Discount professional services before you discount subscriptions

Steven Forth is a co-founder and managing partner at Ibbaka. See his skill profile here.

Many companies offer solutions that bundle professional services with software and data. The raw truth is that virtually all enterprise solutions require some level of professional services to implement and sustain. They are an important part of the value proposition. This goes against the current Silicon Valley orthodoxy of pure play subscription models and frictionless growth, but that model is coming under increasing pressure as people question its long term profitability and sustainability (see work being done on this question by the TSIA).

So most of us will be selling, and therefore pricing, bundled services.

The other reality of enterprise sales is that discounts are part of the picture. There are several good reasons for this. When price is connected to value, and for whatever reason there is a value shortfall, some form of discount is warranted. Procurement gets paid to negotiate discounts and some accomodation with procurement is generally necessary. There is also a need to give sales people some autonomy. The best salespeople are proactive and need to have some flexibility in negotiations. (Of course some discounting is just undisciplined and reactive, and that is a problem that pricing and sales leaders need to address.)

So not only are we going to be selling bundled solutions, we are also going to be managing discounts.

When you have a bundle that includes software, data and professional services, what do you discount?

Many people default to discounting whatever has the highest gross margin. Many years ago, when there was still a company called Sun Microsystems, I worked with some of the people on the software side of the business. They found that the salespeople, trained to sell hardware, were discounting software rather than hardware. They were doing this to maintain the margins on hardware, and as software margins were thought to be high, they often discounted software all the way down to the marginal cost, as conventional economic theory suggests they should be. As the marginal cost of the software was thought to be zero, the sales teams often gave away the software to sell the hardware.

Over time, value creation migrated from hardware to software, the hardware became a commodity. Sun had not trained itself to extract value from software and at the end of the day was sold, at a steep discount, to Oracle, a company that knows how to make money from software.

It is not that Sun did not know how to develop software, much of the software we use today, including the Java programming language, came from Sun.

Companies that have their roots in professional services are now trying to blend software into their revenue mix, while software companies, even pure play SaaS companies, are finding that they need to provide professional services, especially to their largest customers.

Too many of these companies are disproportionately discounting subscriptions at the expense of professional services. The logic is that gross margins on subscriptions are much higher, generally 80-90 percent, compared to 40-60% on professional services. The perception that there is more room to discount subscriptions, together with a mandate that all functions be responsible for their own profitability, leads to discounting subscriptions first. This is generally a bad choice.

To see why this is, let’s work through a simplified example.

This company has 80% gross margin on its subscriptions (perhaps it invests heavily in customer success, keeping the gross margin down), and a more normal 50% gross margin on professional services. It has a deal on the table with a customer that will only invest $1,000,000 in the first year. At list price, the economics of the deal over three years are as follows (we often use three or five years in analysis as there is an emerging pattern where enterprise customers review their commitments every three or five years).

What happens if the company discounts subscriptions, believing there is more room to move here and wanting to maintain gross margins on all businesses at more than 50%.

One can argue that, logically, the discount need only be applied to the first year. This may make sense, but most buyers will balk at this. A price per unit for the subscription has been established (the anchor price in behavioral economics) and the expectation is that this price will be honored in future years.

What happens if one discounts professional services instead.

The company makes more money over three years if it discounts professional services.

What happens when we drill down into the gross margin? This is what companies should be optimizing.

Let’s compare discounting subscriptions versus professional services.

The deal is still profitable, the customer is happy, all business functions are profitable. Before we go with this, let’s look at the total gross margin over three years when professional services are discounted.

The first thing to note is the number in red. Professional services will lose money in the first year. In most companies, the VP Professional Services will reject this out of hand. But wait a moment, let’s ask the CFO what she thinks. Would you trade an $80,000 loss on professional services and have slightly lower gross margin in year one for an extra $616,000 in gross margin over three years? Most CFOs will take the long term gross margin gain. Companies that would not make this choice are optimizing the short term at the cost of their long term viability.

There is a simple lesson here. When designing discounting, look at gross margin over the long term. Ibbaka Market can help you redesign your pricing to do this. In most cases, our customers double their Average Selling price. In one case there has been a more than 10X increase.