The Dynamics of SaaS Pricing
Imagine your team is launching a new product; you have figured out the minimum feature set for your product and are working with the following teams to validate the minimum viable product (MVP) in the market.
Development, Quality Assurance and DevOps - You work with this team to have the basic features developed, tested and shipped to market.
Go-to-Market (GTM) Team - You work with this team to have the collaterals ready along with the right trial customers with regional mix to have inclusive feedback from customers. The feedback from initial trial customers will validate the idea and highlight its strengths and weaknesses. Early honest dialogue with initial users will be helpful for the future roadmap of the product.
Contract Management Team - You work with this team to have the trial agreements and contracts in place.
But, do you have a pricing strategy?
If the answer to the above question is “No, not yet”, “We will figure it out” or “We have not thought about it” then you are missing out on the most important lever responsible for the success of your product.
Product managers spend considerable time in planning, development, shipping features, quality assurance, GTM and customer acquisition. An equal amount of time should be invested in setting the right price from the initial stage. The price defines the tangible value of the offering. It is the numeric representation of the value customers see in the product or service. Pricing is in fact the primary driver for growth. Growth means an increase in revenue and pricing is its most important multiplier as it also affects the other variable “number of customers”.
As you navigate pricing, think about fundamental questions around positioning and packaging:
- What is the problem your product is solving?
- Who is your buying persona or target audience?
- What is your market segment?
- What is your initial geographical focus?
- What is the unique value you are providing and how do you differ from competitors?
Answers to these questions can help lead you towards the right pricing approach. It is important to have inputs from a group of key stakeholders such as product management, regional sales, analysts, finance and GTM. The group can take early feedback from the market, available competitor pricing, sales and trial customers and their willingness to pay during the discovery process. A thoughtful approach based on the intersection of inputs from the pricing group can help achieve better product-market fit thereby increasing the adoption curve.
Here is an approach that can be explored:
Step 1: Cost plus margins - It is the most widely used approach to arrive at the initial price point. Calculate all possible costs involved including inputs from development, marketing, support and operations. It is important to factor in the future costs that may arise during the scaling of the product. Append the total cost calculated with expected margins in the category to have the starting number say $X per month.
Step 2: Competitor Comparison - Compare the derived value from step 1 with existing competitors in the market. If X > competitor's price, then discuss all possible reasons for overpricing with the group. Similarly, if X < competitor's price then it may be a good idea to increase X and evaluate the reasons for under-pricing.
Another important approach is value based pricing i.e. pricing based on the perceived worth of the product by the target customers. Unlike the previous approaches, this one is more customer centric. Customers expect value from your SaaS offering and renewal decisions are based on the outcomes delivered. Here are some of the steps that can be followed to derive the price point using value-based pricing:
- Meet customers during the MVP stage and understand their willingness to pay.
- Identify segments of customers - such as small, mid-market and enterprise.
- Quantify the benefits you are providing to the customer i.e. cost savings, increased productivity or improving outcomes.
- Derive the price combining the inputs from previous steps.
Value based pricing can be very effective for scaling and increasing margins. As the product scales and provides more value, pricing can be possibly revised to match the new realized benefits provided by the SaaS offering.
This pricing approach needs to be seen in context with the pricing model that the group is planning to finalize. Here are some of the pricing models that are frequently used in the SaaS space:
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Freemium - The freemium model gives a basic service to customers for free. The product comprises of limited functionalities and is available for free. This model helps in quick customer acquisition and establishes early customer relationships. Additional functionality can then be charged as advanced features. The primary advantage of this model is that it can quickly increase initial customer adoption. However, most users may then prefer to remain as free users thus impacting revenues.
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Per User/Seat Pricing - This is a widely used SaaS pricing model wherein the customer pays based on number of individuals using the software for example $X per user per month. One version of this model is per active user pricing i.e. usage is billed based on the number of active users. This model can deliver predictable revenue streams but customers may not go beyond the 10 to 100 users bracket due to higher costs for the same service.
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Usage Based Pricing - This model is based on the amount of consumption of your offering and customers are charged for the number of transactions/API calls or data used. Usage based models can have the following units:
- Transaction or API Calls - With APIs becoming the core offering, pricing based on number of API calls is becoming prevalent in the SaaS space. It also appeals to developers who are mostly the end users and in turn helps in adoption of the product by the developer ecosystem. For example, a block of 100,000 API calls will cost $X per month.
