How Price-Per-Application Can Lead to Mutual Self Destruction

Selling software as a service and pricing it on a per-application has become the vogue thing to do for many good reasons. Yet, sometimes, it serves neither buyer nor seller. In fact, it can lead to mutual self destruction. Sometimes, just sometimes, software sales should transfer reseller rights to the direct customer.

In most markets, the business case for selling software as a service is strong. Software requires frequent updates as business processes evolve, critical applications require back-up and restore procedures to ensure reliability and data safety, and the upgrade process is more economically efficient when handled by the software service provider rather than IT departments and end-users. But in some markets, selling software as a service, or worse buying it as one, kills the value chain.

In a few markets, software is not the end-product but rather a component of an overall system solution required to deliver the full value to an end customer. When software is a component within a larger, well defined solution, it should not be sold as a service, but rather as a reseller’s license.

Where are these markets? They are business markets. Businesses developing even simple machinery require software drivers for the microprocessors embedded within their machinery. More complex solutions, such as remote machine operations, require communication software to match their specific communication protocols and machine commands. Likewise, robotics assembly line providers must connect communications, machines, and operating software in order to deliver a solution.

In these rare markets, software should be sold with reseller’s rights, not on a per-application basis. Why? A competitive analysis using multi-player and multi-round game theory tilts the wheel in favor of selling reseller’s rights as we will learn.

Resellers License

When software is sold as reseller’s license, the software company sells the direct customer the right to resell the software to any end-customer as long as it is one component within a more complex and well defined solution. The direct customer purchases the code, the data models, and the freedom to sell installations to end customers without any further licensing when incorporated within the larger product. Future improvements to the software are contracted to the original software seller. Meanwhile, the original software seller maintains the right to seek other direct customers for their software.

Pricing Models

Clearly, pricing software per application and pricing it as a reseller’s license is very different.

Pricing per-application creates a business model where future revenues are ensured as long as the direct customer’s end-solution uses the software. Per-application pricing requires an understanding of the value that the software provides to individual applications. Since it is software, there are negligible marginal costs per application however future application sales must recoup the initial development costs.

Pricing a reseller’s license creates a business model where the future revenues are dependent upon uncertain upgrade fees. Reseller’s pricing is limited only by the potential for the direct customer to develop their own software component or pay someone else to do so. The full costs of developing the software must be entirely recouped in the first sale.

Model Attractiveness Comparison

While a reseller’s license sounds much less attractive than a per-application license and even worse when compared to an application service provider model, it has other positive attributes. Even the best software needs upgrades as long as the customer uses it. In fact, the more the customer uses the software, the more they will seek to upgrade it. So, it is not as if all future revenue is foregone.

Why would a company seek to sell a resellers license when they could go for a per-application license? Because it ensures the future competitiveness of their direct customer and therefore the likelihood of future projects from them while lowering the risk that they will simply replace your value input in the future. In other words, it avoids potential mutual self destruction and locks-in your position within the value chain.

Where does this mutual destruction come from? Your competitors’ value chain of course.

As a simplistic argument, consider a “price-per-application” model to be tax imposed on your direct customers every time they seek to sell the solution that uses your software to an end customer. Taxes should be applied to discourage activities, not as a penalty for accomplishing the desired goal. In a “price for reseller’s license” model, you are charging the direct customer for the software up-front and simultaneously transferring the risk and rewards of successfully finding end-customers. As such, you are encouraging the direct customer to accomplish the stated goal.

A more complex argument comes from analyzing the direct customer’s pricing latitude, and realizing that a price per application sale puts them at a significant competitive disadvantage.

Pricing Latitude Analysis of Handcuffed vs. Risk Taker

Consider two competitors. Competitor Handcuffed purchases the software on a “per-application” basis and agrees to pay $8 per application and expects to install 50,000 applications. Competitor Risk Taker purchases the software on a “reseller’s license” basis and agrees to pay the software development company $400,000 up front.

Suppose both Handcuffed and Risk Taker are competing in the same market and otherwise face similar cost structures as described in Table A: Current Pricing, Costing, and Profit Forecast.

If they hit their targets and nothing else changes, both Handcuffed and Risk Taker appear to be equally competitive according to Table A.  However, real world competitors rarely hit their targets without making competitive adjustments.

Competing for end customers often requires pricing flexibility.  A Pricing Latitude Analysis, shown in Table B, demonstrates that Handcuffed is at a serious competitive disadvantage to Risk Taker.  Price reductions disproportionately harm Handcuffed over Risk Taker.

As shown in Table B, Risk Taker can bare a 10% price decrease and deliver the same level of profitability as long as volumes increase by 33% or more (perhaps due to taking them from Handcuffed), while Handcuffed can only bare the same magnitude of price decrease and still maintain equal profitability if they grow their market by at least 50%.

Hence, the lesson is that if you’re a software provider seeking to serve a direct customer who will include your software as a component of their solution for their end-customers, it may be wiser to forgo the “per application” upside in favor of ensuring that your customer remains competitive and can utilize your services for upgrades in the future.  In the value chain, when the direct customer fails to serve the end-customer competitively, the software supplier also fails.

__________

References

1.  Thomas T. Nagle and Reed K. Holden, The Strategy and Tactics of Pricing (Prentice Hall, Upper Saddle River, NJ, 2002) p. 320.