dont just roll the dice - pricing techniques

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The Business of Software

Don’t JustRoll the Dice

A usefully short guide to software pricing

Neil Davidson



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Don’t Just RollThe Dice:

A usefully short guide tosoftware pricing

By Neil Davidson

First published by Simple Talk Publishing 2009



Don’t Just Roll the Dice | Neil Davidson

ii

Copyright Neil Davidson 2009

ISBN 978-1-906434-38-0

The right o Neil Davidson to be identifed as the author o this work has been asserted by him in accordance with the Copyright, Designsand Patents Act 1988.

This work is licensed under the Creative Commons Attribution-Non-Commercial-No Derivative Works 2.0 License. To view a copy o thislicense, visit http://creativecommons.org/licenses/by-nc-nd/2.0/ or (b) send a letter to Creative Commons, 171 2nd Street, Suite 300, SanFrancisco, Cali ornia, 94105, USA.

Reviewers : Phil Factor and Michael Pryor

Editor : Tony Davis

Copy Editor : Una Campbell

Typesetting and Design : Matthew Tye

Original photography : Neil Davidson and Matthew Tye.

Page 27 photograph by Jan Kratěna.



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Table of Contents About the Author

About the Reviewers v

Foreword vi

Product Pricing 8

Chapter 1: Some – but not too much – Economics 9

Chapter 2: Pricing Psychology: What is your product worth? 15

What is your product? 15

Perceived value 17

Chapter 3: Pricing Pitfalls 27

Competitors 27

Fairness 28

Pirates 28

Switching costs 30Should you take your costs into account? 32

Chapter 4: Advanced Pricing 35

Versioning

Bundling 42

Multi user licences 44

Site licences 45

The purchasing process 45

Free 47




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Free trials 49

Network e ects 41

Bargains 53

Di erent ways o pricing 55

Choosing the right model 58

Chapter 5: What your price says about you (and how to change it) 60

Practice trumps theory 62

How to change your pricing 64

Product Pricing Checklist 65

What’s your strategy?

What’s your product?

How will your customers judge the airness o your pricing? 65

Who are your customers? 65

Who are your competitors? 65

How are you going to sell your so tware? 66

Can you segment your customers, and create versions? 66

How can you bundle your so tware? 66

Make an in ormed guess at your price 66

Try it out 66 Afterword

Bibliography / Further Reading 68



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About the AuthorNeil Davidson is co- ounder and joint CEO o Red Gate So tware.Red Gate was ounded in 1999 and now employs some 150 people. Itwas Cambridge News business o the year in 2006 and has been in theSunday Times top 100 companies to work or three years running. Itwas ounded with no VC money and little debt. Neil is also ounder o the annual Business o So tware con erence and runs the Business o So tware social network.

About the Reviewers

Phil Factor (real name withheld to protect the guilty), aka DatabaseMole, has 25 years o experience with database-intensive applications.Despite having once been shouted at by a urious Bill Gates at anexhibition in the early 1980s, he has remained resolutely anonymousthroughout his career.

Michael Pryor ounded Fog Creek So tware with Joel Spolsky in

September 2000. He has served as the company’s president since thebeginning, and has also been the CFO since 2006. Michael graduated

rom Dartmouth College with an Honors B.A. in Computer Science(Phi Beta Kappa, magna cum laude). A ter graduation, he joined JunoOnline Services, as a Windows client developer. He writes a column

or Make Magazine called Puzzle This, and runs the popular interview

website TechInterview.org.




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Foreword At Business o So tware 2007 Michael Pryor held an impromptu sessionon how to price your so tware. So many people turned up, and so manypeople kept on arriving, that by the time they’d introduced themselvesthere was no time le t to talk about so tware pricing. I’ve had similarexperiences; in act, “How do I price my so tware?” is probably the mostcommon question I’m asked by so tware entrepreneurs and productmanagers.

This handbook is an attempt to answer that question.

But frst, I’d like to thank Phil Factor, Tony Davis and Michael Pryoror all their editing, reviewing and suggestions. More people than I can

possibly mention have contributed with o ers o help, anecdotes andproo reading. This handbook is way better with their input than it evercould have been without. Thanks guys.

Neil DavidsonCambridge (UK), August 2009

http://twitter.com/neildavidson

http://blog.businessofsoftware.org



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A note on licensing …This book is licensed under the Creative Commons attribution-noncommercial-no derivative works license. That means that you’re

ree to make copies o this and circulate it to whomever you want(please do!), but please provide a link to the eBook (http://www.dontjustrollthedice.com) , and please don’t changethe book or try to make money rom it. I you get something out o thisbook then please pass it on to a riend or colleague. I you fnd it reallyvaluable, then please buy a physical copy or post a review on Amazon.




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Product PricingIn 1938, two young engineers were ready to launch their frst product.They’d struggled with what to build. A ter considering amplifers, radioequipment, air controllers, harmonicas and even muscle-building elec-trodes or housewives, they’d fnally decided to create an oscilloscope.Not wanting customers to be put o by a version one product, theysensibly called it the Model 200A.

The next step? Decide the pricing.

They eventually settled on $54.40. Was that because it represented thecost o manu acturing, plus a decent markup? No. These engineershadn’t taken that into account. In act, they soon realized that the costo building each oscilloscope was more than the price they wereasking. Was it based on what the competition charged? No. They hadn’tbothered to discover that General Radio charged $400 or an equivalentmodel.

They chose $54.40 because it reminded them o the 1844 slogan used in

the campaign to establish the northern border o the United States inthe Pacifc Northwest ( “54” 40’ or Fight!” ).

What a dumb-ass way to price a product.

But these two young engineers recovered rom their stumble. TheModel 200A went on to become the longest-selling basic electronic

design o all time, still selling 33 years later. The company they oundedbecame an institution. Their names? Dave Hewlett and Bill Packard.

I Hewlett and Packard, two Stan ord graduates with the rosiest o utures ahead o them, can ounder so badly when aced with the prob-

lem o how to price their products, what hope do the rest o us have?

Quite a lot, as it turns out.



Chapter 1 | Some - but not too much - economics

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Chapter 1:Some – but not too much –economics

To understand product pricing, it helps to understand some, but nottoo much, economics. The easiest way is through a simple example.

Let’s say you’ve just launched the Time Tracker 3000. It’s a download-able piece o so tware that logs which applications you use throughoutthe day, and sends the usage in ormation back to a central web site.From there, you can fnd out what you’ve been up to all day long. You’vedecided to charge a one-o ee or it. Further on we’ll talk about webapps, social networks and other pricing models, but we’ll keep it simple

or now.

How are you going to price it?




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I you give it away or ree, you’ll get lots o customers. A thousand, say,including Belinda the bargain hunter, Stewart the student, Willhelmthe web start-up ounder, Pat the product manager and Ernest theenterprise developer.

Let’s represent these thousand customers, paying no money, as aninfnitely thin horizontal bar (representing the $0 price), 1000 unitslong (representing the quantity):

price

quantity

($ )

1000

I you move away rom ree, and start charging $100, then the numbero people prepared to buy will drop sharply. Belinda is a bargain hunterand was only using the so tware because it was ree, and Stew is a stu-dent, so neither o them will buy. You’ll get, or the sake o argument,fve hundred customers instead o the original thousand. Let’s representthat as a bar with a height o $100 and a length o 500 units. What’s therevenue you generate rom this? It’s the area o the bar, so $100 x 500 =$50,000.




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Once more, the value o this rectangle is its area: 50 people buying at$500, so 50 x $500 = $25,000.

price

quantity

($ )

1000 5 0 0 5 0

100 2 0 0

5 0 0

30 0

Finally, since the Time Tracker 3000 is valuable, but not that valuable,let’s assume that nobody will buy i you price it at $1,000 and represent

this as a bar o width 0 and plot it on the chart:

price

quantity

($ )

1000 5 0 0 50

100 2 0 0

5 0 0

1 0 0 0

3 00

We’ve plotted fve points on what is becoming a curve o price against

the number o people who will buy the Time Tracker 3000 at that price. What’s more, you can work out the total revenue you will get at anyparticular price by looking at the area o the rectangle (price x purchas-ers) under that point o the graph:



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price

quantity

($ )

1000 5 0 0

4 0 0

15 0

5 0

100 2 0 0

5 0 0

1 0 0 0

3 0 0

Economists call this a demand curve.

To maximize the revenue o the Time Tracker 3000, we need to fnd apoint on the graph that maximizes the size o the rectangle underneath

it. To understand that, it helps to plot the area (i.e. the total revenue)against the price. For the Time Tracker 3000, this looks something likethis. (I’ve plotted the fve data points we’ve already got):

price

quantity

($ )

1000 5 0 0 50

0

0

25 ,000

6 0 ,0 0 0

3 00

From the diagram, you can see you should price the Time Tracker 3000at around $300. It’s not where you’ll sell the most units, but it’s whereyou’ll make the most money.

