You get less of what you tax

by Mark Davis, CEO

Posted Thursday, December 03, 2009 in Software Business          0 comments

Tags: people, pricing

Jerome Wendt makes a good point about storage software pricing on his blog.

He argues that storage software vendors that charge by capacity (terabytes, TB) are shooting themselves in the foot, for three subtly different reasons.

First, customers don’t naturally think of paying for software by the TB. It isn’t how purchasers’ brains are wired. It is hard for vendors to change consumers’ mindset. Even when the vendor is “right” and customers are “wrong”.

Second, TB-based pricing makes the cost of software unpredictable. The customer doesn’t know how much the software is going to cost over its lifetime, because they don’t know how many TB it will be used for. Purchasing and cost accounting people dislike this because they want certainty, up front, on what things will cost.

Third, charging by the TB “taxes” the customer for doing what you want them to do, which is use your cool software on more and more TB. A cardinal lesson from economics is “thou shalt reap less of what thee taxes”. If you want citizens to smoke less, slap a tax on cigarettes.

All three are valid arguments against capacity-based software pricing, but it is the third that most compels me.

Cars, phones, and storage software

A manufacturer of a car that is extremely inexpensive to operate per kilometer might think, “My value proposition is lower cost per distance driven. In fact, the farther customers drive our cars, the better deal they are getting. They should be thrilled to buy our car by the kilometer! So the initial purchase price will be very low, maybe a few hundred dollars, and for that they can drive a short distance. As they need to go farther, we’ll charge their credit card a couple pennies per kilometer.”

If this argument makes sense to you, you’ve probably been part of a storage software pricing meeting. Here’s the line of logic:

1. Our software helps customers get more value out of their storage.
2. The more storage they have, the more value customers get from our software.
3. We want to make it easy for customers to buy our software whether they have only 1 TB or 1,000 TB. That is, we want a very low entry price, but in order for us to make money, we need to get more revenue when people use our software more.
4. Therefore, we’ll charge by the terabyte.

As silly as the car pricing example may sound to you, it has a certain amount of logic. In fact, that pricing model is how many wireless phone contracts work, so don’t laugh too hard.

Perhaps there are lessons to be learned from the mobile phone business. Why is it that per-minute phone pricing works well for some customers, but other customers dislike it?

Hardware versus software pricing

When you sell hardware with your software, or customers can purchase software only from the hardware vendor, pricing is not that difficult. I know because I've done it for billions of dollars of storage hardware and software.

If a vendor's primary driver of revenue is hardware, two phenomena enter the picture. First, making money on selling software becomes a little less important, because they'll make money on the hardware (and services) sale. So the vendor doesn't feel so bad not charging, or charging less, for the software.

Second, it becomes easy to implicitly charge for the software as a part of the hardware price. This is what economists call “bundling”. If one could deconstruct the profit and loss statement of a hardware vendor, it would be easy to see this. There are reasons why a disk drive purchased from your favorite bulge-bracket storage array vendor costs 5X what it would cost to buy the same drive elsewhere. One reason is that you are implicitly paying for the software features of the vendor’s array into which you’ll be stuffing the drive. It most certainly isn’t because the drive is, by itself, 5 times better.

Because of this second phenomenon, software pricing from hardware vendors is, in a real sense, capacity-based pricing. Buy more storage capacity, and you’re paying more for software. But that price is only implicit, which perhaps is one reason why consumers are fine with it.

Please share your input

A pure software business model, however, has no such opportunities for bundling (also known by cynical economists as price obfuscation). This is one of the reasons why it is always harder to price software than hardware in the storage business.

One of the things we’re thinking about at Virsto is how to price our initial product, which is currently in customer beta test. It’s an interesting question indeed. Your input is encouraged.