One lesson for software companies has become abundantly clear during the last 18 months: pricing needs to be on the C-suite’s agenda. Before then, the industry had been growing so fast for over a decade that executives and investors tended not to view individual product margins as an overriding concern. Now, however, that has all changed.
After years of rapid growth, the industry faces economic uncertainty, increased capital costs as interest rates rise, and a still-competitive talent market with accelerating wage growth. In the last year alone, 84 percent of publicly listed software companies saw their valuations drop, and more than a quarter experienced a decline of more than 50 percent.
The message from the market is clear: top-line growth alone is not enough. Investors are increasingly pivoting from valuing growth at all costs to focusing instead on efficient growth. In this new era, the software companies that thrive will be those that grow revenue and margin simultaneously.
Given these conditions, the leaders of software companies increasingly push pricing to the top of their agendas, viewing it as a critical lever to grow efficiently and capture value.
To understand what specific actions software companies can take to get the most out of pricing, we surveyed 184 software companies’ decision makers to learn how executives are thinking about their pricing strategy. We also looked at how outperforming software companies within this group have differentiated their pricing strategies. This analysis uncovered a set of pricing practices that correlate highly with growth rates (see sidebar, “About our research”).
Five actions to strengthen software companies’ pricing practices
Respondents at most of the software companies in our survey (85 percent) indicate that they plan to drive value through price adjustments over the next two years but lack the infrastructure to capture the long-term benefits of pricing and sustain its impact. Worse, many companies also lack the tools and capabilities needed to build this foundational infrastructure. Respondents at about three-quarters of the software companies we surveyed say they lack a dedicated and centralized division to oversee pricing decisions and guidance, relying instead on ad hoc approaches.
Yet almost all our survey respondents say they plan to alter their pricing in the near term. Roughly half say they expect to increase renewal prices and tighten discounting, while just under 40 percent say they plan to increase list prices and drive higher contractual increases at renewal time. Another 12 percent say they expect to reduce prices to disrupt the market. Only 6 percent say they plan to maintain business as usual.
How can companies achieve these kinds of aspirations? To help answer that question, we examined the various pricing actions taken by our survey pool of companies and identified five core approaches that are used more at higher-performing companies and, based on our own experience, generally help produce stronger profits and growth.
Invest in a centralized pricing function
The case for investing in pricing functions has never been more straightforward. In fact, our research has shown that a long-term pricing advantage can account for 15 to 25 percent of a company’s total profits. Investment in the pricing function can take many forms, including head count, training, and organizational systems to enhance pricing accuracy and agility.
Despite the apparent advantages, software companies are generally underinvesting in pricing functions. Only about 49 percent of software executives say they increased investments in their pricing functions in the past year, and even fewer (12 percent) have established a pricing capability-building team to model and spread optimal pricing approaches across the entire organization, especially to frontline sellers.
Nonetheless, investment in pricing functions is quickly accelerating, and higher-growth companies are dedicating more head count to developing their pricing functions. Higher-growth companies are 1.4 times more likely than companies with lower growth rates to devote more than ten full-time employees to product and strategic pricing.
The higher-growth software companies we surveyed also have at the core of their pricing infrastructure a specialized organization that can provide accountability to and ownership of critical pricing decisions. This kind of pricing “control tower” can serve as a mechanism to enforce deliberate and consistent processes around pricing decisions, manage risk, and provide pricing guidance to frontline sellers.
Invest in pricing infrastructure and capabilities
Hiring alone, of course, is not enough. From our broader work with companies that sell to large enterprises, we know the advantage of training sales employees to make pricing decisions that are beneficial in the long run, instead of the more common practice of making concessions to try to close deals as soon as possible. Such concessions often include signing multiyear contracts with capped annual price increases—sometimes even no annual increases or ad hoc discounts. Our survey found that pricing guidance and enablement for the front line is seriously lacking. More than half (57 percent) of respondents say their companies lack adequate sales training in negotiation to communicate and support price changes, and 42 percent say their company provides no deal-level pricing guidance, a shortcoming that may allow an unnecessary loss of value.