Plotting a demand curve is, in theory, straight orward. In practice it isway harder. In the real world, you don’t know what the shape o the

demand curve is, or where your current price sits on it.




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On some curves, and on some points o the curve, you’d be right toincrease your prices: the reduction in the number o people buyingyour product will be outweighed by the increased revenue rom eachperson. On other curves, or on other points o the same demand curve,increasing your prices will lead to a massive drop-o in sales and you’lllose money.

What’s more, the shape o the demand curve is dynamic and depends

on a bunch o actors, including your competitors, how they’ll react toany price changes they make, the amount o money your customershave to spend and the type and quality o your product.



Chapter 2 | Pricing Pyschology: What is your product worth?

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Chapter 2:Pricing Psychology: What is your product worth?

The demand curve, discussed in the previous section, might be dynamic

and depend on many actors, but you can still exert some in uence onits shape. In this chapter, I’ll talk about how people decide how muchthey’ll pay or a product, and how you can change this.

But frst, you need to be able to answer a simple question: what is yourproduct?

What is your product?You might think that your so tware product is just the bits and bytesthat your customers download, but you’d be wrong. In reality, yourproduct is much broader than that. It’s not just the so tware – it’s thedocumentation, the help required to get it working and the promise o support when things go wrong. It’s the uture roadmap o the product,the pledge to carry on developing uture versions. In some cases, it’s adream; a way o li e.

One o the clearest examples comes rom the accounting industry. AtRed Gate, we use Sage’s accounting so tware. We’re not the only ones:Sage is a so tware business with 5.8 million customers, that employs

14,500 people and that has a market capitalization o nearly fve billiondollars. It dominates the accounting market in the UK, and has seen o concerted attacks rom, among others, Microso t and Intuit.

But their so tware sucks.

It’s slow, and it’s hard to use. When I frst used it in 1999, the buttons

on the toolbar didn’t depress when I clicked them; they were just static




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pictures painted on a grey background. The application is so ugly thatthe product walkthroughs on the Sage web site barely eature theproduct itsel .

These two acts, the aw ulness o the product and the magnitude o its success, can be reconciled i you understand that Sage’s product ismore than just the so tware.

When you buy Sage so tware, you are not just buying so tware. You arebuying reassurance : when the tax laws change, the so tware will getupdated too. You are buying familiarity : i you buy Sage, the odds arethat your accountant or bookkeeper will already be able to use it. You’rebuying support : i you don’t understand some o the accounting codesor procedures you need, then you can phone somebody or help. Fortythousand people call Sage’s help line per day.

The reason that Sage is so dominant in the UK is because Sage under-stands exactly what their product is. You need to do the same.




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Perceived Value

Once you’ve determined what your product is, you need to considerits value to your customers. In the case o the Time Tracker 3000, let’ssay that it will save a particular customer, Willhelm, three hours o work and that Willhelm prices his time at $50 an hour. That means that Willhelm should buy the Time Tracker 3000 at any price under $150,

assuming he has nothing better to spend his money on.

O course, this assumes that Willhelm is the rational, decision-makingmachine that economists love. In act, Willhelm is a esh-and-blood,irrational human being who doesn’t price his time and calculate costsand benefts. He has a perceivedvalue o the Time Tracker 3000, whichmay or may not be linked to its objectivevalue.

The perceivedvalue o a product may be higher than its objectivevalue.In 2003, Gartner released a report that claimed that almost hal o allcustomer relationship management (CRM) systems lie unused. That’sseveral billion dollars o so tware that smart people thought was worthit, but wasn’t.




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People base their perceived values on reference points . I you’re sellinga to-do list application, then people will look around and fnd anotherto-do list application. I they search the internet and discover that yourcompetitors sell to-do list applications at $100 then this will set theirperception o the right price or all to-do list applications.

When Microso t released DOS 1.0 in 1982, they set a price o $50. Atthe time, an operating system or a mass-market computer was a brand

new category. Since consumers had no re erence point, and $50 seemedabout right, it became accepted as a ‘ air’ price. When IBM launchedOS/2 1.0 in 1989 and priced it at $340, consumers baulked. Not or aneconomic reason though: DOS and OS/2 were very di erent operat-ing systems, and $340 could well have been a air re ection o theadditional economic beneft consumers would have extracted rom themore-advanced OS/2. But Microso t had already defned the re erencepoint, and when IBM tried to challenge it they ailed.

This doesn’t mean you need to copy the re erence point. I your productgenuinely is better than your competitors’, and you can demonstratethe value o this di erence, or create a perception o that value, thenyou can charge more.




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O course, i your product is signifcantly lessvaluable than your

competitors’ then you may have no choice but to charge less. Compet-ing on price may be the only option you have. Take pharmaceuticals.My local supermarket stocks thirty or so di erent sorts o painkillers.You can buy a pack o 16 Nuro en or £1.97 ($3.40), or a pack o 16 Tescoanalgesics or £0.32 (about 50 cents). The physical good – the 200mg o ibupro en – is identical in both the generic and named brand product.

But don’t orget that the entire product is more than the chemicals. Itincludes the marketing, brand name and packaging. Using this widerdefnition, Nuro en is the superior product, and the only way Tesco cancompete is on price.

The value people perceive your product to have can depend on theirtaste . Some people are passionate about good wine and will pay $50 or

a bottle, but others like the taste o $5 wine just fne. However, the tribe people belong to (see later) can a ect how much they’re willing to pay. As Dave O’Flynn wrote to me:

“I never thought Apple produ s were worth the premium until I joined Atlassian. 12 months later, I gladly paid a large premium for a Ma ook Air.The people I was surrounded w h valued design and elegance. Prior to that,




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I was surrounded by people that valued bang for the bu and my laptopthen was a generic AMD that weighed a ton in comparison. I was essentially the same person; the anges were in the expe ations and sense of value of those around me.”

How much money they have a ects their perception o value. DennisKozlowski, ex-CEO o Tyco, elt that $15,000 was a reasonable price topay or a dog-shaped umbrella stand, but most o us don’t.

Knowledge in uences the value people place on products. A laptopwith a 1.4 GHz Intel Core 2 Duo processor, 4GB o RAM and a blu-raydrive running Ubuntu is worth more than one with an N-Series Intel Atom Processor and a DVD drive to me, but not to my mum.

It’s a cheap trick, but ves and nines exert another power ul psycho-

logical e ect on people’s perception o value. Just as $1.99 seems muchless than $2 in a supermarket queue, $1995 seems signifcantly less than$2000 on a web site.

Increasing perceived values

The pharmaceutical industry holds another good example o how

marketing can increase the perceivedvalue o a product, withoutchanging its substance. In 1981, when Glaxo wanted to release Zantac,their anti-ulcer drug, they aced a marketplace dominated bySmithKline’s Tagamet. Although Glaxo elt their drug was moree ective than SmithKline’s, the US FDA rated Zantac as providing littleor no beneft over existing treatments. Rather than marketing Zantac as

a me-too product, at a similar price to Tagamet, Glaxo decided to spendheavily on saturating their sales and marketing channels. This ubiqui-tous promotion increased Zantac’s perceivedvalue, and they were ableto price the product higher to re ect this added value. By the end o the 1980s, Zantac had knocked Tagamet o its perch as the best sellingdrug in the world.




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Here are some more ways o increasing the perceivedvalue o yourproduct:

Increase its objective value. Perceived and objective values aren’t identi-cal, but they’re still correlated. As Joel Spolsky wrote in 2006 1:

“W h six years of experience running my own software company, I can tell you that nothing we have ever done at Fog Creek has increased our revenuemore than releasing a new version w h more features. Nothing. The ow toour bottom line from new versions w h new features is absolutely undeni-able. It’s like grav y. When we tried Google ads, when we implementedvarious a liate s emes, or when an article about FogBugz appears in the press, we could barely see the e e on the bottom line. When a new versioncomes out w h new features, we see a sudden, undeniable, sub antial, and permanent increase in revenue.”

Give your product a personality . 37signals may not sell the best projectmanagement so tware in the world, but it has personality. The 37signalsteam stands or something: uncompromising simplicity. Want an extra

eature? Tough. I you want eatures, buy something else.

Link your product to yourself , and then defne, and promote, your-

sel as an expert. In its early days, be ore his company was bought bySymantec in 1990, Norton Utilities and Peter Norton were synonymous. All o Norton’s products eatured a picture o himsel , with his armscrossed.