- Per Storage Pricing - This pricing model is based on the amount of storage customers need to use. This is mainly applicable to companies offering storage-based services. For example, $0.04 per GB per month.The advantage of this model is that it accounts for large usage of the service. However, it can be initially tough to predict the revenue on an annual basis since the usage can vary from month to month.
| Customer Segmentation | Features/Functionalities | Tier Pricing |
|---|---|---|
| SME | A | $X |
| Mid-market | A, B | $Y |
| Enterprise | A, B, C | $Z |
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Tier Based Pricing - Tiered pricing models define a price per unit within a range according to the need. This approach allows you to offer different feature sets to different target personas at incremental price points. The advantage of this pricing model is that it appeals to different segmentations. However, if there are too many tiers it can become confusing for the customer.
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Flat Rate Pricing - Flat fee is the simplest pricing structure since it charges a fixed fee for the offering regardless of the usage. The biggest advantage of this approach is that it simplifies communication with customers. However, it doesn’t do justice to future features which will be added later nor the different kinds of customer segmentations. For example, a large enterprise client will pay the same flat price for your product as an upcoming small startup.
The pricing group can use a combination of the above models depending on the hypotheses that have been previously developed around positioning and packaging.
After the pricing group has finalized the approach and pricing model, it is a good practice to maintain a Profit/Loss of the product and forecast for at least the next two years. It can then be tweaked according to customer segmentation addressed by the product and pricing model that has been finalized .
During the actual scaling journey, effectiveness of the derived price point and finalized model in achieving growth can be measured by tracking key metrics such as Annual Recurring Revenue (ARR), Customer Lifetime Value (LTV, earning from each customer over time), Customer Acquisition Costs (CAC) and Churn Rate. These metrics are calculated in the following manner:
ARR is the value of contracted recurring revenue components normalized to one year.
$$CAC = \frac{\sum{Cost\ of\ Sales\ and\ Marketing}}{Number\ of\ Customers\ Acquired}$$
$$Average\ Revenue\ Per\ User\ (ARPU)= \frac{Revenue\ in\ Time\ Period}{Number\ of\ Users\ in \ Time\ Period}$$
$$Churn\ Rate = \frac{Customers\ who\ left\ during\ the\ period}{ (Customers\ at\ beginning\ of\ period + New\ customers\ acquired\ during\ the\ period)}$$
$$LTV = \frac{ARPU}{Churn\ Rate}$$
Net Revenue Retention (NRR) is the percent of revenue from current customers retained from previous years after accounting for churn.
$$NRR =\frac{(Starting\ ARR + Expansion - Downsell - Churn)}{Starting\ ARR}$$
Pricing is responsible for ARR and revenue is the best way to demonstrate product-market fit and signal growth. Growth is important but during scaling you should avoid overspending on sales and marketing as it can disturb the unit economics. You should observe all the above-mentioned metrics holistically for product success and growth.
ARR growth of over 100% may not be a good sign if NRR is in two digits.
Topline growth will eventually be affected if the retention rate is poor and, in this case, you should not spend much on customer acquisition but rather work with customer success and support to explore ways in retaining customers. If the retention rate is healthy and in triple digits then it makes sense to spend more on acquisition and grow the market share.
$$\frac{LTV}{Customer\ Acquisition\ Growth}>1$$
Sustainable growth is important and the ratio between customer lifetime value and customer acquisition growth can be another metric to monitor on a continuous basis. For a profitable business, it should be greater than 1. This ratio is the return you get for every dollar you spend on your product. It can vary for different customers segments such as large organization vis-a-vis early stage startups.
For SaaS we also need to understand that customer acquisition costs are absorbed upfront and realization of lifetime value takes time. Right pricing can help in further cross-selling and up selling thereby increasing the LTV. It can be increased in the following ways:
- Increasing numerator by raising ARPU - Give your customers more value by add-ons and services that augment the core offering.
- Decreasing denominator by reducing Churn Rate - Give your customers a true experience with the help of your customer success team.
Continuous review of pricing with the pricing group can help achieve better unit economics and growth. Although revisions in pricing may not be feasible in large organizations but a quarterly review can help in understanding whether the current pricing is meeting market expectations.
You can find below an experimental template including the approaches we have previously discussed to derive the price for your product. This template can be downloaded and modified according to inputs from pricing group members and market study.
This article was co-authored by Meenal Prasad, Head of Products at SAP Digital Interconnect, and Bhomik Pande, Product Manager at SAP Digital Interconnect, with editorial support from egomonk.