Why service companies discount software ... and why they need to change
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
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Once upon a time there was a great company called SUN Microsystems. Remember them? They made some of the best hardware available at the time. You may not realize this, but they were also a great software company. The Java programming language and many other treasures were developed at SUN. But as the world shifted towards the cloud and business conditions changed SUN faltered and was acquired by Oracle, a software company in 2008. SUN had all of the technical people and technology it needed to succeed in the new era. What happened?
One reason SUN failed to adapt to the new business climate was that its commercial teams understood how to sell hardware but not software. Even worse, they often threw in software for ‘free’ to sweeten a hardware deal. One argument for this was that hardware had fixed costs while software margins tended to be very high. So sales had no problem protecting their hardware margins and discounting software. Finance just sees the numbers and as the software was not contributing to revenues it struggled to get resources (a bad caricature, I apologize, there are many finance people who think strategically about the business).
Why bring up this old story today? Many service companies are now reinventing themselves around software and data. As Marc Andreessen famously said back in 2011 “Software is eating the world.” One of the things it is eating is professional services businesses. Or as B2B growth strategist Ed Arnold said recently in conversation, “People are no longer buying expertise. The expertise is coded into the software. They are buying access to data.”
Services companies are well aware of this, and most of the top companies are well along the path to layering software and data into their solutions. An example from McKinsey …
Software and data are central to advanced services offerings.
There are three main how-to-win choices being made.
Develop software and collect data for internal use, monetize through efficiency or higher quality outputs
Deliver the service through software so that rather than generating spreadsheets and presentations
Connect services to software and subscriptions (often using the service as a way to introduce and embed the software)
Another example of the third approach from McKinsey is its Experience DNA offer, which combines cloud-based data lakes, predictive machine learning algorithms, and an API insight and action engine to help companies take customer experience (CX) to the next level. McKinsey is the company that defined the current case-based approach to consulting that dominates the strategy consulting world, but it knows that this model is on its last legs and new approaches are necessary.
Too often though, services companies are willing to discount software subscriptions to maintain margins on professional services. The reason that is often given is that professional services have lower margins than software and that it makes sense to discount the high margin offer and preserve margins on the core professional services offer.
This is the reason given, but there are often other forces at work. In many cases, professional services are sold by the consultants who will be engaged in delivering the work. They are confident of their ability to deliver value and want their value recognized by the client and by their firm. Psychologically, there is little incentive to discount their own work, and in many cases, they are not sure of the value of the software. They see the software in a secondary and supporting role and believe that they are what delivers the core value.
This is similar, too similar, to how SUN approached the sale of software, seeing it as a high-margin add-on to the hardware that delivered the real value. This was a failing strategy for SUN and discounting software subscriptions will be a failing strategy for consulting companies that want to survive as software eats the world.
Ibbaka generally advises its customers, the ones combining professional services with software, to discount the professional service while holding the line on the subscription. One way to do this is to offer customers a professional services credit that is based on the size of the subscription, so that the more the customer pays for a subscription the larger the credit. This flips the normal approach and changes the psychology of buyers and sellers.
One push back to this is that at the end of the day, it is the total contract amount and the value over time that is being delivered that matters and it doesn’t really matter what gets discounted. In some abstract world, this may be true, but in the real world the consultants doing the selling and the buyer experience the two discount structures very differently.
Another advantage of discounting professional services, at least for the buyer, is that it better aligns payments with the value to the customer. In most cases, value is realized over time, and not immediately on the delivery of the professional service. By transferring part of the payment from the professional service to the subscription, value delivery and payment are better aligned. This alignment of value and payment can be positioned as a powerful value message during sales.
For some professional services companies deferring revenue is painful. This is similar to the struggle software companies have had as they transitioned from the license model (where there is a large cash payment for the license upfront) to the subscription model. In general, subscription models have proven more resilient and profitable, and have fostered better customer relationships.
See OpenView’s research on this topic.
The subscription model is robust and resilient, but there can be a painful transition period that needs to be navigated.
In the interests of …
Moving your professional services to a resilient and scalable footing
Aligning value-to-customer with payment
Building long-term relationships with customers
Consider discounting professional services before discounting software or data subscriptions. One of the best ways to do this is by basing discounts on the size of the subscription.