Make people love your product . When Black and Decker introducedits DeWALT line o drills, it went to building sites and lumber yards atlunch times to hand out pulled pork sandwiches, give product demosand hold drill-o competitions, with prizes. They went to NASCAR races and rodeos, where their end users hung out. They made peoplelove the brand, not just the product. Now the DeWALT drills have amassive ollowing amongst amateurs too; people who are keen to

1. http://www.joelonsoftware.com/items/2006/12/09.html




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associate themselves with the pro essionals. Despite the amous adageto the contrary, it turns out that people buy drills, not holes. And $400drills, too.

Provide a better service . When somebody buys so tware, they wantreassurance that it’s going to work and that you’ll be around i itdoesn’t. I you’re a small company with big competitors, this is some-thing you can do better than they can. Capitalize on it.

Provide reassurance , through your reputation. Originally, brands werea mechanism or creating trust. Back in the 1880s, you were guaranteedthat the next bar o Ivory soap you bought would be the same as thefrst. More recently, the frst manu acturers o PC clones struggledagainst the common “nobody ever got fred or buying IBM” mentality.

Create a tribe . Products can be symbols o belonging. I you can turnyour product into a badge that people wear to make a statement aboutwho they are, which groups they belong to, and which they don’t, thenthat’s valuable. Amateur DIYers don’t need to spend $400 on a DeWALTdrill, but they like eeling part o the ‘pro essional’ tribe.

Remind people of how much work you’ve put into your product .

People are more likely to pay or years o your time than or an easily-copied so tware product. The twenty year old Bill Gates used this tech-nique in his now- amous ‘open letter to hobbyists’ in the HomebrewComputer Club newsletter in 1976:

“Almo a year ago, Paul Allen and myself, expe ing the hobby market toexpand, hired Monte Davido and developed Altair BASIC. Though thein ial work took only two months, the three of us have ent mo of thela year documenting, improving and adding features to BASIC. Now wehave 4K, 8K, EXTENDED, ROM and DISK BASIC. The value of thecomputer time we have used exceeds $40,000.”

Appeal to people’s sense of fairness . When co ee shops charge an

extra 10 cents or co ee made with Fairtrade beans, they’re lining their




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pockets with your ethics. How much o those ten cents go to the armerwho originally armed the quarter o an ounce o co ee beans that wentinto your Fairtrade latte? Under a penny.

Sell more than just the physical product. The latest BMW adverts areabsolutely explicit about this. Set to videos o beauti ul people doing

un things, the voiceover says “We are a car company. But we don’t justmake cars. […] We realized a long time ago that what you make people

eel is just as important as what you make. At BMW, we don’t just makecars. We make joy.” How much is joy worth? Certainly more than justthe price o a car.

Ultimately, it comes down to di erentiating your product . It almostdoesn’t matter on what – eatures, benefts, the way that you sell, theservice that you provide, the country you’re based in – more or less

anything will do.




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Signposts

Now that you know that customers will fnd re erence points tocompare your product’s price against, you should do all you can toencourage avorable re erences and discourage un avorable ones. I youwant to sell a to-do list at $200, when the market price is $100, thenyou need to add a couple o eatures so your customers cannot make adirect comparison, and then promote comparisons to other companies’$300 productivity suites, not their to-do lists. At the same time, avoidall comparisons to open source alternatives.

I your customers can’t fnd a re erence point or your product, thenthey look or proxies, or signposts . Supermarkets take advantage o this: consumers decide whether luxury ice cream (something they

don’t buy regularly) is reasonably priced based on whether diet coke(something they buy all the time) is good value. I a supermarket sellsa can o diet coke or $2, consumers assume all their other products willbe expensive too.

Say you sell two products: the Time Tracker 3000 and the Task List400, a to-do list application. When somebody thinks o something




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they need to do, they store it in the Task List 400. Later on, they canprioritize their tasks, split them up into sub tasks, track their progressand smugly mark o the tasks as done.

Let’s say the Time Tracker 3000 has no competitors, but the Task List400 has plenty. Your customers will judge your Time Tracker 3000 priceon how you’ve priced the Task List 400. Charge a reasonable $25 oryour to-do list application and customers will take your word that $300

is a good price or the Time Tracker 3000. Charge $1000 or the frstapp, and they’ll assume you’re eecing them on the new one too.

I your product is unique, and customers can fnd no re erence pointsor signposts, then you have a chance to set your customers expecta-tions, and defne their perceptions. I you tell your customers that theTime Tracker 3000 is worth $300, then the odds are they’ll believe you.

We’ve already seen how Microso t did that with the frst version o MS-DOS.

I you havecompetitors in your market, then your customers will bemore conscious o cost, but i your product creates a new category ,then early adopters are less likely to be price sensitive. I you can createa teleporter, a brand new category o product, that will beam you,unharmed, rom New York to Paris then not only can you defne yourprice, but you can also raise your price rom $20,000 to $25,000 andpeople will still buy it. But i you create a car, a new product within acategory that already exists, and increase your price rom $20,000 to$25,000 then your sales will su er.



Chapter 3 | Pricing Pitfalls

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Chapter 3:Pricing PitfallsSo ar, we’ve looked at some economic theory, and the psychology o pricing. Hope ully, you’ve now got some idea o how to set a price. Butthere are some other actors to bear in mind too, and some pit alls to

watch out or.

Competitors

When you set your product’s price you need to think about how yourcompetitors will react. I you undercut them, will they start a price war?Even i your competitor has a high-cost business model and cannotcompete on price in the long term then there’s a risk they’ll respond inkind i you pose a serious enough threat, and just hope you go out o business be ore they do.

The airline industry gives the best example o the utility o starting aprice war. On September 26 th 1977, Freddie Laker’s frst ever Skytrain

ight to New York took o rom London Gatwick. The price or thereturn ight was $238.25 (plus an extra ew dollars or a meal), wellunder hal the price o rivals’ tickets.

Five years later, Laker Airways was bust, the victim o the vicious, dirtyprice war that it had initiated. As Laker had ound out, and as EOS Air-lines ( ounded 2004, closed 2008), Silverjet ( ounded 2006, ailed 2008)

and MaxJet ( ounded 2003, ailed 2007) subsequently relearned, takingon an incumbent on the basis o price is highly risky at best, suicidal atworst, especially when your competitors cannot a ord to lose and haveno option but to fght to the death.

I you are going to compete on price, then you should minimize thepossibility o a counter-reaction rom your competitors. Don’t bang




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your drum and tell the press how you’re going to destroy them (amistake that Marc Andreessen o Netscape made when he said “we’regonna smoke ‘em”, re erring to Microso t (or “those idiots up in Red-mond” as Andreessen put it). Focus on their marginal customers andhope that by the time they notice you it will be too late.

On the other hand, i you set your product price too high, will othercompetitors emerge? Price the Time Tracker 3000 at $10,000 and you

could create the market, only or a competitor to produce the TymeTrakka 3000, undercut you, and steal your business.

Microso t is amed or this. They wait or competitors (and o ten part-ners) to prove markets with low volume, high price products – whetherit’s CRM, testing tools or business intelligence – and then jump in witha low-cost, high-volume model.

Fairness

However you price your product, remember that consumers have anacute, although o ten irrational, sense o airness. Think twice be oreyou betray that.

Books provide a good example. An economist would point out that Iderive the same value (traditional economics is all about value) romreading a paperback version o Sebastian Faulks’s James Bond thriller‘The Devil May Care’ as I do rom reading the electronic version.But the list price is the same in both cases ($14). It’s just not fair thatshort-sighted book publishers charge the same or paper as they do orelectrons. I eel screwed over, and I don’t like it.

Pirates

I your price is way o whack, you will provide an opening or a specialtype o competitor: the pirate. Price so tware too high, or at a pricepoint that most people judge ‘un air’, then be prepared to be ripped o

in return.




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But pirates can also be your riends, in two ways.

Firstly, i your strategy is to achieve world domination by providinga product to every potential customer, at a price he or she can a ord,then pirates provide a cheap back channel. They put a copy o yourso tware into the hands o people who will not pay, cannot pay, are toodishonest or too principled to pay, or who simply don’t value your work that much. However, a pirated copy will end up, eventually, in the hand

o somebody who will pay.

That’s how early shareware so tware operated. In the early 1980s,bulletin boards and user groups were a network commonly used to passaround pirated so tware. In 1982, Andrew Fluegleman and Jim Knop piggy-backed onto this pre-existing network, added a notice in theirso tware asking people to pay them i they liked their so tware, and

invented shareware.

Adobe use pirates too, although possibly without realizing it.Photoshop costs $700, even though the product has many cheaper, oreven ree, competitors. How come? People use pirated versions o Photoshop and then buy when their conscience kicks in, or they getrich. I Adobe dropped the price to $300 then the pirates probably stillwouldn’t buy, and they’d lose money rom people who’d pay the ull$700. They’re best keeping the prices high and having a product thatpirates aspire, one day, to own legally.

The second reason that pirates can be your riends is that they are abellwether. They indicate the existence o a market ailure. Most people

aren’t natural crooks, but high prices can orce them to do thingsagainst their better nature. Apple realized that the success o illegaldownload sites indicated the need or cheap, downloadable music.Their strategy o satis ying people’s needs worked ar better than theostrich-like behavior o the music labels.




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Switching costs

I you’re trying to persuade people to switch to your product rom acompetitor’s then you’ll need to position the price to overcome theswitching costs your customers ace.

Say you’re trying to persuade a customer to switch rom his garbage$500 word processor to your superior $100 one. First o all, you’ll needto price to overcome the economic switching costs. It’ll take him time,and there ore money, to convert his fles to a new ormat and to learnthe new menu layouts.

Secondly, you’ll need to overcome the psychological switching costs.People overvalue what they have, and undervalue what they don’t have. What do you reckon the three balsawood penguins in the photographare worth? They cost me ten dollars ( rom the Kontiki exhibition inOslo). Care to raise your price? Didn’t think so, but I wouldn’t sell themto you or even a hundred. I bet your house is probably ull o similar junk too.




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Another power ul psychological actor people struggle to overcome isthe emotional attachment to money they’ve already spent. Rationally,it’s gone. It’s a sunk cost. Your customer shouldn’t care that he’s alreadyspent $500 on his garbage word processor. But he does.

To see this, take the case o a group o students who were told toimagine that they’d accidentally purchased tickets or both a $50 and a$100 ski trip or the same weekend, but that they’d have more un on

the $50 trip. Which trip would they give up and which trip would theygo on? Rationally, they should have chosen to go on the cheaper trip. In

act, over hal the students chose to go on the less enjoyable, but moreexpensive trip.

There are some things you can do to mitigate switching costs, and evento use them in your avor. Here are a couple o examples. Open O ce,

which includes open source word processing and spread sheet applica-tions, lets you open fles saved by Microso t Word. Early versions o Microso t Word not only opened WordPer ect fles, but had a dedicatedsection in the help or WordPer ect users, and even allowed you to usethe WordPer ect shortcut keys.

Here’s another example. I you decide to stop using FogBugz withinninety days o your ree trial expiring, then Fog Creek will re und youall the money you’ve spent.

These strategies have two e ects: frst o all, they reduce the psycholog-ical and economic impact o switching to Word or Fogbugz. Secondly,once you have switched, you’ll have invested time and energy into using

the new so tware, and will have incurred a whole load o new switchingcosts, which will then stop you rom switching back.




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Should you take your costs into account?

Clearly, you cannot price your so tware or less than it costs you toproduce, and sell, each unit. These are your marginal costs. You mightthink these costs are zero, but they are not.

You need to fnd potential customers and persuade them to buy.I you have a sales team then you’ll need to pay them commission.

It will cost you money to support customers, and chase the customerswho don’t pay.

I you’re relying on an intensive sales model, with ace to ace meetings,then your cost o sales will, o course, be higher than i you have a low-touch, web sales model. But you need to count the costs in both cases.

I you’re planning on not charging the majority o your users, thenthink very care ully about the cost o each additional user. I you think it is zero then you are almost certainly wrong. I you’re running a website, then each additional user will cost you storage space, CPU cyclesand bandwidth. This might be a very low cost – ractions o a penny,even – but i you need huge numbers o users to make money then

small costs multiplied by vast numbers can equal big outlays.

Take YouTube. It’s a ree service and, theoretically, supported byadvertising. The cost o serving each additional video is tiny (aboutone tenth o a cent), but in 2009 it will serve up an estimated 75 billionvideo streams. Multiply together the tiny cost and the large volume andyou can see understand why YouTube costs Google an estimated $710

million a year to run. It nowhere near covers its costs throughadvertising revenue.

Paperback So tware o ers another example o how misunderstandinghow your so tware is sold, and ailing to account or your costs, canlead to catastrophe. When Adam Osborne set up Paperback So tware in1984, it was ounded on the premise that so tware cost too much.




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They released VP-Planner or $99.95 in 1986 and marketed it directlyagainst the $500 Lotus 123. Back in the 1980s, most so tware was soldthrough dealers. The dealers earned a commission or every piece o so tware they sold, but so hated the low margins on the low cost VP-Planner that they bad-mouthed it and encouraged people to buythe high-cost, high-margin Lotus 123 alternative. Furthermore, since VP-Planner was essentially a direct copy o Lotus 123, customersdemanded as much support or the cheaper product as the more

expensive one, destroying any proft that Paperback So tware made.Paperback succeeded in harming Lotus’s market share, but ailed toearn enough money to de end themselves against the lawsuit that Lotuslaunched.

I the price your customers are willing to pay is lower than what it costsyou to sell your so tware, then you haven’t got a business and yourproduct will op. You need to cut your cost o sales, or change yourpricing mechanism so customers end up paying more over the li etimeo the product.

When Panasonic launched the 3DO, its gaming console, in 1994, TimeMagazine nominated it its product o the year. With a 32-bit RISC

processor, custom math co-processor and 2MB o RAM, it was ar aheado its time. But Panasonic priced it at $699, way above its competitionand much higher than what even its target market o early adopterscould bear to pay. That, combined with muddled marketing, caused itto bomb.

Other games console manu acturers learned rom this mistake. When

the PS3 and Xbox 360 were launched, they cost more to produce thanthe selling price that the market could bear, so Sony and Microso tcharged consumers a low price, and accepted that they would losemoney (up to $300) on each console sold. They then recovered therevenue through royalties on games people bought. The real price o the console is hidden; buried in a clever pricing model.




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With the Wii, Nintendo took a di erent approach. They wanted toreach a much wider market than their competitors’ 18 – 35 year oldmale sweet spot, but realized that older people, housewives and amilieswould pay less or a console than hardcore gamers would. So they cuttheir cost o manu acture and used cheaper, slower components. Whenthe Wii was launched in September 2006, Nintendo made a proft onevery console sold. That made the games cheaper to produce too, sinceroyalty payments can be lower, but not necessarily cheaper to buy.

Why? By now, the answer should be obvious to you.

You’ll notice that there’s one actor I’ve not mentioned, and that’s howmuch your product has cost to develop. So ar I’ve talked aboutmarginal costs – how much it costs to produce, or sell, each additionalunit o your so tware. Your up- ront cost is di erent. You might havespent one hundred dollars developing your product, or a million, butthat money is all spent. Gone. It’s a sunk cost. What matters now is nothow much you’ve spent, but what people are prepared to pay.



Chapter 4 | Advanced Pricing

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Chapter 4:Advanced PricingUp to now, we’ve considered selling single products. But what happenswhen you have several products to sell, or sell multiple versions o thesame product?

Versioning

Each o your potential customers has a price they’ll buy your productat. Revisiting our previous example, Belinda (the bargain hunter) andStewart (the student) will only use the Time tracker 3000 i it’s ree. Willhelm will pay up to $150 and Pat’s maximum price is $400. Let’s sayErnest will pay up to $600.




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pro essional edition that lets people compare how their usage o di erent products compares with other people doing similar work.

• By availability. Some o your customers might be prepared to paymore to get your product quickly. Hardback books are a goodexample o this. They have the same content as paperbacks, but arepackaged di erently and aimed at people who cannot wait or thecontent. For the Time Tracker 3000, you could sell an additional

subscription service that gets customers early access to so tware.

• By demographic. Students have less money than businesses, hobby-ists than pro essionals and school kids than baby boomers. You couldprovide a version o the Time Tracker 3000 which students couldget, but only i they prove they’re in ull time education.

• By geography. Customers in the USA will pay more or the sameproduct than those in India and China. Microso t, to compete withthe threat o open source, provides a cut-down ‘starter’ edition o its Vista operating system, available only in poorer countries suchas India and Mexico. The Time Tracker 3000 might be available inIndia or 10% o its US cost, but be localized into Hindi, rendering ituseless to Westerners.

• By industry. Perhaps architects, or so tware developers or aircra tdesigners have specifc needs, and perhaps your so tware can becustomized to suit them. The Time Tracker 3000 could come in aspecial edition, aimed at law frms, that not only tracks applicationusage, but also bans certain applications.

• By plat orm. Mac users might be willing to pay more money oryour so tware than Windows users, or vice versa. You could sell aTime Tracker 3000 or the Mac at a higher price than the Windowsversion.

O course, you need to be aware o the dangers o versioning too. You

need to make sure that the eatures you choose or each version appeal




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to the segment you’re targeting. For example, i you introduce a ‘Lite’version o your product, you need to be sure that pro essional userswon’t downgrade to it.

