When determining prices for their products, founders should consider how to configure the five major components of their business model. These are:
Understanding your competitors’ prices and your internal cost structure
Defining the key value metrics of your business
Segmenting your customer base into high-value, mid-value and low-value customers
Establishing minimum margins you will honor
Tracking net revenue retention as opposed to trial-to-paid conversion ratio.
Building a Strong Foundation
By doing so, you can create a solid base that will allow you to take full advantage of future opportunities and avoid having your margins collapse.
In order to create an organic, defensible pricing model, founders must first establish an understanding of the total cost of their product, determine the primary key value metric they want to measure and how they segment their customer base. Lastly, they must develop a way to track their customers’ ongoing revenue while ensuring that they retain the required minimum margins.
Keep in mind, the structure for establishing your business model is the same regardless of the size of the business. The decisions about pricing and value metrics are just as critical for a start-up with a revenue goal of $1 million as they are for a multi-million dollar corporation.
Establishing price is not an easy task and requires an in-depth analysis and creation of five components of your pricing strategy:
Defining your value metrics
Determining your minimum margins
Segmenting your customers
Tracking net revenue retention
Developing a pricing model
These five components must all be established to achieve a successfully priced SaaS business.
In addition to establishing the five components of a pricing model, founders must establish a market price point for each of their products and the pricing strategies they wish to implement with their customers. A market price point is defined as the level of revenue per customer and revenue per product, at which a business can maintain its minimum margin.
Establishing a market price point for your product will drive how your pricing model is determined. Certain market price points will have a direct impact on the risk of selling your product at different prices and will ensure that your business can achieve its minimum margin, while fulfilling its customer’s expectation of paying for value delivered.
To ensure that your business achieves its minimum margin, all five components must be established prior to going to market. After going to market, if you have not established all five components, you are going to have a difficult time establishing a successful pricing strategy.
Once you have established your market price point, your price points must be set according to your established margins. Doing this can be a challenge. To effectively price your products, your margins must be established accordingly, as your margins will determine your price point.
Since the pricing of a product can easily change due to competition, it is important for software founders to understand how to price a SaaS product using an established market price point that they can rely on.
The Five Inputs Behind a Defensible Price
Many software founders focus solely on their competition’s pricing and internal costs. This is only half of the equation for an effective SaaS pricing strategy. In order to price your product in an effective manner and achieve a defensible pricing strategy, you must first understand the total cost of your product. You must also establish your key metrics for value and customer segmentation, develop a pricing strategy that maximizes your profits, and track your net revenue retention.
By gathering the necessary information for your pricing model, you will have a better understanding of how to price a SaaS product. This information will enable you to develop a defensible pricing model and a pricing strategy that may create significant future opportunities for your business.
Value to Customers Will Drive Your Price
The price you set for your software must convey the economic benefit it provides to the end-user. If a single company saves $10,000 per month through reduced manual labor, the price of $50 per month would demonstrate a failure to capture value. The buyer is not interested in how many hours the engineers spent developing the product; they care about the time and money saved as a result of using the tool. You must provide the customer with a quantifiable economic benefit.
The Market Sets the Limit
Just because you believe your product has a certain customer value doesn’t necessarily mean your customer will pay for that value. Your customer’s willingness to pay is your ultimate pricing ceiling. To determine your customer's willingness to pay, you must utilize direct market research, sales negotiations, and checkout behavior. Although potential customers may express their perceived value of a product, their actual procurement behavior will exhibit a spending limit that is less than their expressed value.
Using Competitors as a Reference
In order to understand how customers will compare your product to other competitive products in the marketplace, you need to understand that your competitors are the reference point in the marketplace. Your sales force will need to justify the difference in price to customers. For example, if your product is priced at three times the market average, your sales team will need to demonstrate three times the value to your customer. Competitors’ pricing should be considered a reference point when establishing your price, but should never be used as a target.
Costs and Margins
The cost of delivering a product is your price floor. In the case of traditional software companies, server and storage costs are relatively low; however, in the case of companies that build large infrastructures, such as AI tool companies, variable delivery costs greatly influence the price of the product. The calculation of a minimum viable price requires the establishment of a price point that will ensure that your target gross margin is protected. If your customer has higher support and hosting costs than their subscription fees, they will be classified as a liability.