Providing this level of guidance relies on access to insights, which in turn requires investment in pricing analytics capabilities. Reluctance to invest in these aspects of the pricing function can impose a high cost. For example, despite the preponderance of multiyear contracts in the B2B space, our research shows how surprisingly common it is for companies to lose value from existing customers on contracts that lack mechanisms for annual price hikes. Over 85 percent of respondents indicate that their companies had a contract annualized price increase that fell below the United States’ year-on-year inflation rate in 2022. Setting minimum price increase thresholds for renewals can safeguard margins, yet only about a third of respondents say their companies have incorporated such pricing guidance into their renewal infrastructure.
Recently, a global IT services provider achieved an approximately 5 percent increase on earnings before interest and taxes by setting up a pricing negotiation recipe and library of documents and reference materials to help frontline sellers conduct negotiations with key accounts. Sellers had been given a pricing target but were unsure how to broach the conversation with clients outside of the renewal cycle, so the company armed them with content and tools. These include a fact base to illustrate how price adjustments—or the lack thereof—have been out of step with inflation and their clients’ own price adjustments. Other content consists of talking points for responding to potential clients’ objections. In addition, capability training programs were tweaked to align with how adults learn; the new design includes short, optional, and interactive sessions with role playing, rather than compulsory full-day sessions packed with theoretical information. The new format commands better attendance, as sellers spread the word and encourage others to attend.
In another example, a large enterprise software player with a massive installed base was struggling to monetize renewals pricing, especially in the current high-inflation, high-uncertainty environment. To address this issue, the company set up a pricing control tower with resources including deal desk support, analytics, strategic pricing, marketing, legal, IT, and customer success. The price control tower drove an incremental 3 percent price adjustment by ensuring focus on four key elements:
- Value messaging. The company created customer-specific messaging on the value derived from core products and tied it to product investments made by the company. For example, customers who used extensive advanced search capabilities received messages that showcase investments in AI to improve search tools.
- Price reporting on renewals. Dashboards were built to provide real-time information to the C-suite on renewal pricing uplift.
- Contract analysis. The company analyzed contract terms and conditions for all upcoming renewals to understand price clauses (such as price increases not being written into contracts) and came up with a strategy to change customer contract terms (such as offering one-time discounts to customers willing to have an annual price escalator clause added to their contract).
- Pricing system changes. The company identified and prioritized key system changes to eliminate pricing roadblocks. For instance, they identified a cohort of about 1,000 customers that were on automatic-renewal plans in which the renewal rates were lower than target and whose churn risk was low, and as a result, were able to bring prices in line with targets.
Inform pricing guidance with advanced analytics or AI
An option software companies can consider for differentiating their pricing strategies is to employ sophisticated, data-driven approaches that align pricing options more closely to customer preferences. Higher-growth companies lead the pack in pricing analytics capabilities: they are 1.7 times more likely than lower-growth organizations to integrate advanced analytics into their provision of pricing guidance to frontline sellers.
Most companies, though, have taken a more cautious approach to investments in pricing analytics capabilities. Many software companies we surveyed haven’t yet embraced core analytics tools (Exhibit 1). Only about a quarter of respondents say they have tools to provide descriptive analytics (the ability to report pricing performance and results), and almost as many have diagnostic analytics (the ability to diagnose underlying reasons for pricing results and trends). And fully 15 percent of respondents say their companies have no pricing analytics capability whatsoever.
Companies that lack the new advanced analytics tools emerging for pricing use cases are missing out on capabilities to forecast pricing results (predictive), anticipate customers’ unique needs and behaviors (prescriptive), and continuously improve artificial intelligence (AI) models based on purchasing patterns (self-learning).
Software companies also tend to hold back on investing in other analytics tools, such as pricing and KPI dashboards. These could enable companies to establish organization-wide transparency over pricing performance, but only 38 percent of respondents say their companies have pricing dashboards to track these metrics and inform pricing decisions and broader sales strategies. The higher-growth companies in our survey sample are catching up: 44 percent of respondents at these companies say their companies are leveraging sophisticated pricing dashboards. Such tools could help software companies identify sources of lost value at the customer and product levels by tracking real-time price changes, allowing the pricing center to continuously iterate and refine its overall strategy.