When attempting to version by one o these criteria, and i your goalis happy customers, then it’s best to remember consumers’ keen senseo airness. Adobe attempt to version on geography; their Acrobat 9Pro costs $449 in the US, but £445 ($750) in the UK. Economically, this

might make sense, but it still leaves me banging my keyboard in impo-tent rage. And is that good, in the long term, or Adobe?

Versioning has a couple o subtleties. Take a ast ood restaurant thatserves the ollowing sizes o diet coke:

Product Price

Small $1

Medium $1.50

Large $2

These prices have been chosen, presumably, to maximize the ast ood

chain’s profts. People with little money, or who aren’t very thirsty, buythe small drink; those who are marginally thirstier buy the medium oneand very thirsty people buy the large one. The additional uid ouncescost the restaurant virtually nothing: this is all about fnding a pricepoint that works or everybody.

You can also see the use o re erence points here. Consumers see the

‘small’ drink, and consider the ‘medium’ drink a bargain (a lot moredrink or just a ew more cents).

So ar, so blatant, but here’s one subtlety: adding a ‘jumbo’ drink willincrease the sales o the ‘large’ drink, even i nobody ever buys the‘jumbo’ one. Adding more choices at the edges drives people to themiddle o the range. They don’t want to appear stingy, or greedy, so go




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or the sa ety o the middle. In this example, adding a ‘jumbo’ versionon top shi ts where the middle lies, so makes more money.

But here’s the second subtlety. This only works if people can easilycompare the products being versioned. For the sodas, it works. The jumbo soda is clearly larger than the large soda, which is clearly largerthan the medium soda, which is clearly larger than the small soda.So people go or a sa e option, somewhere in the middle.

But the e ect reverses i people struggle to compare the di erent ver-sions o the products. In that case, people eethe middle and head orthe extremes. Take laptops. Say you ask people to choose between the

ollowing products:

Laptop type Features Price

‘Standard’ laptop Normal eatures $1000

X100 Standard + DVD player $1100

X102 Standard + Wireless card $1100

X103 Standard + Faster processor $1100

X104 Standard + DVD + Wireless $1200

X105 Standard + Wireless + Fasterprocessor

$1200

‘Extreme’ laptopStandard + DVD + Wireless +Faster processor

$1300

Rather than migrating towards one o the middle options, people are

pushed towards the edges. They go or the ‘standard’ laptop or the‘extreme’ one. This is because it’s impossible to compare the benefts o the di erent items being o ered. Is a wireless card a better option thana aster processor? Or how about a DVD drive? As a result, people takean easy “all or nothing” decision.




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When people are presented with a bunch o con using options theycannot compare, going or an extreme isn’t their only option.They also have a tendency to de er: to simply not buy, or go or acompetitor’s product.

This counter-intuitive behavior has some interesting consequences.I consumers are aced with a choice o , say, a Sharp or a Panasonicmicrowave then roughly hal o them will plump or a Sharp and

hal or a Panasonic. I they are asked to choose a microwave rom aselection that contains a single Panasonic and multiple versions o theSharps, then one o two things can happen.

I they can easily compare the Sharps ( or example, because they di ersolely in price and one other attribute, such as size or power), thenmore people will buy the Sharp than the Panasonic. This is a demon-

stration o how providing multiple versions o a product will increase the product’s sales.

On the other hand, i they cannot easily compare the Sharps then thee ect is reversed. For example, i one Sharp has an adjustable speedturntable, another has a moisture sensor, one has programmable menusand another has a ‘hold warm’ eature, then consumers will shun theSharp, reject con usion and go or the Panasonic. This shows howproviding multiple versions o a product can decreasea product’s sales.




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Here are just some o the possible versions o Microso t’s Vistaoperating system:

Is protecting against hardware ailure more important than havingall-in-one media center unctionality? And does being able to remotelyaccess your business resources outweigh being able to easily makeDVDs? It’s hard to tell, so consumers will tend to do one o three things:

• Go to the extremes – buy Home Basic (at $199.95) or Ultimate(at $319.95)

• De er a decision – stick with Windows XP

• Buy a competitor’s product.

I bought a Mac – my frst one ever.




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Bundling

Bundling is another way o giving your customers better value, persuad-ing them to buy and generating more revenue. Most straight orwardly,people love a bargain.

The idea o getting $5140 o so tware or $1,595 (in the case o the SQLToolbelt that Red Gate sells) is clearly compelling.

But even without price discounting, bundling makes sense.

Say you’ve got two products, the Time Tracker 3000 and the Task List400. Willhelm, the web start-up ounder, is hyper- ocused. Once hegets going on something, he’ll see it through to completion. But hestruggles to organize the list o things he has to do. Pat, on the otherhand, doesn’t see much point in task lists, but she has the eeling thatshe wastes much o her working day, and would like to know how shespends it. Pat and Willhelm are there ore willing to spend di erentamounts on each product:




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Customer Time Tracker 3000 Task List 400

Willhelm $150 $400

Pat $400 $150

I you sell your products individually then, product-by-product, youneed to choose the maximum price that the person who values thatproduct the least will still pay. You need to price the Time Tracker 3000at $150 (so Willhelm will buy it) and the Task List 400 at $150 (so Patwill buy). That means that Willhelm and Pat will each give $150 or eachproduct, and you generate revenue o $600.

But let’s say you create a bundle o the Time Tracker 3000 and the Task List 400. At that point, the bundle is worth $550 to Willhelm and $550

to Pat. Set the price at $550, sell the bundle to both people and yougenerate revenue o $1100. Willhelm and Pat have got all the so twarethey want, and you’ve generated an extra $500.

However, bundling has drawbacks too. When you bundle so twaretogether it becomes harder or your customers to understand whatthey’re paying or. In turn, that might mean they are less likely to use it.

For example, a diner eating a fxed price menu is more likely to skipco ee than a diner who’s paid explicitly or the co ee. The co ee isbundled, so the disconnect between what the diner is paying or andwhat he is consuming makes it easier to not consume.

For so tware, i a customer is less likely to use a piece o bundled so t-ware then he might be less likely to buy a uture version, or to continueto spend money on maintenance contracts. One way o counteractingthis e ect is to continue to be explicit about the worth o each item ina bundle.




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Multi-user licenses

Multi-user licenses are one more way o bundling so tware. But be oreyou decide to o er multi-user discounts to your customers, rememberthree things:

1. Larger companies tend to buy more copies o so tware since theyhave more users. O er them a three or the price o two discount

then they’ll get a better deal than individual users and small busi-nesses. Larger companies also have more money and tend not to beso price sensitive. This means that the poor are e ectively subsidiz-ing the rich.

2. You might lose sales in the long term. The company who paid ortwo licenses may have paid or three i you’d asked.

3. On the other hand, they might not have done. Everybody likes adiscount, even large companies.

4. Larger companies might have more money, but they can also havestricter purchasing policies.

It’s hard to know which o these actors are the strongest in any givensituation. I know o one company who moved away rom multi-userdeals based on the frst two reasons above. They moved rom selling a‘fve or the price o three’ bundle to a simple 10% discount per copy, ormultiple copies.

It turned out that their customers pre erred the convenience o buyingmulti-user bundles. I their customers had two users, they liked beingable to buy a fve user license or the price o three and get the possibil-ity o a bargain (two ‘ ree’ users) i another person started using it. Thisoutweighed the risk o overpaying, and never having a third user. Twomonths and several hundred thousand dollars o lost revenue later, thecompany switched back to multi-user deals.




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The important point is that theory cannot tell you about the wisdom orotherwise o multi-user deals. The only way to fnd out is to try it out.

Site licenses

You need to be care ul with site licenses. Sell a site license to Microso tor Walmart and, unless you’ve customized your pricing accurately andhigh, you could be orgoing enormous amounts o uture revenue. I

you insist on selling a site license then make sure you defne ‘site’ well.Is it or a specifc o ce, or country, or worldwide?

The purchasing process

You must consider your customers’ purchasing processes when you setyour prices. I you’re selling to businesses, then there will be a number

o thresholds that you need to think twice about be ore crossing. Forexample:

I you sell a product at $10 or under then an end user will charge it tohis personal credit card and not claim it back.

Up to $50, he might charge it to his card and claim it back rom the

company he works or.

Up to $995, he might borrow his boss’s company credit and charge itdirectly to the company.

At $1000, he might have to fll in some paperwork and justi y, strongly,his reason or purchasing to his boss.

At $5,000 he might have to talk to the head o his department.

At $25,000 he might have to talk to his CEO.

At each stage, not only does the cost increase, but the hassle does too. I you can fgure out where these thresholds lie (and they move around as




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the state o the economy changes, and according to the characteristicso your customers), then it’s worth pricing your so tware just under athreshold rather than just over it.

Once you cross a threshold, you can o ten move up to the next onerelatively easily. It’s easier to persuade somebody to spend $10 instead o $1 than it is to get them to open their wallet in the frst place.

