easily fixed, and I’ve seen these two political factions in companies fight for months about a solution to the high costs that a value-based pricing deal imposes. To break the impasse these companies end up going to a hybrid pricing approach, starting to replace applications purchased on value-based pricing with ones that often deliver equal or better performance and features at a per CPU or named-user pricing approach.

Buyers Rule

There is no excuse for software vendors’ move into value-based pricing today. It is clearly a move to set a permanent financial hook in their OEM and large user accounts while at the same time taking control over their lower-market pricing strategies. If you’ve already locked into a value-based pricing contract, consider the following: