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Microsoft goes direct to drive profits

A move by the software giant to boost the amount of software it sells directly to businesses could save customers money, but it has angered some longtime partners.

Read more about Microsoft and software costs
Microsoft has a new strategy to boost its sales and fend off rivals: go direct.

During the past two years, the Redmond, Wash.-based giant has increased the amount of software it sells through its Enterprise Agreement (EA) licensing program, under which the company sells applications directly to businesses.

That's a big switch from previous plans, under which Microsoft relied on a worldwide network of resellers to find customers and sell its software, ideally for profit. Resellers are always pulled into EA agreements, but to service deals largely consummated by Microsoft. Microsoft then pays them a commission out of fees paid to Microsoft by the customer.

Under the EA plan, Microsoft representatives also spend more time and energy at customer sites discussing the technical or economic benefits of its wares.

"We now estimate that 30 (percent) to 35 percent of large customers have Microsoft Enterprise Agreements," said Alvin Park, an analyst at Gartner. That's up from 15 percent in the recent past.

In March, Microsoft CEO Steve Ballmer said that 2,500 to 3,000 of Microsoft's largest 4,000 accounts, or 62 percent to 75 percent, have EA agreements.

The direct push has only just begun. In 2001, Microsoft dropped the entry requirement from 500 desktops to 250, which has fueled growth and widened the customer base. Many of the company's new hires are field reps for EA, said Rebecca LaBrunerie, product manager for the worldwide licensing and pricing group at Microsoft.

"They have been pushing it very, very hard," said Paul DeGroot, an analyst at Directions on Microsoft. "It is the most lucrative form of agreement for Microsoft and involves the tightest relationship."

Microsoft is taking a similar approach to smaller customers as well. A program that shares many of the attributes of EA--standardization, for instance, and a pricing plan that mimics direct pricing--has been put together for companies with as few as five PCs. Called Open Value, the plan was launched in March.

A direct bargain

Microsoft's Enterprise Agreement licensing program can lower costs for large business customers. Here's an example:

A company with between 250 and 2,399 Windows XP Pro PCs needs Office XP Professional and four client-access licenses (CALs) to use Exchange and three other Microsoft servers. It will also eventually require upgrades to Windows, Office and the CALs.

• Under Enterprise Agreement (software direct from Microsoft): $289 per year per seat. Price includes Office, four CALs and upgrades to everything.

• Under Select License (reseller lines up customer): Around $345 per year per seat. $110 for Office XP and four CALs, plus $235 for all upgrades to everything.

Source: Gartner, Directions on Microsoft

The increase in Microsoft's direct involvement with customers makes sense, given a memo sent by Ballmer to Microsoft employees earlier this month. In the memo, Ballmer spelled out the challenges the company faces from Linux, and he emphasized the need for Microsoft personnel to "spend (more) time talking to customers." The CEO has said the company needs to get a firmer grasp on what its customers want, or it risks losing them to competitors.

The new licensing plan could be one way to increase sensitivity to customers. EA customers "are the least likely to try Linux," DeGroot said.

The EA deals, which last three years, get customers and service providers to swirl in a tighter Microsoft orbit. EA licensees also agree to buy more software from Microsoft, such as Windows upgrades and Office XP for all desktops and notebooks, even those from Apple Computer.

"With Enterprise Agreements, if you standardize across your company on these products, we will give you the deepest discounts," LaBrunerie said. "The key advantage is that customers will standardize on a set of products."

For customers, Microsoft's hands-on approach could save serious money. Under EA deals, customers receive software discounts that can be up to 30 percent deeper than the discounts offered under other volume licensing programs, LaBrunerie said.

Customers said the EA deals also lower costs for managing software and make for better Microsoft support. "The perception of all our executives was that they did not get the benefit they paid for" under previous Microsoft licensing agreements, said Douglas King, CIO of Magnatrax, a manufacturing conglomerate that consists of 11 separate companies. "Up until last year, it was more of a situation where you felt handcuffed."

The potential losers in Microsoft's new plan are some of the company's network of software resellers who served as the middlemen between Redmond and business customers. But the new EA deals don't entirely cut those resellers out of the loop; many serve as liaisons to administer deals brokered by Microsoft.

Partners, while not selling directly to companies, can serve an important role by eliminating some of the gear-grinding that goes along with managing software assets or getting advice from Redmond. Microsoft is also trying to ensure partners can benefit through commissions or better technical support.

"We can call Microsoft on behalf of our customers now. It's a big deal," said Jeff George, vice president of alliances at Epicor Software, which develops Windows applications for small and medium size companies. "Customers have this view of Microsoft. They know the amount of support they get is very limited. Heaven forbid you are going to make calls."

Sorting out the options
On a conceptual level, EA deals differ in two ways from Microsoft's other major licensing programs, Select Licensing (for medium and large customers) and Open (for smaller companies). With EA, Microsoft sells the software directly to the customer, negotiating the price and other terms on its own, and the customer agrees to put Windows and Office on everything.