This is yet one more reason to provide multi-user discounts andbundles. I you’re selling to an organization, then the individual you’reselling to will help you cross the thresholds, and once you’re past athreshold he may even be keen to help you beyond there.

Say you’ve persuaded Frank, the IT manager o Blue Door So tware, tobuy a one hundred user license o the Time Tracker 3000. Frank has

negotiated hard and you’ve agreed on a price o $25,000. Frank knowsthat he now needs to persuade Victor, the CEO, to authorize thisexpenditure. Victor is a scary, busy man and hard to persuade. Frank realizes that he may well need some copies o the Task List 400 at somepoint in the next six months, and doesn’t want to have to persuadeFrank twice. He also knows that, although Blue Door So tware cur-rently has one hundred employees, it will probably grow over the nexttwelve months. I he’s going to ask or $25,000 to buy the Time Tracker3000, why not ask or $30,000 and get you to throw in some copieso the Task List 400 or ree? Or or $35,000 and ask or an extra f tylicenses? It’s in Frank’s interests, and yours, and Blue Door So tware’s.




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past, present and uture blood, sweat and tears. Is that worth $100?Or $1,000? Heck, yes, and you should tell that to your customers.

Secondly, there is no such thing as a commodity. Or, more accurately,there need not be such a thing as a commodity. Your job is to de-com-modi y what you are doing. I your potential customers consider yourto-do list, or your word processor, accounts package, web site or iPhoneapp as just one o a hundred indistinguishable others, then the price

you can charge will be driven ever downwards. You need to fgure out away to either make it stand out, or impossible to compare.

I Starbucks can de-commodi y co ee and charge $4 or co ee beansand hot water, i Stormhoek can de-commodi y grapes (the only winemaker I know o who sells branded G-Strings), and i Perrier can de-commodi y water, then you can certainly de-commodi y the compli-cated so tware application that you have created.

Despite all this, there is no doubt that ‘ ree’ holds a tremendous powerover consumers. And it’s a power that you can harness.




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Free trials

Free trials let your customers try out your so tware or ree, to makesure it fts their needs be ore they buy it. They don’t even need to usethe trial or you to beneft. The mere act that customers could try outyour so tware, i they wanted to, transmits a strong signal about itsquality.

When customers do try out your so tware, it can increase its perceivedvalue. In a amous psychology experiment, people who were able tohold a co ee mug were willing to pay signifcantly more or it thanthose who were just allowed to seeit. People start to eel that they ownan object be ore they buy it i they’re allowed to use it and, as we’vealready seen, people value what they own more than what they don’t.

Free trials aren’t always possible. Red Gate used to sell a tool that letyou recover deleted data rom a SQL Server database. The ree trialworked against it: people would download it and recover their databe ore their ree trial expired. Free trials only work or so tware thatpeople use again and again, and where the ree trial doesn’t fx theproblem by itsel .

Similarly, i people require a lot o hand-holding to use your so tware,or i it is o a low quality, then ree trials are unlikely to work.

The freemium model involves providing a ree version o your so twareor some people, and a paid- or version or others. Typically, the

‘standard’ product will be ree, and the ‘pro’ version will be paid or.

Flickr, LinkedIn and Skype all use this model.

However, it’s not clear that giving your so tware away or ree is a greatway to make money, despite being extremely ashionable. At the veryleast, you need to be care ul, and make sure the ree version is goodenough to be use ul, but not so use ul that it cannibalizes paid- or sales.It can also require extremely high volumes to make it work. Flickr only




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manages to upsell around 5% o its standard users to its pro essionalaccount. And storing, searching and serving the 3.5 billion imagesFlickr’s ree customers store certainly isn’t ree.

In 1993, the UK mobile telephony market was heating up. One2One,a edgling mobile telecommunications company backed by Cable & Wireless and US West, decided that ree was the way to go and o ered

ree o -peak local calls to all new customers. The network was soon

overwhelmed as thousands o customers tried, and ailed, to getthrough, or ree, on Christmas day. One2One quickly gained a reputa-tion or unreliability, losing nearly a million dollars along the way.

Flickr has Yahoo, and One2One had Cable & Wireless, but i you adoptthe reemium model without a sugar daddy, then beware.




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Network e ects

There is, however, one situation where ree is the best price or yourproduct: where there are strong network e ects.

Network e ects occur where the value to your customer o using yourproduct increases as the total number o users increases. For example,the value o using a telephone increases as the number o people youcan call increases; the value o a social network increases as more peo-ple join, the value o e-mail as more people get accounts, and so on. Inthese cases, you get a eedback loop: more people use your application,it becomes more valuable and more people join, and so on.

Free becomes even more important when your networked product hascompetitors. In this situation, it turns out there are two stable situa-tions: no customers, or plenty o customers, and that there is a criticalpoint beyond which user numbers accelerate quickly.




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Get past the tipping point and your user base will accelerate rapidly. I you don’t quite reach the tipping point then your user base will shrink back to zero.

Take a look at Twitter’s tra c stats:

As you can see, there’s a clear tipping point at the beginning o 2009.Look at the uptake o the ax machine, the telephone and otherinventions that rely heavily on network e ects and you’ll see a similarpattern.

It becomes, there ore, extremely important to reach the tipping point asquickly as possible, and the ‘ ree’ price point is a good way o doing that.O course, once you’re past the tipping point you’ll need to make money

rom your product, without losing users.




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Bargains

Bargains are closely related to ree: people like getting something ornothing. Bundling is a type o ree. When you buy Windows, you getInternet Explorer or ree. The SQL Toolbelt gives you 12 applicationsworth a total o $5140 or only $1595. That’s $3545 or ree.

Put a ‘sale’ price on one or two products on your web site, and peoplewill assume that they are, in act, getting a good deal. But put ‘sale’ onall your products and people will assume you’re taking them or a ride.

To work best, bargains should be limited to specifc products, or specifctimes. When Steam, the online gaming community, held a sale on third

party games over the holiday season in 2008, a 10% discount led to anincrease o 35% in sales (in dollars, not units). A 25% discount led to a245% increase; a 50% sale to a 320% increase and a 75% discount to a1,470% increase.

I there’s something people like more than getting a bargain, it’s gettinga bargain and eeling smart.




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Just be ore Christmas 2006, Threshers (a UK wine merchant) o ered itssuppliers and riends a 40% discount i they turned up at any store witha special voucher.

When this voucher was “accidentally” leaked onto the web (on theStormhoek web site – we’ve already met them – and promoted by HughMacLeod), word spread like wildfre. Eventually, millions o peopledownloaded it. Threshers elt obliged to honor the voucher. Theircustomers elt smart and got cheap wine while Threshers made a killingand promoted their brand.




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Di erent ways of pricing

The amount you charge or your product isn’t the only decision youhave to make. You also need to decide how you want to charge. Thereare plenty o models:

Subscription Most SaaS companies use this. As with any model, thisone has its pros and cons. The cons, obviously, include less money up

ront. But there are surprising benefts beyond the obvious recurringrevenue stream:

• Paying lots o small amounts is psychologically easier than payingone large amount. That’s why people buy cars with credit cards andpay it back at 20% interest, or place the cost o a holiday that’s overin a week on top o a mortgage that will last 25 years. Although thetotal amount paid is larger, it somehow eels smaller.

• I you’re selling to businesses, then your end user will fnd it easierto justi y a small, regular payment to his boss then a single large,one-o payment.




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• Recurring payments promote regular usage. Take members o healthclubs. Those who pay a one-o annual ee tend to use the club inten-sively or a ew weeks a ter their he ty payment, but then stop usingit. The usage pattern o people who pay quarterly displays a sawtoothpattern, peaking shortly a ter payment and then declining until thenext payment. People who pay monthly show a steadier, higher,usage. Importantly, since they are more regular users, they are alsomore likely to renew membership and stay members longer.

I’ve already covered the Freemium model, where a small number o paying customers subsidize the majority o reeloaders. The Gillettemodel is a twist on the Freemium model. Gillette amously sells theirproduct in two parts: the razor and the blades. The razor is cheap,but they make their money on the blades. This strategy is surprisinglycommon. Adobe ollows a similar strategy with Acrobat. It’s ree toread documents, but you need to pay to create them. Hewlett Packardloses money on its printers, but makes it back on the ink. The frst FordFiestas were sold at a loss, but Ford recovered the money on spares andfnance. Microso t and Sony lose money whenever they sell an X-Box orPlayStation, but make it back on royalties or games.

There are many ways o pricing per user . Common schemes includelicensing per named user, or concurrent user. At Red Gate, we licenseper user. I you have a team o ten people, all o whom want to use ourso tware, then you need to buy a ten user licence. I you can’t count thetotal number o users, or i only a ew use it at a time, then pricing byconcurrent user can make sense. This model is o ten used or server-based so tware, such as databases.