Market Positioning
The price set for a product signals where a business falls within the marketplace. A low entry-level price for a product that is self-serve, high-volume indicates that it is a commodity. A high starting price indicates that the product is an enterprise-grade solution that requires sales support, significant compliance, and managed onboarding. You cannot charge enterprise-class prices for a product that has been positioned and supported as a self-service tool.
Selecting the Right Value Metric
The value metric is how you charge your customers. You can charge by user, transaction, or gigabyte. The choice of value metric has a direct effect on how your revenue scales with your customer's growth.
Per-User Pricing
Per-user charging is the most common pricing model for collaborative/in-home workflow tools. It is easily understood by buyers and also provides sales teams with easy-to-forecast sales prospects. The per-user pricing model penalizes product adoption. When a product is sold at a per-user price, businesses will actively limit the number of employees who can access the product, sharing logins and restricting accounts. Use this pricing model only for products that have a basic requirement for true individual user accounts.
Usage-Based Pricing
Usage-based pricing correlates directly to customer consumption of a product. Usage-based pricing is typically the model used by API platforms, communications infrastructure, and cloud storage providers.
The major benefit of a usage-based pricing strategy is that your revenue will grow automatically as the customer becomes more reliant on your product.
Invoice Predictability
The main problem is the unpredictability of invoices. Buyers dislike unexpected bills. When implementing a consumption-based pricing model, customers should know about projected spend through clear notifications and dashboards, as well as being able to set pre-established limits for their spending.
Tiered Feature Access
Tiered access is a tiered feature model used by companies that target different customer segments based on their preferences. Individual plans can be built using distinct features grouped based on targeted customer needs.
This model allows you to attract smaller organizations at a lower cost while charging larger organizations additional fees for premium feature sets. The potential downside of this model is the inability to unlock the right features for customers in the appropriate tier. Tiers should be based on customer work and maturity, rather than arbitrarily eliminating access to particular features.
Flat Rate Models
With this pricing model, a flat rate per product for every use or end user is applied. The end user will always know their monthly billing amount, which provides transparency. There is no opportunity for upselling. A company that has 10 employees would pay the same price as one that has 1,000 employees. For a product with a very narrow purpose, that will be suitable for businesses with a very similar need.
Hybrid and Outcome-Based Pricing
A hybrid pricing model combines the benefits of both predictable monthly billing with some variable component. According to research conducted by Maxio, a hybrid model recently produced the highest median growth rate (21% growth) out of all pricing options studied.
Chargebee states that at least half of the recently surveyed recurring revenue companies also utilize some form of hybrid pricing model. If you want to create predictable revenue from subscription billing while also having the opportunity to generate future revenue from new customers, there are multiple benefits of using hybrid or performance-based models. Performance-based pricing models take the concept one step further in charging customers only based on measurable results, such as how many successful customer payments were processed or how many leads were generated.
Determining the Initial Starting Price
When figuring out how to price a SaaS product, your starting price should not be simply a guess. You should develop a reasonable range of prices based upon the economic value created by the software and your costs to produce and support it.
The Economic Value Equation
You must identify exactly what your software does for your buyer and put a number to it. The simplest way to calculate the economic value is to add up the financial benefit, the cost that has been avoided and the amount of time saved.
If your workflow tool saves the team of 20 people at a rate of 100 hours per month, and the average labor cost for that team is $40 per hour, then you will have a theoretical monthly economic value of $4,000 for the software. You will not automatically charge $4,000 for the software, or a set percentage thereof. This number will be the maximum possible value for the software. You will then find the starting price for your software based on where your desired capture of value for the software intersects with your customer's true willingness to pay for it.
Identifying the Gross Margin Floor
Customer value will establish the maximum price you can charge for your software, while your costs to produce and deliver the software will establish the minimum price you can charge. In establishing a minimum viable price for your software, calculate your variable cost to deliver the software to each customer divided by the reciprocal of your target gross margin.
While cost-plus pricing should not determine your final price in the marketplace, it will be the bottom line that protects you from disastrous pricing decisions. If your hosting, support and third-party API costs are $30 per account, and you are seeking an 80% gross margin, then your minimum viable price would be $150. Any price less than that would make it impossible for you to sustain viable unit economics. This calculation is especially important for AI tools as the compute costs can fluctuate significantly based upon the purchasing behaviours of users of those tools.
