**Steven Forth** is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.

Pricing for SaaS transformation needs to reflect your long-term strategy

A number of Ibbaka’s clients are moving on premise software to the cloud and shifting from a perpetual license pricing model to a subscription model in the process. This is a well trodden path at this point. Microsoft has done this with its Microsoft 365 suite (365 days in a year) and Adobe with its very successful Creative Cloud. Back in 2008, I was asked by a major LMS vendor to lead its transition to the cloud (I turned down that offer to co-found LeveragePoint). So many of us have been at this for more than a decade. Why do people still need guidance?

The challenge is rarely on the technology side. That is now well understood. Most people also understand that organizational change will be needed. Customer support becomes customer success, renewals are as important as new sales, data and predictive analytics become part of every solution.

Ibbaka has written about some of these themes in other posts:

The challenge for most of our current customers is elsewhere. These companies often have large existing businesses, in some cases worth billions of dollars. Their shareholders expect them to preserve these revenue streams even as they move to the cloud. This can lead to internal conflicts in the business. Given their past success, why are they moving to the cloud? There are generally three main motivations:

Investors and stock market analysts are demanding a cloud story
Cloud solutions can iterate faster and they are afraid of being left behind by cloud-native competitors
There is a desire for more predictable revenue and subscriptions are seen as a path to this
Customers are demanding a cloud alternative

It is the customer pressure that will be most useful in framing a cloud subscription pricing strategy. Before we dig into this, let’s put the decisions here is the context of the strategic choice cascade for pricing. This is an application of Roger Martin’s classic approach to pricing decisions.

In order to make the right choices when pricing a cloud subscription (often just referred to as the SaaS model) the organization must have alignment on the winning aspirations. Some of the winning aspirations we see are as follows:

Move all customers to SaaS as quickly as possible and retire the legacy solution
Maintain the legacy solution for as long as possible with the SaaS platform as lower priority alternative
Milk the legacy solution and use it to fund the SaaS offer
Use the SaaS offer to lift the share price
Use the SaaS offer to enter new markets
Use the SaaS offer to test new innovations that will later be added to the legacy platform
Develop a balanced strategy where the legacy solution and the SaaS offer have clearly defined roles to play

These are just some of the aspirations we have heard from management teams. In the right circumstances, any one of these could be the right strategy. Problems ensue when different parts of the company have different aspirations. In some cases sales, because of its compensation structure, remains focussed on the legacy solution and uses the SaaS offer as bait with a long term goal of selling the commission optimizing legacy solution. Or the SaaS team’s goal is to drive up the revenue, or market share, of their own offer no matter what damage this does to the legacy business. The justification here is often ‘if we don’t cannibalize ourselves someone else will do it for us.’ We have even seen the financial leaders of the company send mixed messages, wanting both the predictable revenue from SaaS and the large cash injections from a perpetual license.

The first thing to do with any SaaS pricing strategy is to make sure that leadership, the product or service team, sales, customer success, and finance are all in agreement on the winning aspirations.

Once this happens, which is sometimes easier said than done, one can follow a standard value-based pricing analysis to design the pricing model.

One begins with value drivers, economic, emotional, and community.

The critical questions here are

Are there new value drivers or is it simply a question of improved delivery on existing value drivers?
For cases where there are no new value drivers, are existing value drivers enhanced or is this simply an alternative way to deliver the same value drivers at the same level?

Once one has investigated and begun to quantify the value drivers, the next step is to segment, or resegment, the market. In the value-based approach, a good market segment is one that gets value in the same way and that buys in the same way. In the SaaS transition, one of the critical questions is whether the same buying process will be used for the SaaS offer and the legacy solution.

Combing the questions on new vs. existing value drivers with new vs. existing segments leads to four possibilities.

On the far right, we have one common situation. The SaaS offer provides the same basic model to the same market. At least in this case the pricing is straightforward. One generally takes the current perpetual license price, adds in the maintenance and support fee (typically 15-20% per year), and possibly includes one upgrade cycle. One adds this up, generally over three years (36 months) or five years (60 months), and then divides to get the subscription price. Some companies want to add a premium, as they are now covering the cost of managing the servers. In my experience buyers are resisting this these days. In fact, they generally expect the cost of the subscription to be slightly lower than the legacy pricing as an enticement for them to switch.

Things get more interesting when new segments are being targeted. Ideally, one can find a new pricing metric that better tracks the value metric for the segment. (The value metric is the unit of consumption by which the customer gets value. The pricing metric is the unit of consumption for which the customer pays. Value-based pricing succeeds when the pricing metric tracks the value metric.) The hidden issue here is that when value drivers are the same, markets and segments tend to converge over time. One has to plan for this and assume that buyers are smart and will pick the pricing model (put themselves in the segment) that most benefits themselves. Comparing the new SaaS pricing model with the legacy pricing model under different scenarios is important here.

The real goal with a SaaS offer should be to deliver new value drivers. This should be seen as a core goal for the SaaS offer development team. When this can be done there are still two possibilities: the value drivers are relevant to the current customer base or they open the possibility of new customers and segments.

When the SaaS offer is targeting the current customer base with new value drivers there is a high risk of cannibalization. This may be acceptable, depending on the winning aspirations for the SaaS offer, but it needs to be carefully managed. The best way to do this is to find a new pricing metric for the SaaS offer that sharpens the differentiation from the legacy solution. This is a powerful way to control each market and should be a high priority in this scenario.

In some cases, somewhat rare in our experience, the SaaS offer will deliver new value drivers to a completely new set of customers. When this happens the SaaS offer is a kind of blue ocean opportunity. It may even amount to category creation. (See our work on pricing and value for category creation.) This is exciting for everyone, but it is important to make the required investments in understanding the new value drivers and being able to provide proof.

The one, two, three of pricing for SaaS transformation is

Get aligned on winning aspirations
Investigate the value drivers (are they new, improved, or just alternatives)?
Segment the market and resegment your existing customer base

SaaS transformation is not going away. Within ten years the majority of software will be hosted in the cloud and priced using some form of subscription model. Mastering successful transition is critical for all software companies, even for those born in the cloud. Software companies born in the cloud will encounter more and more competition as their initial offers get commoditized and they need to bring new innovations to market.

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