Another common licensing model is per processor or per proces-sor core . The obvious drawback o this model is that processors get

aster, and get more cores, quickly. I , say, you’re selling a bug trackingsystem that’s tied to the physical power o your customers’ hardwarethen Moore’s law dictates that they will get double the beneft o yourso tware every two years, without paying you a penny.




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The per physical / virtual server licensing model has the same draw-backs as the per processor model. As more processors are crammed intophysical boxes, your customers get exponentially increasing beneft ora fxed cost.

The per usage model involves charging users based on how o ten theyuse your so tware. This could be per megabyte stored, transactionprocessed, gigabyte transmitted, or many other options. Historically,

this has been less common than other models but will become moreusual as cloud computing takes o and people expect to pay or com-puter usage on-demand. One disadvantage o this model is that it candiscourage people rom buying since it is unclear, up ront, how muchthe user will need to pay.

Charging your end user isn’t the only way o pricing so tware. You can

choose to give it away or ree and then make money by, or example,charging or consulting, installation and training; or selling advertis-ing. The latter, although a common model or web sites, is extremelyhard to make work. CPM – the cost per thousand impressions – canbe as low as a dollar. In other words, to generate one thousand dollarso revenue you might need to serve up as many as a million pages. To

generate enough revenue to support a team o three or our people, thatmeans having ten million page views per month. Most web applicationssimply aren’t going to attract that sort o tra c.

Giving your customers a choice o licensing models can make sense.For example, i you’re buying Microso t’s SQL Server 2008 then you canchoose to license per processor, or buy a server license and then pay per

client who connects. The frst model will cost you $5,999 per proces-sor. For the second option, you’ll need to pay $885 to run it on a singleserver, and then $162 or each additional user to access the database.

Many businesses end up with a mixed model . For example, Red Gatecombines a one-o ee with an annual 10% – 25% support and upgrades ee.That way, we get both up- ront revenue and a recurring yearly income.




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However, i you choose to do this, you need to be aware o the pit alls.Support and upgrades ees aren’t just a cheap way o generating cash,and they can pressure you into releasing so tware just or the sake o it,at times that are not right or you, your customers or your product. I you’re going to charge your customers regularly, then you need to makesure they get – or perceive – value regularly.

Shortly a ter launching Windows XP in 2001, Microso t introduced its

‘So tware Assurance’ program. For an annual ee, enterprise customerscould get guaranteed upgrades to next versions o the operating system.In theory, everybody would win: Microso t would get a guaranteed rev-enue stream to und uture development and customers could spreadcosts and would get a cheaper upgrade to Microso t’s new operatingsystem, code name Longhorn, when it shipped in 2003. But Longhorndidn’t ship in 2003. Or 2004. Or 2005. It didn’t reach the market untilthe end o the 2006, largely neutered, as Windows Vista. And even thenmost enterprises re used to upgrade.

Choosing the right model

When choosing your pricing model, here are two recommendations.

Firstly, be boring . Secondly, license your so tware as your customersexpect it be licensed – ft in with their business model.

Red Gate’s frst product was Aardvark, an online bug tracking system. When we launched this in early 2000, we decided to ollow a usagemodel. We charged per bug raised. This made sense rom our perspec-tive since the cost o providing the service was linked to how much

our customers used it, but it didn’t ft in with the way our customersworked or expected to be charged. That was our frst mistake. Our sec-ond mistake was to orget to be boring, and to call the usage units ‘canso worms’. We thought it was pretty cool. Our customers had a di erentopinion, and we quickly moved to per-user pricing.There are even worse ways o getting price models wrong. In the late1990s, The Dialog Corporation was ormed through the merger o



Chapter 5 | What your price says about you (and how to change it)

59

Knight-Ridder and MAID plc. It was in the business o selling data tocorporations and government bodies. Users logged on and searched orin ormation in the six billion pages o in ormation that Dialog stored.

Dialog decided to implement a per-usage model. Subscribers bought‘DialUnits’, and di erent actions cost di erent amounts o DialUnits,depending on how much resource the action took and the value o thedata being accessed. Want to sort your results? That would cost more

than saving them. How much more? It would depend on the type o database you were searching, and the intensity o your search. Ranking,or removing duplicate results, was especially resource intensive so costmore DialUnits. Some actions were ree. It took our pages o instruc-tions to explain the pricing model to customers, and that was a ter around o simplifcation.

In 2001, Dialog then introduced multiple pricing plans and expectedusers to choose whether it would be cheaper to use pricing basedon usage, or on time. Then there were di erent plat orms – DialogTransact, Dialog Advantage and Dialog Enterprise. Throw in discounts,multiyear options and di ering inter aces such as Dialog Classic,DialogWeb and DialogClassic Web and, as one user put it, thinking o

a number, doubling it and adding your mother’s age would have been aclearer, better pricing strategy.




60

Chapter 5:What your price says about you (and how to change it)

Prices are never neutral. They send signals. For example, a high price

can signal that you have a quality product. Consumers assume thatexpensive per umes and wine are better than cheap ones, even in theabsence o much evidence.

A low price can tell customers that you’re value or money, or thatyou’re special. I your competitors are selling so tware at $10,000 a seat,and you’re selling yours at $100, then that says something about you. O course, you might be saying ‘game changing’, but your customers mightbe hearing ‘toy’.

Copy your competitors and you could be indicating that you’re just a‘me too’ product. I you’re a me-too product, with me-too eatures anda me-too price, why would people buy rom you, especially i there’salready a strong, dominant product in your market?




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Whatever price you choose, the signals it sends need to ft in with yourbrand, and your brand needs to ft in with your reality. There’s no pointusing a high price to signal that you have a quality product i you’renot willing to spend marketing dollars sustaining that brand, develop-ment dollars making that quality a reality and customer service dollarsproviding the level o service people expect rom a quality brand.

In 1996, McDonalds launched the Arch Deluxe in an attempt to create

a burger or a more sophisticated, adult consumer. To recoup the extracost o the higher quality ingredients and the $200 million dollar mar-keting campaign, McDonalds priced the new sandwich 32 cents higherthan a Big Mac. But the product they tried to create (high quality,premium) con icted with the McDonalds brand (cheap and convenient)and the Arch Deluxe opped. One argument could be that they pricedthe burger too low , and that a 32 cent premium did not send enough o a quality signal.

Your business model and your strategy have to support your pricingmodel. I you have expensive sales people driving expensive cars, takingyour customers’ CEOs out to gol , and end users who expect plenty o hand-holding and customization o the so tware you sell them, then

you can’t sustain a low price point. Similarly, i you’re selling shrink-wrapped, mass-market so tware over the web then a high price pointwill be counter-productive.

When Red Gate tried to get into the automated web load testing marketone o the reasons we ailed (there were plenty o others, including aproduct that wasn’t up to scratch) was that we attempted a low-price,

high-volume approach in a market dominated by high-price solutions. We fgured that consumers would love a product that they could justdownload, try and then buy, but it turned out that our customerswanted much more handholding than we were able to provide. For themost part, they didn’t want a product , they wanted a people-intensive serviceand the reassurance that a big-name, expensive vendor could




62

provide. Our load testing tool was moderately success ul, but itachieved nothing like the success we had dreamed o .

The dotcom boom and bust contains plenty o illustrations o com-panies who ailed to align their pricing with their business model. Forexample, Kozmo.com’s business was built around delivering snacks,DVD rentals and Starbucks co ee, within an hour, to city dwellers.Un ortunately, the low price, high volume business model it chose

clashed with the reality o the expense o delivering small items by bikecourier. This could have worked as a high price, low volume businessmodel, as the butlers o English aristocrats will testi y.

Switching strategies can be hard. For example, when Intel introducedthe 8080 processor, it priced it at $340. Ultimately, it was selling or $2a unit, but Intel ound it very hard to shake the initial imprinting o the

high cost in people’s minds.

Practice trumps theory

You’ve read a lot o theory here. Wherever I can, I’ve based it on myexperience and sound research (you can fnd some o my sources in thebibliography later on). But your own circumstances are di erent to anyo those described here, so never orget that practice trumps theory .

Product pricing is as much art and cra t as it is science. Sure, it helpsto understand the economics and psychology o pricing, but theorycan only tell you so much. At some point, you need to make a decisionand do it. Use the in ormation in this handbook to make an in ormed

stab at what a good price would look like, and how your customerswill react, and try it out. The exact price almost doesn’t matter – get itbroadly right, don’t screw up totally – and you can tweak it later.

You’re never going to know i you’ve chosen the exact right price ornot, but you should experiment once you’ve set your initial price; notexperiment in the scientifc sense o orming a hypothesis, changing




63

a single variable, and accepting or rejecting the hypothesis, but in thesense o changing something and seeing what happens.