Conducting Willingness to Pay Research
Do not assume that you know what your buyers will pay. You need to go out into the market and extract this information through structured research methods. Surveys often show a difference between stated preferences and revealed preferences during the final check-out, so it is necessary to validate on multiple levels.
Qualitative Buyer Interviews
Begin with the buyers of your products. Do not ask them what price they will pay for your tool; rather, ask them about their current reality. Determine what they do now and how much time and money they spend doing this. Ask them what will happen to them if they do not address this issue. Identify precisely who has the authority to authorise this purchase and what specific budget will result from the purchase of this new tool. This will provide the context to understand the pricing limits that you have.
The Van Westendorp Method
This specific survey methodology assists you in determining an acceptable price range by asking four specific questions. The first question requires that you ask the respondent at what price do they believe the product becomes too cheap to be trustworthy. The second question is, at what price it feels to the buyer as a bargain? The third question is at what price it feels to the buyer that the product is expensive yet not out of consideration? The fourth question is, at what price it becomes too expensive to purchase?
After mapping out the intersection points of the answers to these four questions, you have a definitive range of acceptable prices for your products. According to PayPro Global, they advise obtaining around 100 to 200 survey responses for each segment of your customer base when attempting to apply this method of research. Although surveying is a good way to obtain data, it does require validation through actual purchasing behaviour when the research has been completed.
Using Conjoint Analysis
Conjoint analysis is a powerful tool when it comes to determining the optimal bundles of features for future pricing tiers. Rather than asking respondents about the price they would be willing to pay directly, this approach requires them to make trade-offs between packages that include different combinations of features, usage levels, support types and prices.
Through the analysis of which packages are chosen by respondents, it is possible to mathematically assign values to the individual features. This analysis allows for the elimination of the possibility of placing higher-value features into lower-priced packages or the opposite by placing no-value features in the highest-priced package.
Engineering Your Pricing Tiers
When pricing your product, you should consider the mechanical aspects of engineering your pricing tiers. It is not a good idea to have more than three or four tiers because too many options will create paralysis in the potential buyer.
Each pricing tier should cater to a distinct customer segment with different business needs.
The Starter tier should address the needs of individual users or small teams who are trying to solve their core business problem with minimal implementation effort; i.e., to provide a mechanism for reducing user/adopter resistance and getting users up and running quickly.
The Growth or Professional tier serves the requirement of teams that have grown and now require collaboration features, as well as expanded usage requirements, and basic administrative controls. This tier is typically where the majority of your revenue will be earned.
The Enterprise tier is for large and complex businesses. The buyers of Enterprise tiers expect more than just a software package; they also expect to be compliant with security and regulatory requirements, will want to have the ability to log in with one username and password, an advanced level of governance and reporting capabilities, and a dedicated support or account management team with whom to negotiate pricing and features.
Features to Build Tiers Around
Do not build tiers by unilaterally taking core features away from lower-priced tiers. If a customer cannot use a specific feature to benefit from the core value of your software product, it must remain included in your lowest-priced, base tier. Instead, differentiate your tiers based on factors that vary based on company size. For example, a Tier-1 customer will benefit from increased capacity (more products, more concurrent user slots), more automation (more workflows, for example), better security practices (depending on the industry they are in), custom API integrations, and enhanced or premium support. A small company will not find advanced compliance (SOC2, PCI, etc.) useful, while larger corporations may be willing to pay for it.
Market Testing and Validation
Once you have established your pricing model and tier structure, you need to conduct market tests to validate that you are correctly understanding your customers, that you have priced your software correctly, and that you are providing the right type of software to your customers. According to Chargebee, 83% of successful software companies conduct extensive testing of their pricing before implementing any permanent pricing changes.
Testing Variables and Cohorts
In order to have an effective and accurate test of a new pricing model, a new tier structure, and a new landing page design, you cannot test everything at once; otherwise, you will not know what caused a conversion drop. You need to isolate each variable individually in your tests.
When testing a new price point, you will want to conduct your test only on a specified cohort of new signups. You do not want to use experimental pricing for your entire site traffic. According to Chargebee, the statistical power threshold for subscription tests should be set at 80% and tested over at least two full billing cycles. Before you could make an assessment on how your pricing strategy will influence the way your users expand and downgrade or upgrade their plans, you need to keep track of your users for at least a couple months after you change prices.
Protect Your Revenue Stream
If you want to experiment with pricing strategies, it's recommended that you conduct your experiment on new customers first. With regards to your current customers, first and foremost, do not attempt to run any experiments on your current paying customers; doing so comes with serious risks.
