Pricing Enterprise Software

I find the economics of enterprise software to be quite interesting, but have never had a theory of pricing that I really felt comfortable with. I’d like to present a new (to me) explanation for how price is deterimined.

Many people are uncomfortable with the concept of “enterprise software” as some how different from other software. To me, the important difference is that enterprise software is purchased by a large organization for use in a business-critical system that they will be stuck with for many years, possibly decades. The “enterprise” isn’t so much in the software, as in the company that is selling it, from their sales and marketing through their services and support.

Enterprise software is also consistently of very high price. There are a couple of potential reasons for this. One is that the benefits of the software are large, because the company is large (value-based-pricing). Another is that the software is built for a small market of large customers, so even though it is duplicable like most software, its development costs much be recouped from just a few sales (cost-based-pricing). I don’t think either of these is a good explanation. The benefits of enterprise software don’t generally scale with organization size, since the software is frequently used by a single group or business unit which is no larger than many non-enterprise customers. And even products where the cost is easily recouped over many customers (Oracle, SAP) maintain high prices.

I submit that the price of enterprise software is high to provide incentive for companies to go through the enterprise acquisition process. Because the enterprise customer is going to be stuck with the software for many years, their costs will be dominated by their internal costs of support, maintenance, training, etc. To any given business unit, the value proposition for a piece of software might be clear, but organizations quickly learn that they must restrict purchasing authority, lest they end up with an unmanagable IT infrastructure. Enterprise customers establish processes for buying software with long timelines and signficant technical and political hurdles. The result is a process so difficult companies must employ full time experts (enterprise software salespeople) to manage it. Some large organizations even go so far as to have their own internal consultants that work with new vendors, to help them through the process.

To a software vendor, which previously had an infinitely sharable good, this purchasing process greatly complicates their business model. They are limitted in the number of sales opportunities they can pursue. They must compensate their sales organization. And they must expend signficant effort before there is any guarantee of revenue. So, in order to incent companies to work through their process in the first place, large enterprises must pay a premium for their software.

One interesting corollary to this theory is the application to Free and Open Source Software. With free software, the common case is to treat the good as sharable, make it available online, and charge nothing. If cost of software were a significant part of large enterprise purchasing decisions, then free software would be doing really well. But, in fact, the important aspect of software sales is not price, it is having a professional push the deal along, assuring that your software meets with each of their objections and concerns. Free Software, without any such advocate, doesn’t have a chance against commercial software in many enterprises.

Realizing this, many companies who already happened to have enterprise sales forces are developing techniques for using selling free software to enteprises and claiming their prize at the end. Some startups, like MySQL and Redhat, have also gotten involved. However, the enterprice acquisition process is still slanted towards buying from traditional vendors who understand enterprise concerns. And unfortunately, with a free software product, a small company has little protection against an establish enterprise vendor taking over their product, as Redhat is experiencing recently with Oracle.

If this is all true, then there is a different approach to be taken by Free Software: internal advocates. Rather than pay vendors significant sums of money to sell them a piece of free software, enterprise customers could develop a system of internal advocates, who filled the same role. Much like sales people, they would develop expertise in the acquisition process, and personal relationships with IT buyers throughout the organization. Unlike sales people, they could advocate for a variety of products, and they would be in a position to identify new free software products long before vendors like IBM, Oracle, and Novell. I don’t know of any organization with such a structure, but it seems likely to emerge.

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