The 5th DO for SaaS startups – Get your pricing right

Following some advice on choosing the right market (here and here), building a team with product/tech DNA and the importance of an awesome product and an awesome marketing website I would now like to turn to the topic of getting your pricing right:

5th DO for SaaS startups

Get your pricing right

If you're following this blog for a little while, a part of this post won't be new for you because I wrote about the topic before and will repost a large part of it here. But I'm going to add a few new thoughts as well, especially about Freemium.

As you're getting close to the launch of your product you'll have to make a number of decisions around pricing:

1. Will there be a free plan?
2. What pricing model am I going to use?
3. How much am I going to charge?

Pros and cons of Freemium

Starting with the first question, there is no general answer on whether you should or should not adopt the Freemium model. Having a free plan can be extremely powerful in getting large numbers of users quickly but there are costs to it. Here are some of the factors that you should consider:

• How much does it cost you to serve a customer? While the marginal costs for hardware and bandwidth to serve an additional customer are of course very low, keep in mind that when you offer a Freemium model you might very well end up with 95% free customers and 5% paying customers. So assuming your CoGS are the same for free and paying customers (which may not be true), the free plan might increase your costs for hardware and bandwidth by a factor of around 20. Also consider the burden on your support team when you think about the costs to serve free customers.
• Is there a natural upgrade path from free to paying? That is, do you think a free plan will allow you to attract users who will eventually upgrade to a paid plan e.g. because their business grows or because they need premium features? Or would a free plan primarily attract users who will never pay for your product and who you might not be interested in acquiring at all?
• How price sensitive is your target group?
• Do you have a good idea for defining the limitations of the free plan? Will you be able to offer compelling reasons for upgrading?
• Is there an opportunity to make money off the non-paying customer base using alternative revenue channels? Or are there network effects in your business that let you benefit from a large user base?
• Is there strong competition? Are you in a "land grab" situation?
• How well are you funded, can you afford to give low priority to short-term revenues?

A good example for a successful Freemium model is MailChimp, the popular email marketing solution. MailChimp offers a free plan that lets you send up to 12,000 emails per month to up to 2,000 subscribers. If you look at the questions above you'll notice that for an email marketing solution there's a strong case for Freemium. Most of the aspects are pretty obvious (costs to serve a free user can be calculated fairly precisely, smooth upgrade path, high price sensitivity due to strong competition). One maybe less obvious aspect is that its large base of free users allows MailChimp to process and analyze hundreds of thousands of email lists and billions of email addresses. This for sure gives MailChimp lots of valuable insights which small competitors don't have. For example, it allows MailChimp to build a database of invalid email addresses which they can use to reduce bounce rates for their customers and thus become a better emailer (from the perspective of spam detection), improving email deliverability rates.

By the way – if your product doesn't lend itself well to a Freemium offer, try to think of something else that you can give away for free to get users and make them aware of your paid product. This could be an add-on to your core product, a mobile app or a small separate product. Hubspot's website grader is a great example.


Using the right model, charging the right amount

Let's move on to the second and the third question from above – what pricing model am I going to use and what should I charge?

It’s obvious that getting pricing right is extremely important: If you’re too cheap you will leave money on the table and reduce your ability to invest in customer acquisition. You may also hinder adoption especially from bigger customers who think that your product can’t be good because it’s so cheap. If you’re too expensive you might be scaring away the majority of your potential customers.

Unless your target customers are all very similar (which is unlikely), the most important thing that your pricing model has to accomplish is to capture different amounts of money from different customers based on their willingness and ability to pay, which correlates with the value that they’re getting from your product. In the old enterprise software world this used to be the job of the sales people – talk to the customer, find out about his needs, get a sense for what he can pay, offer him a solution and negotiate a price. In the world of SaaS, customers (rightly) expect more transparency and will look for a price list on your website before they start a trial.

In many cases a per-user pricing (often also referred to as “per seat”) is an obvious choice, and some of the most successful SaaS companies including Salesforce.com are using that. Other successful examples include pricing based on:

• number of clients managed with the software (e.g. Freshbooks)
• number of newsletter emails sent (e.g. MailChimp)
• number of email recipients in the system (e.g. ConstantContact)
• amount of storage that is used (e.g. Dropbox)
• number of events tracked (e.g. KISSmetrics)

What these companies have in common is that they've found an "axis" that highly correlates with their customers' willingness to pay, which allows them to keep their service affordable (and in some cases free) for small customers while asking bigger customers for much more. It also allows them to benefit from the growth of their customers, since a growing company needs more seats/emails/MBs/events/etc over time. Ideally this can lead to what is known as "negative churn" – the wonderful situation when the MRR growth of some customers of a customer cohort more than offset the effect of terminations from that cohort.

Importantly, most successful SaaS companies differentiate their prices along more than one axis (David Skok wrote about this here). Secondary axes include the level of support, additional features or other usage parameters. For example, Freshbook's pricing is based on a combination of the number of clients that you can manage and the number of seats, plus two additional factors:

So what's the right pricing model for your SaaS startup? The right answer is of course "it depends", and all I can do is offer a few practical tips:

• Try to find one or more axes which correspond with the value that your customers are getting from your product and which correlate with your customers' willingness to pay. Talk to your customers and analyze how your early users are using the system to find out the ways in which larger customers are using your product differently from smaller customers.
• If you don't know how much to charge, take a look at the prices of other products in the market and try to get a sense for the value that customers get from your product. How much time and thus money can a customers save with your product? Does it allow your customer to increase revenues?
• In the beginning, err on the side of being too cheap rather than being too expensive. In the beginning the most important thing is to get customers. You can optimize your margins later.
• Later on, make sure you're not leaving too much money on the table. If not a single customer ever complains that you're too expensive that's a strong sign that you're too cheap. Also keep in mind that a higher ARPU means more money that you can reinvest in customer acquisition and that a higher ARPU can open up completely new ways of acquiring customers, so higher prices can also be a driver of customer growth.
• Accept the fact that it's very unlikely that you will get your pricing right at the first shot. Go out with something that you think makes sense, get feedback from the market and be prepared to make changes quickly.
• If you increase prices, try to do it along with new value-add features that help justify the price increase. And offer your existing customers extremely generous grandfathering terms.
• If your pricing is differentiated based on features, consider giving all users the high-end plan with all features during their trial so that they can play around with the full product.
• Maybe not necessary to mention since these are all known best practices, but just in case: Give users a self-service free trial. Offer monthly pay-as-you-go subscriptions that users can cancel at any time. Provide an option to pay in advance for a year (with a discount). Create a clean, beautiful pricing page.