In our experience, companies that develop and implement a successful pricing analytics journey focus on the following actions:
- Invest in dynamic deal scoring to empower the front line. Software companies that invest in dynamic deal scoring have experienced four to ten percentage-point increases in return on sales. Far from the early, rudimentary approaches to control of discounting in software companies, dynamic scoring tools leverage sophisticated machine-learning (ML) algorithms to provide real-time information on the quality of discounts to frontline sellers, are integrated directly into the company’s cost per quote, simplify approval processes, and link frontline compensation to the quality of deals.
- Ensure that reporting systems can isolate pricing impact. As software portfolios get increasingly complex, it can become difficult to isolate the impact of pricing. One large information services software player was able to improve price realization of existing customers by 3 percent in part by creating transparency in price reporting.
- Build an analytics-based price-setting engine. The velocity of new software product and feature introductions has accelerated with, for example, monetizable APIs and add-on or third-party partnerships, but the price setting has not kept pace with them. Sophisticated players have invested in developing semiautomated approaches to rapidly gather and analyze customer and competitor input that can inform pricing for new products and features.
Align pricing metrics more closely with value
The most popular pricing metric at respondents’ companies continues to be seat based (based on number of users), with roughly 40 percent of respondents indicating that their companies use this as their primary pricing metric. Seat-based metrics can certainly be the right choice for a subset of companies, especially upstarts that prioritize sales velocity. Seats are easy for customers to understand and accept, especially given that this pricing metric has long been the most prevalent.
However, for many businesses, using seats as the primary metric comes with serious downside. This approach is not scalable to support future growth in revenue per customer. Also, this kind of metric is not auditable in some cases—for example, with shared licenses or credentials. Oftentimes, seats are not directly linked to value either. Consider an analytical product that has 100 users at an enterprise company, with three power users accounting for 95 percent of the usage. Beyond the initial three licenses, the value to the company would not increase consistently as more users are added.
The higher-growth software companies in our survey recognize these deficits. Fully 97 percent of respondents at these companies say they expect their pricing metric to evolve in the near term. One shift we are seeing is companies exploring usage-based metrics, driven partly by the increasingly popular pursuit of product-led growth and the potentially significant revenue growth that such a model can bring (Exhibit 2).
However, usage-based pricing is not necessarily the right strategic move for every company. Depending on the product, usage may not be the sole determinant of the value the product provides to customers. Oftentimes, a product’s value comes simply from access to that product. Also, shifting to usage-based pricing requires a multi-month, cross-functional transformation. This includes preparing sales and customer success teams and upgrading back-end systems to help customers predict how much capacity they will need and be capable of refunding them when predicted estimates don’t match actual usage.
Given variations among companies, software executives who want to investigate changing their pricing metric may want to resist the urge to follow popular trends. Instead, they should consider what matters to customers. To set the right price metric, begin by examining where value comes from for your customers. Consider the following set of questions as a method to identify the right pricing metric for your specific software product:
- Is the metric under consideration linked to the value customers derive from the product?
- Is the metric scalable?
- Is it auditable?
- Is it predictable?
- Is it acceptable to customers?
Simplify pricing and packaging structures
Customers, according to classic economic theory, tend to prefer choice. However, a proliferation of options, in the form of bundles, add-ons, and customized pricing, also has a downside. Too many options create complexity and confusion for sellers as well as buyers. For sellers, this complexity may lengthen the sales process and hamper companies’ ability to control unnecessary discounting and its negative financial impact.
Over the past three years, the average number of buying personas per software customer has increased from one to four. In addition, the average software company also offers more than seven pricing schemes (for example, perpetual, subscription, pay as you go) and ten-plus separate pricing metrics (such as per seat, usage based, or outcomes based). Many end up with highly complex pricing architecture. For instance, one software player offers more than 15 price metrics—including per host, per gigabyte of data ingested, per million log events, and per thousand tests run—and more than 20 different price points for those metrics. It is no wonder their customers describe their bills as complex, impossible to predict, and often much higher than expected.
Companies with simpler pricing and packaging structures (such as three simple tiers for pricing and good/better/best packaging with fewer than five add-ons) are nearly 30 percent more likely to report having effective pricing and discount controls than companies with extremely complex pricing and packaging, our research shows. Simplicity also translates to greater likelihood of high growth, courtesy of faster sales velocity, less customer confusion, and ease of control and reporting on discounts (Exhibit 3).
