Chris Mele is the managing partner of Software Pricing Partners.
When a private equity firm purchases a software company, customers often worry they’ll have to pay more for the same software.
Unfortunately, that concern is actualized in some cases. The traditional playbook many private equity firms use in the process and aftermath of acquiring software companies can leave customers in a lurch and, in turn, cause massive financial losses.
How The Traditional Private Equity Playbook Can Alienate Customers
Private equity firms come in different shapes and sizes. Not all have operational control post-acquisition; some serve as silent partners. For the purpose of this piece, I’m focusing on the private equity firms that do have operational control post-acquisition.
I’ve observed that the traditional private equity playbook for software acquisitions goes like this: A private equity firm acquires a software company. The firm’s stakeholders determine that the software is underpriced and decide that the best way forward is to instill a price increase during the hold period (which typically lasts several years) in an effort to increase recurring revenue as soon as possible. Typically, a churn analysis ensues, and the firm’s stakeholders estimate how much they can raise the price without losing more customers than they can afford.
Usually, the result is that the private equity firm and software company end up alienating and destabilizing their customer base. Some customers might switch vendors, especially in mature markets with many alternatives. Other customers might remain on board, despite their reservations about the price increase, because their workflows are strongly intertwined with that particular piece of software. But they feel trapped—and, as a result, begin earnestly working to decouple. Some succeed in a matter of weeks. Others, months or years later. When these customers do eventually leave, their departures creep into churn data. The executives don’t always recognize that those departures tie back to the original price increase. Making matters worse, if a competitor learns about these defections, it can swoop in and attract that customer base with a better offer.
Often, Increased Pricing Isn’t The Issue In And Of Itself
As counterintuitive as it might sound, the problem with the private equity playbook for software acquisitions usually isn’t a given pricing increase in and of itself—it’s how leaders approach the pricing increase.
Consider this: According to G2’s 2023 Software Buyer Behavior Report, buyers “prioritize value over cost; regardless of size, buyers are more concerned about showing value than focusing on software costs or total cost of ownership.” Buyers are willing to pay for software if they feel they’re getting value from it. But when buyers face a sudden price hike without being offered additional value, it’s difficult, if not impossible, for them to justify paying more for the same software.
Customers expect a certain amount of features in exchange for their subscription fees (called “maintenance features” in the on-premise days). They’re willing to pay more for features that go beyond mere maintenance. For instance, an executive might be willing to pay only $30,000 annually for workflow management software for their company. But the following year, if that workflow management software solution has new artificial intelligence capabilities that can help their team work even faster, they might be willing to pay $39,000 for that solution. They might look into alternative solutions that are cheaper, only to realize their firm’s workflows are so entangled in the existing vendor that it wouldn’t make sense to switch. Upon that realization, they’re willing to pay 30% more to keep their firm’s workflows running smoothly.
Software is not static. It is constantly evolving. Customers’ needs are not static either; they develop over time. With each new feature a software solution provider releases, with each new need a customer realizes they have, a customer’s willingness to pay can increase. If anything, private equity firms and software companies should raise pricing to ensure they aren’t underselling the software. The trick, though, is approaching price increases strategically.
Moving Toward A More Sophisticated Pricing Approach
The evolution of software is a process. Likewise, the evolution of customers’ needs is a process. As such, pricing should be treated as a process, not an event—and this is what the private equity playbook often gets wrong.
Part of the reason for this faulty practice stems from the on-prem paradigm of the past. It was easier to attach prices to on-prem software; companies could charge customers for each new version of their software solutions on CDs. In the on-prem paradigm, the evolution of software and the pricing were, in essence, events that occurred simultaneously. But the SaaS deployment model has upended that. Companies can swiftly push updates and new features, bundling them with services to customers paying for subscriptions. The timing of updates has effectively been decoupled from the timing of price increases. A software company that pushes a new feature monthly can’t update the pricing at the same pace. There’s a disconnect between when new features are delivered and when prices increase, which begs the question of how and when to update pricing. Customers are suddenly confronted with a price increase post-acquisition—it’s no surprise that they don’t typically hold private equity firms in high regard.
Private equity leaders must treat pricing as a process from the get-go. They need to get out of the habit of treating pricing as a one-time event that occurs at the beginning of the hold period. Instead, to come up with a pricing strategy for the hold period, they need to deeply analyze critical factors, such as the software’s existing capabilities, the product roadmap, existing and potential use cases, the current customer base and the pool of prospective customers. Similar to how a company’s leaders create a cadence for product development and updates, they should create a cadence for price increases that closely aligns with the product’s strategy.
As for implementing new pricing strategies, there are two main mistakes private equity firms make. For one, I’ve observed a tendency in the private equity world to think, “A customer is a customer,” and treat legacy and new customers the same. However, legacy customers need to be treated differently than new customers. Legacy customers, after all, have a point of reference for a software company’s pricing. A new customer might view a $150,000 price tag as a great deal, but a legacy customer paying $100,000 for the past five years will likely balk at a 50% increase. To avoid the perception of market unfairness, software companies should leverage packaging strategies; for instance, placing new customers on product two, which comes with expanded capabilities, and leaving legacy customers on product one, which won’t receive as many new features over time.
Moreover, through smart packaging, companies can avoid the mistake of grandfathering customers into new contracts. When companies grandfather customers into new contracts, they give away a significant additional value for free. Instead, private equity leaders need to work with the leaders of the software companies they’ve acquired to develop and refine new software packaging options. By doing so, private equity firms can get better investment returns.
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