Once you've successfully tested a pricing strategy and plan to roll it out globally, it is vital to protect the revenue stream from your current subscribers. One way to do so is through grandfathering, or holding the price level of your most senior customers, those that have been with you the longest and are therefore your most loyal customers. The new pricing will only be applied to the remaining subscriber base upon their contract's renewal date, and a minimum of 60 days' notice has to be communicated in advance to the subscriber. A sudden price increase for an existing user will cause substantial churn and permanent damage to your brand's reputation.
Tracking Long-Term Economics
Your pricing strategy will only be considered a success if the economic factors relating to your business enhance its long-term profitability. It is essential that you keep a close watch on your metrics so that you will make the best decisions based on the correct information.
Look Beyond Trial Conversion Rates
Your trial conversion rate (landing page conversion rates and trial starts) may be much higher when you reduce your price, but as a result, your average revenue per user (ARPU) will decline dramatically, and your overall gross margin will experience severe compression.
While price plans that are low may generate 'mass-bulk user acquisition' - meaning count the users, however, they come with a tremendous amount of unnecessary burden on the customer support teams, and the users may eventually cancel after 1-2 months. Conversion as a metric is simply 'a vanity metric' because it is disconnected from revenue-generating opportunities.
Guardrail Metrics
The primary metrics for every pricing decision made should have grouping based on the specific decision made.
When increasing your pricing, the primary metric for success will be the monthly recurring revenue (MRR) associated with every new account. The guardrail metrics will include the overall churn rates of new customers.
When you implement a new usage-based billing strategy, the metrics for measuring success will be expansion revenue and net revenue retention (NRR); guardrail metrics will include invoice dispute rates and involuntary churn.
The success of any pricing decisions will be based on the user's gross margin adjusted lifetime value (LTV) against the customer acquisition cost (CAC) payback period. The goal should be to build a profitable and increasing revenue base, not just a large quantity of low-cost users.
Matching Models to Software Types
Several different types of software will require their own specific pricing mechanisms. A universal model of pricing will never work in specialized markets.
Artificial Intelligence Costs
Product costs related to AI technology have massive unpredictable infrastructure costs. Every iteration and action within the generative and artificial intelligence compute space requires very, very expensive compute resources. The potential loss of profitability may occur very quickly if a business were to charge a flat monthly fee for an AI-based tool/software product.
Subscription and usage consumed models in AI technology must include both a predictable monthly subscription or licensing fee + a variable credit system. The business should include a clarification on what is considered a unit of work (or activity). Depending upon the level/volume of usage of the product, businesses must be able to track their margins at the workflow level vs. account level to alleviate customer invoice anxiety and provide a top-up credit for those customers close to their monthly limit.
API and Infrastructure Products
API and infrastructure-based product/services have no definitive limit of usage; there will always be a scale factor associated with the cost(s) to supply the products to build the infrastructure. Some API/infrastructure product/services businesses that have an unlimited scale factor use a strict consumption-based pricing model: Stripe, Snowflake, BigQuery, etc.
Businesses must provide real-time visibility of usage by customers; therefore, customers should have access to view every daily usage amount billed to their credit card. Businesses should also offer predictable volume package programs, i.e. customers could commit to a specific volume of usage with a price reduction off the per-unit rate.
Executing a Price Increase
Mature SaaS companies with a long history of legacy contracts have an immense operational challenge when attempting to raise pricing. Companies should never send one email out to increase everyone’s invoices by 20%.
Companies need to segment their customers based on a number of factors: the plan currently being utilized, how long the current user has been with the business, how often the current user utilizes a subscription, and how much value the customer derives from the product/service being offered. Gain some insight by testing the price increase with new customers, i.e. market entrants. An established customer should be offered a migration plan to gradually implement the price increase based on when they would/will be seeing/renewing their annual subscription. During the implementation of the migration plan, businesses should track any increase or decrease in customer support ticket volume, downgrade rates, and expansion activity.
Execute the Next Revenue Cycle
Businesses can now attempt to connect their SaaS pricing to what is occurring within the market for their specific product category, maintain strict margin floors, and determine customer value. Will businesses continue to operate/measure their prices based on the legacy pricing model that has left them with millions of dollars on the table over the last 20+ years, or will they implement a controlled revenue experiment in Q2?