However, simplicity comes with trade-offs. Companies targeting customers in commoditized software subsectors often find that simplicity encourages price-comparison shopping and drives lower price realization.
To simplify pricing and packaging, it can help to understand “value-adding complexity.” This means identifying areas where pricing and packaging complexity does not deliver incremental customer value and targeting only those areas for simplification, versus pursuing simplicity at all costs. Additionally, when companies have multiple discrete products that necessitate different individual metrics, it can be beneficial to wrap these disparate metrics into a single “token or credit” that acts as a secondary, all-encompassing price metric to drive simplicity without sacrificing the link to value.
Tie sales reps’ incentives to pricing
Pricing-specific incentives can help software companies align sales efforts with the overall pricing strategy. As the case study in Exhibit 4 illustrates, this approach can encourage sales reps to negotiate the best possible pricing outcomes for the company.
Despite the advantages of pricing-related sales force incentives, 53 percent of respondents to our survey report that their companies have no pricing-related sales force incentives. Once again, higher-growth companies are ahead of the curve: they are 50 percent more likely than their lower-growth peers to adopt pricing-specific sales incentives for their reps.
In practice, this involves introducing upside and downside multipliers or one-time bonuses, depending on the specific business context, that are tied to pricing decisions. For instance, a B2B software company leveraged AI to give its frontline sales force discount guidance on live deals but did not activate multipliers on sales compensation tied to meeting the discount threshold. Unsurprisingly, the guidance had a negligible impact on deal outcomes.
Another B2B software and services company tied its sales compensation to margin targets but not to specific pricing actions. The result was that sellers found ways to achieve margin targets by changing the product mix, rather than pulling on cost levers, to sell more higher-margin products. In contrast, a robust sales incentive strategy minimizes the potential for misaligned incentives, so the salespeople reap the benefits of pricing-related incentives in a sustainable manner.
Pricing capabilities as competitive edge
Acting now to rethink pricing strategies can help software companies propel efficient growth and stay competitive in a pricing market that is rapidly maturing. Even in less turbulent times, software leaders can push for more strategic pricing agendas by setting specific pricing targets for revenue leaders and empowering the sales force with incentives to tailor customer-specific price strategies.
Furthermore, building a dedicated and mature pricing function helps software companies adapt quickly to shifting market trends and customer needs in order to capture the full value of their product and services. The following steps offer a starting point for software companies looking to get ahead.
Step 1: Prioritize pricing now
Companies can immediately elevate pricing to the top of the corporate strategic agenda by assigning a specific owner for pricing. That role should have a direct reporting line to the C-suite. To act on this priority, leaders should incorporate pricing into strategic business reviews and set specific pricing targets for revenue leaders.
Step 2: Stand up a SWAT team over the next month or two
Over the next one to two months, companies can maximize short-term pricing realization by standing up a pricing SWAT team with the following responsibilities:
- Develop a segment-based methodology for renewal pricing—for example, by creating tiers of price increases based on elasticity of each customer cohort, building a value narrative to support price increases, and establishing a price control tower to monitor price realization.
- Set up an infrastructure to enable tracking of renewal pricing.
- Tie sales incentives to specific pricing targets—for example, with sales performance incentive funding formulas (SPIFFs) if a sales compensation redesign is not easily achievable.
Step 3: Align pricing and packaging to value within a year
Over the next six months to a year, companies can embark on a customer-backed, data-driven journey to align pricing and packaging to value. The journey would involve the following multiple steps:
- Explore alternative pricing models that might be better aligned to value and more scalable, such as usage-based pricing.
- Understand list prices in relation to willingness to pay, and adjust price points to match value perception.
- Invest in advanced analytics capabilities to track pricing performance and provide pricing guidance for the front line.
- Simplify and optimize packaging, including the introduction of add-ons that contribute to value creation.
- Systematize corporate-level pricing policies and terms and conditions—for example, by baking in annual adjustments that link the consumer price index to current and future contracts.
By building and capitalizing on new technologies, tools, and capabilities to support sophisticated pricing operations, software companies can implement new pricing models and strategies to promote efficient growth at a time when the price of inaction on this front is soaring.