The impact of these changes ultimately lowers the price for customers, and it raises the profits for Microsoft in a variety of ways.

For customers with 250 to 2,399 desktops, An EA license will cost $289 per year per employee, Park said. The fee includes any Windows

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XP Professional upgrades that come out during the term, a copy of Office XP Professional, all upgrades to Office XP Professional, four client-access licenses (CALs) for accessing Exchange and three other commonly purchased Microsoft servers, and upgrades for all four CALs. Like all Microsoft licensing agreements, customers can get Windows upgrades but not Windows through the contract. Microsoft demands that customers get Windows through hardware manufacturers. EA contracts last three years.

Under Select, which is geared for the same type of customers, the annual upgrade costs per seat would come to $235, but the customer would also have to obtain a base copy of Office XP Professional and base copies of the CALs. Office XP Professional can cost $300 or more for a three-year license, according to estimates, which would add $100 extra per seat per year. Shelling out for the base copies of the CALs tacks on approximately another $10 per year.

Under both programs, buying more leads to further discounts. Level B pricing on EA, which involves organizations with up to 5,999 seats, costs $269. Level C pricing, for companies with between 6,000 and 14,999 seats, is $246, according to Gartner.

Upgrade costs under Select and Open rose with Software Assurance, a controversial policy launched in 2001 that eliminated the old policy that let customers skip various upgrades. Ballmer and other Microsoft executives have admitted that the Software Assurance introduction wasn't handled well. The company has since spent $20 million in trying to better explain the program.

"If you think you need upgrade protection, it is cheaper to go with an Enterprise Agreement," Gartner's Park said. "There is a big uptake in enterprise agreements for a couple of reasons, and one is the fact that they got rid of version upgrades."

Software management is also simplified. In Select, software buyers commit to purchase a specified volume of software over a three-year period. Different pieces of software are awarded point values--buying a copy of Office XP counts for two points, while a three-year Office XP upgrade counts for three points.

Tracking points and documenting purchases often devolves into a time-consuming and expensive process.

EAs are far easier to manage. Licensees count how many computers they have worldwide and buy a license for each. Unauthorized use is also eliminated because customers obtain the right to use any version of Windows, Office or a CAL that comes out during the three-year period.

In turn, blanket standardization makes it easier to manage information technology assets, said King at Magnatrax. The key selling point for the company's board was the fact that, by making desktops uniform, it would ensure that all employees could access enterprisewide applications deployed later on.

The company, which signed for a combination of EA and Select licenses (such combination deals are common), has also seen more active involvement from Microsoft. When resellers appointed by Microsoft to service the account weren't working out, Microsoft removed them.

Until the EA collateral benefits kicked in, the licensing deals--the only way to continue to get upgrades--had a questionable benefit, King said.

Naturally, blanket standardization lets Microsoft sell a lot of software, which can lead to higher profits. Although subsidiaries and separate legal entities aren't subject to an EA deal, every desktop within an organization is.

"Probably the majority of EA customers buy more software than they need. They are also always upgrading," said DeGroot, who added that the deals can reduce interest in experimentation with alternatives. Since all desktops have Windows, fewer customers will be inclined to try Linux. Having CALs makes adopting Microsoft's server software a more attractive proposition, DeGroot said.

Raking in the cash
Because Microsoft negotiates software prices on its own and sells directly, the EA deals give the company an opportunity to achieve higher margins on software sales. In Select and Open, Microsoft sells software to distributors and resellers, who then retain any markup.

"We suspect that the new direct-selling model allows Microsoft to retain the same or greater margin, while helping to keep its channel partner healthy or viable," Park said.

In an interview in February, Ballmer disputed that Microsoft makes more on EA deals, while affirming the program was good for resellers. "For us economically it is the same. For our partners, I think there is a chance, I actually think their profit margin per account is probably also about the same either way," he said.

Resellers nonetheless generally had little good to say about EA because it deprives them of a potential sales opportunity. The conflict is ameliorated in part because Microsoft appoints a reseller, called an Enterprise Software Advisor, to administer the account. In return, the advisor obtains 7 percent to 10 percent of the contract's value.

Microsoft's rules and requirements for participating in these programs, though, can be arcane and expensive, sources said. The commissions can often be low in dollar terms. Nonetheless, the obligations for servicing an EA contract can be comparatively simple. "It's a lower margin, but it comes with no risk," said Tom Barnes of Syscom Technologies.

Profits from software sales have been elusive for partners. Before EA came in five years ago, Microsoft recommended that resellers sell their software at 17.7 percent above the wholesale price, Park said. Many ended up selling at cost or below cost to get the deals and qualify for a 2 percent to 4 percent sales rebate. In one extreme case, a reseller offered the software at 5 percent below cost, got the contract, and then recovered a 4 percent rebate.

Ultimately, as more business goes direct, Microsoft will come to resemble its rivals, such as Oracle or Sun Microsystems.

"They are saying, 'We need to be more than a software company and (we) need to be a services and solutions company,'" King said.