Tuesday, September 04, 2012

The Case for Grandfathering

If you're running a SaaS startup it's likely that sooner or later you'll want to increase your prices. The reason is simple: It's impossible to find the perfect pricing right off the bat, so most startups launch with a pricing scheme that's on the low end to make sure that they don't scare away potential customers. "In the beginning, err on the side of being too cheap", was also one of the tips that I gave in my previous blog post about SaaS pricing.

Now let's say 12 or 18 months have gone by, you've acquired your first couple of hundreds of customers, you've added lots of features and made your product better and better. By now you also have a better feel for what your customers are willing to pay, maybe supported by A/B tests with different prices or customer interviews, and you want to increase your prices. 

There are a number of questions that you'll have to answer: Do you want to keep the pricing model and just increase the amounts or do you want to change the structure of the pricing – axes, plans, limitations – as well? How much do you want to increase prices by? Are you introducing new features or editions that justify a pricing increase or are you going to increase prices for the existing offering?

In this post I want to focus on just one question: Should the new, higher prices be applied to your existing customers as well or should their plans get grandfathered?

At first you might be tempted to increase prices for your existing customers. They like your product and are used to it (and will incur "switching costs" if they switch to a different product), so most of them probably won't leave even if they are not thrilled about the price increase. The additional revenue from the higher prices will probably more than offset the revenue that gets lost due to some customers who leave. So increasing prices for your existing customers promises to give you an immediate, maybe very significant revenue bump.

In spite of this I want to argue that if you take a long-term view grandfathering your existing customers is almost certainly the better choice. (At least if you're a fast-growing early-stage startup. If you're a big company in a saturated market things may be different, but then you're most likely not reading this post anyway!)

The main reason for grandfathering existing pricing plans is that it just doesn't feel right to attract customers, get them used to and maybe even locked into your product and then demand more. Unless the pricing increase is very modest or your customers all agree that the old price was way too low relative to the value of your product, this will almost certainly upset a significant percentage of your customers.

However, the reason I want to focus on is mainly a mathematical one and is related to the effect of fast growth. It also doesn't require you to think much about business ethics as I will argue that grandfathering is also better for you, not just for your customers. :-)

Take a look at this Google Spreadsheet

Let's say your customer churn rate is 2.5% per month, your customer growth rate is 5% per month and you're planning a price increase of 50%. Based on these assumptions, by year 3 after the pricing increase the additional revenue that you get from not grandfathering your pre-price-change customers (named "Group A" in the spreadsheet) will – maybe surprisingly – account for a mere 7% of your total revenues. Here's how it looks like on a chart:

This does not yet include the effect of cancelations due to the price increase! If you assume that you will lose 5% of your existing customers due to the price increase (see the second scenario in the spreadsheet), the net revenue gain of not grandfathering has shrunk down to less than 2.5% by year 3, and by year 4 the gain will have turned into a net revenue loss:

If you're assuming a higher cancelation rate that will obviously happen even earlier.

You can download the Google Spreadsheet to play around with the assumptions (or let me know if you want the Excel file via email, in that case you'll also get the charts which didn't survive the Excel => Google conversion). It depends on your assumptions if and when the positive effect of not grandfathering will reverse itself, but unless you're not predicting much growth it won't take very long until the additional revenue will have become a pretty insignificant factor.

Importantly, I have not even taken into account the potential negative effect which not-grandfathering might have on your future growth rate by reducing referrals from your existing customers and generally by losing goodwill in your target audience (whereas generous grandfathering could motivate your loyal customers to give you even more referrals than before). These effects are hard to measure but I'm sure they exist and if you keep them in mind the decision will be even clearer.

Finally, if you agree with the above, consider creating a "Customer Bill of Rights" which, upon signup, explains to customers how you're going to deal with pricing increases in the future. I think I've never seen this on a signup page but I'd be curious to find out whether this would have a positive effect on conversion rates.

PS: While writing this blog post I learned two surprising things (surprising for me, at least). More on that soon. :)


Daniel Clough said...

Interesting read. Increasing the price of SAS models intrigues me and I've taken a large SAS product through a few significant price increases and fully grandfathered in both cases. We crunched many different scenarios before doing it but in general just felt the risk related to forcing a price increase on existing customers was just too big (we were dealing with a relatively mature product though).

Two other positive things to remember that come as a result of grandfathering with a freemium / subscription model (depending on how you do it).

Announce the price increase early and you will find many free users of the product lock themselves in at that lower price point. Its a good incentive to subscribe as they think they are getting a deal.

If you put in a grace period (i.e if you drop back to free for longer than 7 days you then have to go onto the new, higher price point) it has a positive impact on long term retention as customers will tend to leave their subscription running to avoid having to pay the higher price point at a later date (even if mathematically it doesn't make sense).

The other thing I would say is showing a clear step change in the product is important, particularly if it is a mature product. If you are raising the price, you need to show you're either upping the offering or investing more heavily in things to come.

daverocks said...

great article - literally working on a startup and considering this very topic. Thanks