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May 27, 2009 03:13 PM

Categories: Sales and Distribution

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bbimson

Member
Joined: 12/07/2003

What discount rates (or perhaps range of discount rates) are appropriate to apply to a custom software development project (25-40%) vs. an integration of a software tool that delivers the same functionality (say, 8-12%)?

Now for the background . . .

We sell complex, database-driven software development tools and related applications to ISVs and systems integrators. For ISVs, we try to remain flexible and often tie our pricing to the same royalty metric that our ISV customer uses for its end users.

We have an ISV prospect that wants to distribute our software as part of its own product. They want to have the right to unlimited distribution of our software in every copy of their software to their current (and future) customer base. They have tens of thousands of end users, and our software will add substantial value to their offering. As an ISV, it all comes down to a build-versus-buy analysis for our prospect.

We have created a fairly complex pricing model that takes into account more than 25 variables to calculate the NPV of (1) the stream of Â?theoreticalÂ? royalties that we otherwise would charge for this particular opportunity, (2) the incremental cash flow that our customer could expect by adding the functionality our tools provide, and (3) the cost of developing the same functionality on its own. Based on conversations with our prospect, we are fairly comfortable that we are using realistic numbers for nearly all of these 25+ variables.

The only variables that seem arbitrary to some extent are those related to the appropriate discount rates to use. As you might imagine, the discount rate used will have the most dramatic impact on the NPV calculation.
Our tools will drastically reduce the development time our customer will need to bring the combined solution to market and the inherent risks associated with developing this functionality �from scratch� (i.e., using a combination of lower-level development tools). Consequently, our tools significantly increase the likelihood that our customer will realize the projected incremental cash flows vis-à-vis developing the same functionality on its own.

Discussion:    Add a Comment | Comments 1-2 of 2 | Latest Comment

roydaya Avatar
Forum Moderator
May 28, 2009 12:10 AM

[FONT=Calibri]It is always nice to create a formula to automate the negotiation process but at the end it is a negotiation. You said that you customize your revenue stream to the VAR's and this makes it easier for them as you take away all of their risk because they can never loose and always have guaranteed margins.[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]If every deal is different (and we do the same, we might charge a yearly OEM pre-purchase, a fixed sum per user, a monthly lease or even a percentage from invoice) why force yourself to a formula that is full of plug numbers that have nothing to do with the customer willingness to pay.[/FONT]
[FONT=Calibri] [/FONT]
[SIZE=3][FONT=Calibri]Every case is different and there is a different strategy behind it. I would be worried to use an excel formula because it gives you an excuse not to think about the overall deal and just punch in numbersÂ?[/FONT][/SIZE]
[FONT=Calibri] [/FONT]
[FONT=Calibri]You are not only limiting yourself to the VAR margins but also want to assume all the risk and want to automate it.[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]What if you want to bundle only the first 12 months of product lease and their end customers will need to purchase additional years if interested?[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]What if you want to get 200k from new VAR and allow him to distribute freely for the first 12 months? (this way you cover your costs dealing with him and not taking the risk for his initial sale attempts).[/FONT]
[FONT=Calibri] [/FONT]
[SIZE=3][FONT=Calibri]What if you want to give them a basic product as a free add-in or for a small fee and work with them to up-sell to a pro or enterprise versionÂ?[/FONT][/SIZE]
[FONT=Calibri] [/FONT]
[FONT=Calibri]What if you want them to white label the product under their brand in exchange to a monthly retainer as well as a cut from sales or pre-purchase?[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]When you use formulas you donÂ?t think out of the box.[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]My suggestion is to stop the plug number method and have a brainstorming session for each such VAR. You should have various options to copy paste from and some excel formulas to simulate and demonstrate but this is to complement thinking and not to automate.[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]When you are signing these deals several times a day and have experience doing thousands of them you can probably automate the process with specific scenarios that proved most valuable. While you can still handle the deal flow maximize the potential of each deal.[/FONT]
[FONT=Calibri] [/FONT]
[FONT=Calibri]Remember that a formula is as effective as the numbers you plug in. Junk in-junk out [/FONT][FONT=Wingdings][FONT=Wingdings]J[/FONT][/FONT]
[FONT=Calibri][SIZE=3][/SIZE][/FONT]

Roy Daya, CEO
www.digital-clay.com

DigitalClay is a smart application engine for building dynamic software solutions without coding.

http://roydaya.com

pmorettini Avatar
Forum Moderator
May 28, 2009 10:32 AM

I definitely agree with Roy's final words about garbage in-garbage out. With 25 variable's to estimate, the odds that you have not greatly missed the boat on at least a couple are very small.

In essence, you have an unbelievably complex formula with a hard number at the end, that gives you the illusion of precision. It reminds me of startup business plan forecasts, which are always fiction. In fact, all those variable estimates are probably drawing you farther and farther from reality, not closer.

As you said yourself, this is essentially a make-vs.-buy decision for your OEM customer. They're not interested in allocating you a "fair share" of their revenue. I would simply the discussion. I would not focus on discount rates, but try to estimate their cost to develop from scratch without your software. This won't be exact, but you should be able to come closer to reality that the formula you are using. I would then add in a reasonable "time to market" premium due to the reduction of their development time from using your products. Add in a bit of margin of error for negotiation purposes.

That would be your starting point, and the negotiation begins from there.

Sorry we haven't answered your question as you posed it--I have to tell you what I believe.


The other, less customer-focused approach would be to simply take your product list price and multiply it by 10-50% to get to a per copy royalty. OEM licensing tends to fall in this range, and of course the percentage would be based upon how bad they really want your stuff and the resulting negotiation. Royalty rates are more often closer to the lower end of that range than the higher.

Phil Morettini
PJM Consulting
Moretti on Management Blog
http://twitter.com/TechnologyGuy
+1 858 792 1062

Discussion:    Add a Comment | Comments 1-2 of 2 | Latest Comment

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