Scientifc experiments are simply too hard to do, and the results tooambiguous, to be much use in pricing. Too many variables change. When you change your prices, you’ll probably do it when you releasea new version o your product, or it will coincide with a big marketingpush, or some other variable you cannot control, such as the state o

the economy or the reaction o a competitor, will inter ere.

Although scientifcally purer, it o ten doesn’t make sense to change asingle variable at a time. Theoretically, you shouldn’t change the priceo your product, your discounting strategy and the types o bundle thatyou sell, all at the same time. But practically, it can be the right thingto do. It’s more use ul to fx the problem than to understand why it’s

broken. When a scientist goes on a blind date that doesn’t work outthen, in theory, he should fx one variable at a time, and re-run the date.First, he should change the partner but go to the same flm and buy thesame owers. Next, he should keep the partner the same, vary the flmand keep the owers the same, and so orth. But the pragmatist in himwill, or should, change the girl, the flm, the owers, and buy some new

clothes and shave too. I it works, he might not understand why , but atleast he’ll have a girl riend.

In the old days, experiments were easy to run. You’d A/B test, splittingyour customers into random groups, post each group a di erent lea etwith a di erent price and measure the outcome. Nowadays, this is risky.The Internet makes it easy or people to fgure out what other people

are paying.

You might be tempted to frst run a survey , testing how customersmight react to a proposed new pricing model, or change to an exist-ing one. However, surveys rarely work. There is always a disconnectbetween customers’ words and their actions. When McDonalds




64

launched its Arch Deluxe burger (see above), consumers in ocus groupsloved it, and 80% said they’d buy it. Few o them did.

How to change your pricing

You might be worried about how your customers will react when youchange your prices. Don’t be. For most o us, our customers have betterthings to worry about. I we shi t our prices rom $100 to $150 then

most people won’t notice, and o those who do notice very ew will care.I you bought a copy o SQL Compare rom the Red Gate web site in2000 it would have cost you $50. Do the same thing now, and you’ll fndthe price is $395. Buy the ull suite o tools and expect to pay $1,595.

O course, at Red Gate we’ve reached that price over the course o almost a decade. We’ve spent millions o dollars developing the so t-

ware, and tens o man years. The increase in value that our customersget rom our so tware vastly outweighs the increase in its cost. But, o the hundreds o thousands o customers we have, only a hand ul haveever commented when the price went up.

It’s not what your customers say that’s important, it’s how they behave. Whenever you make a price change, pay close attention to what yourcustomers do. I they stop buying, rethink.



Product Pricing Checklist

65

Product Pricing Checklist Wrapping up, here’s a checklist to help you decide your pricing:

What’s your strategy?

Are you going to price low and sell lots, or price high and sell a ew?

How does this ft into your brand, the product you have and the imageyou want to project?

What’s your product?

Don’t orget that it’s not just the so tware that you’re selling. It’s theentire package around it.

How will your customers judge the fairness of your pricing?

What re erence points will they use? How will they determine what seemsright? Will they baulk at the price you choose, or will they accept it?

Who are your customers?

How does their business work, and how do they expect to be charged?How much money do they have? Do they pre er a one-o ee, or amonthly subscription? Get under their skin.

Who are your competitors?How will they react to your pricing? How much more, or less, valuableis your product than theirs? What is their business model? What aretheir prices? I you undercut them, will you trigger a price war? I youdo, are your pockets deep enough or you to win it? Do you want toco-exist with your competitors, or destroy them?




66

How are you going to sell your software?

Do you need to send out sales people to take customers golfng? Orare you planning low-touch sales over the internet? Will you require atelesales team? How much will each sale cost you? Do you need to sellvia a channel or reseller? What cut will they take?

Can you segment your customers, and createversions?Is your so tware worth di erent amounts to di erent people, and canyou create pricing that re ects that? Students and business people

or example, or normal and power users, or maybe you can split bygeography or taste.

How can you bundle your software?

Can you create a larger package that contains more than one so twareproduct?

Make an informed guess at your price

Despite all the psychology and economics, you ultimately just have topick a price. Some price – any price – is better than no price.

Try it out

Practice trumps theory. Try out your pricing and see what happens.

I you’ve got your pricing broadly right – and i you’ve got this ar youshould do – then you can tweak it later.



Bibliography / Further Reading

67

AfterwordI hope you’ve got something out o the past 70 pages. I you have, thenplease orward the eBook onto your riends and colleagues, tweet aboutit, buy a copy o the physical book or write a review on Amazon.

You can fnd in ormation on how to do that at

http://www.dontjustrollthedice.com.

I you think I’ve missed something out, or got something wrong,then drop me an e-mail at [email protected] .My twitter handle is @neildavidson and my blog is athttp://blog.businessofsoftware.org




68

Bibliography /Further reading Anderson, E . and Simester, D. (2003) ‘Minding your pricing cues’Harvard Business Review,S 2003

Breckon, N. (2009) ‘Valve: Le t 4 dead hal -price sale saw 3000%increase, beat launch numbers’http://www.shacknews.com/onearticle.x/57308

Chapman, R. (2006)‘In Search of Stupidity’,2 , A , B

Crampes, C. and La ont, J-J. (2002) ‘Copying and so tware pricing’

Cusumano, M. (2007) ‘The changing labyrinth o so tware pricing’Communications of the ACM, V . 50, I 7, . 19-22

Davidow, W. (1986) ‘Marketing high technology – an insider’s view’,T F P , N

Y

Gallaugher, J. and Wallace, E. (2002) ‘Understanding network e ects inso tware markets: evidence rom web server pricing’ MIS Quarterly, V . 26, N . 4, . 303-327

Gilbert, A. (2003) ‘CRM so tware or CRM shel ware?’http://news.cnet.com/CRM-software-or-CRM-Shelfware/2100-1012_3-990880.html

Gourville, J. and Soman, D. (2002) ‘Pricing and the psychology o consumption’ Harvard Business Review,S 2002

Gourville, J. (2006) ‘Eager sellers and stony buyers’,Harvard Business Review,J 2006



Bibliography / Further Reading

69

Gourville, J. and Soman, D. (2005) ‘Overchoice and assortment type:when and why variety backfres’, Marketing Science, V . 24, N . 3, . 382-395

Gourville, J. and Soman, D. (2001) ‘Transaction decoupling: how pricebundling a ects the decision to consume’ Journal of Marketing Research, V . 38, . 30-44

Gourville, J. and Soman, D. (2007) ‘Extremeness seeking: when andwhy consumers pre er the extremes’,Harvard Business Review

Harford, T. (2008) ‘Business li e: Fair trade or oul’http://timharford.com/2008/04/ business-life-fair-trade-or-foul/

Knopf, J. (2000) ‘The Origin o Shareware’http://www.asp-shareware.org/users/history-of-shareware.asp

Levitt, T. (1980) ‘Marketing success through di erentiation – o anything’,Harvard Business Review,J – F 1980

Macrovision (2007) ‘Key trends in so tware pricing and licensing’

Mason, M. (2008) ‘The pirate’s dilemma’,The Free Press,N Y

Miller, P. (2006) ‘Sony losing mad loot on each PS3’http://www.engadget.com/2006/11/16/ sony-losing-mad-loot-on-each-ps3/

Murph, D. (2006) ‘Wii Manu acturing Costs ring up to just $158?’http://www.engadget.com/2006/12/15/ wii-manufacturing-costs-ring-up-to-just-158/

Packard, D. (1996)‘The HP Way’,H C , N Y



Quint, B. (2001) ‘Dialog rolls out new connect-time pricing’http://www.allbusiness.com/sales/1012692-1.html

Sink, E. (2004) ‘Product Pricing Primer’,

http://www.ericsink.com/bos/Product_Pricing.html

Spolsky, J. (2004) ‘Camels and Rubber Duckies’http://joelonsoftware.com/articles/CamelsandRubberDuckies.html

Spolsky, J. (2006) ‘Simplicity’ –http://www.joelonsoftware.com/items/2006/12/09.html

Sti , D. (2007) ‘How DeWALT turned customers into in uencers’http://credibilitybranding.typepad.com/blog/2007/03/how_dewalt_turn.html

Sutton, J. (2001)‘Technology and market structure’, 2 , T MIT P

Varian, H. (2003)‘Intermediate Microeconomics’,6 , W.M. N , N Y

Wendt O., von Westarp, F. and König, W. (2000) ‘Pricing in Network E ect Markets’,ECIS Proceedings,P 82

Wayne, B. (2009) ‘YouTube is doomed (GOOG)’http://www.businessinsider.com/is-youtube-doomed-2009-4

Wikipedia – ‘3DO Interactive Multiplayer’http://en.wikipedia.org/wiki/3DO_Interactive_Multiplayer



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dont just roll the dice - pricing techniques

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