A Tough Year For Software: Thoughts on Driving Growth and Margin

by | Jul 21, 2009 | Pricing, Product Management

HomeBlogPricingA Tough Year For Software: Thoughts on Driving Growth and Margin

A Guest Post by Tom Lucke

It’s been a tough year for the software industry.  Enterprise IT budgets have been slashed, corporate layoffs have reduced the need for incremental seat licenses, and consumer PC sales are off. Even the supposedly recession-proof consumer video game market has been hard hit.

A few statistics show just how difficult the last 12 to 18 months have been for the software industry. Among a representative global group of 259 software companies  I recently analyzed:

  •  From Q1 2008 to Q1 2009, aggregate revenue grew by only 6%, down from annual growth rates of 16% in 2006 and 18% in 2007
  • Fully 45% of the software companies in this group saw their revenue fall between Q1 2008 and Q1 2009 – with an average drop of 17% over this period

Certainly the global economy is challenging, and will remain so for some time. However, my recent work in software has made it clear that the current environment presents software companies with a unique set of short- and long-term opportunities to increase profitability and growth by:

(1)    Improving near-term price realization;

(2)    Restructuring existing products;

(3)    Preparing for the inevitable upswing in larger deals; and,

(4)    Moving aggressively to investigate new software business models.

Improving Price Realization

Given the relatively high gross margins of the software business, there’s always a temptation to engage in ad hoc discounting to ensure a sale. Even in companies with relatively strong controls on discounts, it’s not unusual to see wide variations in net prices. For example, I’ve seen many clients with ASPs that vary by 20% to 40% across similarly situated customers – even after adjusting for both the size of the deal and the size of the overall relationship.  While this type of discounting certainly does drive some amount of incremental revenue among price sensitive customers, it also fuels an ongoing decline in ASP, damages long-term customer relationships, and unnecessarily reduces margins.

My experience is that a coordinated program to improve price realization can produce significant near-term increases in the bottom line. This isn’t about just tightening discount policy – the key is to understand the magnitude and pattern of unneeded discounting, and then identify and address its root causes.

For example, in one case, analysis of discounting patterns revealed that many of the customers who had received particularly high discounts had evaluated my client’s product against a less functional (and less much less expensive) competitive offer. Isolating this issue and developing sales materials that provided appropriate point-by-point comparisons substantially reduced the problem. Very often, careful analysis will reveal groups of customers who game the system to win discounts that are large relative to their peers. In this case, the solution is to use a combination of non-price incentives and account-specific programs to retrain these customers and wean them from additional discounts.

Even in a market as challenging as the one we are in today, approaches like this can rapidly improve margins.

Restructuring Existing Products

The slowdown in global software sales is the result of a complex set of forces.

  • IT departments have cut their budgets and focused their remaining funds on projects that deliver significant near-term business results
  • Deployments are generally smaller, and customers have made it clear that they want to buy in more relevant and “bite sized” functional increments
  • Finally, changes in both company economics and their IT environment are making customers think long and hard about the value of high-end software features

In short, customer’s perspectives about what is valuable have shifted. And for many customers the price-to-value relationship for existing software packages is no longer compelling. Importantly, many of these shifts are likely to be durable, lasting well beyond the end of the current economic downturn and requiring fundamental changes in how software companies configure their offers.

The solution is to adapt existing suites of products to these new customer requirements. This means developing a clear understanding of which specific elements of the software offer create economic value for different types of customers. These elements could be specific features, or they could be aspects of the business relationship (e.g., availability of different license types, flexibility of upgrades, ability to select appropriate support levels).  Understanding value in this way allows a company to selectively reshuffle offer elements and provide specific groups of customers with new, more appropriate combinations of price and value – increasing growth and improving margins. Importantly, it’s usually possible to make many of these changes without the need for complex and time-consuming development efforts.

In one case, the solution was to recombine existing functionally-defined software modules into packages that were structured around important and well understood business activities. In another case, the answer was altering the licensing metric (which had been $ per server) to a different one ($ per port) that created better alignment between price and value across a broader range of customers. Of course, there are often longer-term product restructuring opportunities that can be identified as part of the process – the key is to pursue the best near-term options, while developing a prioritized roadmap for longer-term changes in product architecture.

Preparing for Larger Deals

One factor in the downturn in the software industry has been the relative absence of large enterprise deals.  But corporate IT budgets will recover, and large-scale deployments that have been on hold will eventually move to the fore. Unfortunately, the return of these large deals will place significant pressure on ASPs and margins. As always, the largest deals will be highly competitive with multiple suppliers vying for the business. At the same time, corporate procurement organizations will aggressively bargain for the lowest possible prices while refusing to acknowledge differentiation among vendors.

Simply put, now is the time to prepare for the return of these larger deals. Success in large account sales stems from the ability to develop, price, and defend a differentiated offer that produces clear economic benefits versus the competition. The key is to develop a superior understanding of the customer’s economics and the competitor’s capabilities – two areas where vendors often find themselves outmatched by procurement.

For example, in a recent case a client was told by a prospective customer that a competitor could provide essentially the same benefits at roughly half the price the client was offering. By digging in to the customer’s economics, it became clear that while this was narrowly true for one functional element, the overall economics favored the client’s solution. Using this insight, we crafted a revised offer that resulted in the client winning a greater share of the customer’s business at a higher aggregate margin. Developing this type of information – and drawing implications for potential deal structures – takes time and focused effort, but typically yields substantial rewards.

Investigating and Testing New Business Models

Across the industry, the traditional software model of perpetual license plus maintenance has remained relatively strong. Nevertheless, cracks have recently begun to appear:  Renewal rates for maintenance are down for some vendors, and upgrades are lagging in other cases; some vendors have also reported more interest in subscription models, and several companies offering SaaS have seen significant growth. A combination of tighter IT budgets and a lower tolerance for risk is forcing companies to fundamentally rethink how they acquire, use and maintain software. The current economic turmoil, then, seems likely to spark a broad and sustained re-evaluation of software business models, as both customers and vendors look for alternatives.

Going forward, multiple models will co-exist, even within individual vendors. That is, some customers will best be served through a SaaS model, others via subscriptions, others through new models of licensing and maintenance. The key for software companies is to understand which segments of the market will benefit most from which models, and then structure their business accordingly. Analytically, this means understanding the economic benefits that customers obtain from different models, and comparing that to the benefits that accrue to the vendor (e.g., access to new market segments, increased growth, and higher margins). Operationally, vendors need to develop a thoughtful transition plan that takes into account the impact of new models on revenue recognition, revenue mix (e.g., license, service, other recurring, etc.), profitability, and company valuation.

The Path Forward

Despite the challenging state of the economy, my recent work in software suggests that now is the time to position for improved growth and profitability. In particular, there are substantial near-term returns that will accrue from better aligning market price, offer structure and value, and there are significant longer-term opportunities that will arise from identifying and deploying an optimized set of software business models.

About the Author

Tom Lucke works with clients in software, IT, technology, and telecommunications to develop and implement competitive marketing and sales strategies. He can be reached by email.

This post copyright (c) 2009 by Tom Lucke. All rights reserved.

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