There are certain pertinent comments in life which you will remember for a long time. An observation by a friend, a quote you read in a book, an acknowledgement of the fruits of years of work, each of these contribute to our own fabric of consciousness that determines how we perceive the world.

One such comment was by a colleague who looked at me in disbelief when I revealed that I was going to form a software company. “But all software will one day be free…” he offered. I have not forgotten this comment after many years.  It was perhaps understandable because in his world view, you had to invest millions in equipment before you could make anything of value (he was an engineer). Software was too easy, no significant upfront investment, no barriers to entry in comparison to starting a manufacturing business. “You could start up in a garage” – you could sense the disbelief. This venture to make money from software was in his mind destined for failure.

The reality is that like the work of artists and musicians, even the best, most elegant software will one day be up on a wall in a virtual museum for the public to freely examine, no charge, no compensation for the talents of the developers, the programmers, the architects and the many supporting roles that go into making good software great. I recall the heady days of playing games like Manic Miner on a Sinclair Spectrum 48k computer. Today these games are freely downloadable to recreate this experience. For free, by enthusiasts and volunteers who set out to preserve great moments in software engineering.

Yet, some of the worlds richest and most valuable companies are based today on software for which you pay a decent price. Their positioning of intellectual property has somehow found the sweet spot where value is understood, articulated and created and therefore paid for.  Pure play software companies can be very successful indeed, even in an industry where the barriers to entry are very weak, and the pace of change renders work obsolete in a year or two. Consider the potential game changer when Apple recently announced free versions of upgraded operating systems and the iWork suite – Apple will in future simply make most of its money on its premium branded hardware which is the platform for its ecosystem.

This morning I was looking at some applications that came (for free of course!) on my tablet. One such application allowed me to watch free high definition movies. The selection was good, there were no catches. No advertising, no downside. Just a company giving away value for free, to build brand loyalty presumably? Yet, something in me said that if I did not pay for these movies then they are in fact without any value. I would rather go to the iTunes store, purchase the digital copy and watch the movie in my own time; with a feeling that I was somehow contributing fair value to the utility I was receiving.

It is the same with music. My iTunes playlists have several “favourites”. If I analyse these playlists, those albums for which I paid premium prices featured more in my favourite playlists than the other music that has accumulated from years and years of collecting magazine free discs, vinyl, tape and radio recordings. Somehow in my subconscious, the music that was the most expensive must be the best. Hence these tracks were in the playlists I listened to the most; even though technically there was much better content in the same music library.

When a company invests in enterprise software it will value the software in direct proportion to the amount paid.

The implications for software pricing are significant. Software needs to be priced on perceived value. Irrespective of the actual cost of writing the software, or the actual functionality / utility in a business; it is the perceived value to the business that matters. In a world where there are multiple alternatives, something that is paid for will probably be valued more than a free equivalent,  people just assume this has to be so because it applies in most other areas. This reverse economics of software pricing is evident in many leading brands and is also the underlying basis of “premium” products in industries such as personal healthcare, restaurants, fashion etc. In essence, perceptions matter most, and perceptions are shaped by brand, which is shaped at a much more emotional level by human experience.

Another example is the world of art.  Hypothetically you could exhibit the exact same painting in a world class upmarket gallery or in a park. The painting is identical. But it is the setting that will determine perceived value and the affordability of the buyers. If you hang a price tag of $10,000 in the world class gallery; you have just as much chance of a sale as a price tag of $1,000 in a public park. The buyer will get $10,000 of utility or $1,000 respectively. Both buyers will be satisfied with their purchase, they consider the experience of the painting first and foremost, and the opportunity cost of the cash paid is hardly considered after the buying decision.

The perception of value by the buyer of a painting is a combination of the perceived utility (and this will differ from person to person) and the amount sacrificed (paid) for ownership.

Some authors I know have excellent blogging sites. One acknowledges that he collated his best blogs into a book which he compiled, edited and sold on Amazon. The reality is that people can get all the content for free on the blog, or they could buy the book. Reverse economics of pricing intellectual property (software) means that people will still perceive the book to have more value, even though the source material is freely available elsewhere. They will happily purchase the book for the fact that they now “own” a consolidated reference that might save them time in future. (Even more bizarrely, many people who buy business books rarely read through them all. They simply want them as references, for some future moment). At a deeper altruistic level, people will sometimes buy the book to reward the author for the content and having summarised the freely available information that they would otherwise have had to do.

In the software world, most of the day to day software tools we use are available for free somewhere. It is entirely possible to function in the information age without spending a cent on software licences ever. But few of us do this. In business particularly, in the face of free open source productivity packages; businesses will still pay premium for a commercially produced product. Not all of this is simple perception, or brand strength. There are undoubtably many real benefits on multiple levels in these commercial packages. And if things go wrong as they inevitably will, people are happy that they paid some form of insurance for their software and at worst they will get their money back.

As can be inferred from the above, software purchases can be a very complex process, and not entirely related to the value of the software itself. It involves psychology, utility perception, brand perception, recognition of authorship, elements of insurance and many other “soft” human emotions.

The challenge for software companies then is how to price software licences. At the extreme, offering value for free is a legitimate strategy, provided of course your business can make its profit in other areas. An example of this is offering the software licence for free, while charging for the training and consulting services that are necessary to use the product effectively. The downside is that free software, as we have seen above can be perceived as having low value. And this perception can have a negative knock-on impact on the perceived value of the associated training and consulting services. On the other extreme the software can be priced very high, so high that the utility is significantly less than the price and the size of the market willing to pay this premium is reduced to zero, or at best a handful of individuals or companies. Competitive products will be much more attractive all else being equal. At the high end of the price range the perceived value will be high, after all you have paid a premium. But the market for this product will be so small, you risk selling nothing at all. In the middle somewhere is the economic optimum.  Finding this is not easy and might involve trial and error.

The problem is that once a software company locks in pricing and has several licensed enterprise customers it becomes nearly impossible to change the pricing afterwards without damaging the brand and customer loyalty.   Just try to offer differentiated pricing in the same enterprise and you will find out (if the company is half aware of what they are buying) that the lowest price will become the standard for the whole Group of companies.

Successful software pricing strategies are not easy. Depending on the strength of your brand, the perceived utility of the product itself and the positioning in the target market; your pricing can result in several vastly different outcomes for your business. Frequently the temptation will be to drop price to win a larger market share. This could be precisely the wrong move in this upside down world of software economics. Get it right and you could become one of the highly profitable and successful software companies around. Get it wrong and you might soon be giving your software away for free on a magazine cover.