By Lincoln Murphy, Managing Director
Sixteen Ventures

 

“Quality in a product or service is not what the supplier puts in. It is what the customer gets out and is willing to pay for.” – Peter F. Drucker, Innovation and Entrepreneurship

SaaS and Web App companies often charge their customers based on usage in an ongoing or recurring fashion. This can be subscriptions, usage, credits, etc. and is generally their primary revenue stream. This is the typical “pay as you go” model everyone is familiar with.

It is recurring revenue that is primarily responsible for Software-as-a-Service or SaaS becoming so disruptive against legacy software companies and their outdated licensing and pricing models. The ability to pay for a product or service over time makes it more attractive to the customer and results in more predicable revenue for the company and their investors.

(Recurring Revenue is only one of seven different revenue streams available to SaaS & Web App vendors as identified by Sixteen Ventures – download the 7 SaaS Revenue Streams PDF for details on the other six).

To make recurring revenue work, what a SaaS or Web App company charges the end-customer must be aligned with the market position of the company as well as with the end-customer; how they buy and what they’ll pay. Unfortunately pricing is one of the least understood elements within a SaaS or Web App company. For startups with no time in the market, it is even more difficult to figure out since there is no historical transaction data to analyze.

One common non-market or non-value driven method for developing a price is the bottom-up method. Using this method a company will figure out their cost and try to apply a profit margin to come up with pricing. To illustrate why this isn’t ideal, consider the incredibly simplified idea of trying to get to a 35% net margin because you heard that is a good margin for a SaaS company.

If it costs you one dollar to acquire and support the customer and you add 35% to that, you’ll meet your margin goal. Now scale that up in your spreadsheet and you’re in business, right? No. You’re missing a big piece and here are a few scenarios to illustrate the point:

  1. You charge $1.35 for your service knowing you have a built-in 35% net margin and find that no one will buy your product. It turns out the market will only pay $0.85 for what you have to offer. And they don’t care that it costs you $1.00 to land a customer (Customer Acquisition Cost) and to support them. They will only pay $0.85. How do you deal with that knowing that your cost is $1.00?
  2. You charge $1.35 for your service knowing you have a built in 35% net margin and find that everyone buys your product. It turns out the market would have paid $5.00 for what you have to offer. Since you consulted your spreadsheet and not your market and potential customer base, you left a lot of money on the table and positioned your company as the low-price leader.  Many people think that you can just raise prices, but how does your self-created low-end market position affect your ability to do that?
  3. You charge $1.35 for your service knowing you have a built in 35% net margin and are in-line with how your competitors have priced their solution. But you find that no one will buy your product. In this case you consulted your spreadsheet and the competitors’ websites, but again, not your market and potential customer base. How will you deal with this misstep?

These scenarios can play out all day long. The lesson from all of those is to not only rely on spreadsheets, formulas, or competitive intelligence to come up with pricing. You need to know how your customers will buy, what they’ll pay, and how they’ll pay. If you don’t know those three things intimately, everything else, including your financial modeling is worthless.

Rule number one about pricing: it is marketing. Pricing is one of the 4 P’s that make up the traditional Marketing Mix, along with Product, Promotion, & Place (distribution). This means that your product or service pricing must be part of an overall pricing strategy, which must be part of an overall marketing plan. An effective pricing strategy must go beyond simple financial modeling and include distribution, sales methods, positioning, market segments, etc.

For a SaaS or Web App company that uses an automated sales process where marketing, e-commerce, and application functionality are tightly-coupled, getting your pricing right is even more important since there is not a sales person to negotiate, convince or otherwise defend your pricing. For those companies, the Pricing Page is something by which their company will live or die. To that end, we have recently introduced our Pricing Page Tune-Up™ service to help SaaS & Web App companies optimize the most important page on their marketing site.

The keys to increasing the effectiveness of a pricing strategy are to know and understand the following items before you develop it:

  • Your Pricing Strategy Goals – Market Position, Hyper Growth, something else?
  • Ensure Market Alignment – Know how they buy, what they’ll pay, and how they’ll pay
  • Market Segmentation – Do you have one-size-fits-all pricing, is that the right strategy?
  • Distribution – Will you sell direct or through channel partners or App stores?
  • Sales Model – Do you have a sales force or will you use an automated process?

After you’ve come up with those items and dive back into your spreadsheet to work on your financial model, keep the following in mind:

  1. Pricing is Marketing
  2. The market doesn’t care what profit margin you want to make only what they’ll pay
  3. Don’t copy 37Signals pricing page
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Lincoln Murphy (@lincolnmurphy on Twitter) is Managing Director of Sixteen Ventures, where he works with SaaS & Web App companies on Business Strategy, Revenue Modeling, Distribution and Pricing Strategy – including the new Pricing Page Tune-Up™ service.