My name's David Wadler, and I am Co-Founder and CEO of Vendorful. I'm also an investor in a variety of startups, almost all of which are SaaS businesses.
In this article, I'm going to go through some ideas about how you can start to think about pricing SaaS.
The SaaS model
When you think about SaaS, it's an amazing business model. If you're drawn to SaaS, bravo for you. I like to think about it as a better version of pharmaceuticals.
Think about Viagra, a billion dollars to create that first pill. But thereafter, it maybe costs two cents to create a pill that they can then sell for $2 or $3. A very high margin and oftentimes, in pharmaceutical, we get recurring revenue.
SaaS is even better. Software is much cheaper to build, and it scales very, very nicely. So if you can find a good SaaS business, and you can figure out how you can scale it, then you're going to have something pretty magical.
From my perspective, pricing should be an exercise you engage in before you even start building a product. It doesn't mean you're going to land on a number or a set of numbers or anything else. But at the very least, you want to start thinking about the model.
Questions to ask yourself
You've got to wonder:
- Who's going to buy my product?
- Am I selling this to individuals?
- Are they going to be paying on a recurring basis?
- Am I selling it to businesses?
- What part of the business?
Validation is key
The most important thing early on in the SaaS business is going to be validation. You need some people to use and pay for your product, extracting the maximum amount of revenue from them is really a secondary concern. Maybe not even a secondary concern, it's probably not a concern at all.
Think about how large your market is and if you're selling a product for $10 million a year versus $10 a month, you're serving different markets, those markets should be different sizes.
Are you going to be very engaged in the selling of your product, or is it going to be more of a product-led growth, people can sign up, put in a credit card, and it's automated?
Once they're engaged, how much time are you spending supporting, expanding, and all that kind of stuff? These are the things you need to think about as you're building your product, as you're thinking about the business before you can even get to the price.
Because if you don't answer these questions, at least in your own head, pricing is going to be effectively an impossibly challenging exercise.
Let's talk about some of the numbers you're going to end up focusing on, you're going to want to try to the extent possible to build out or at least model this in some vague way as you are thinking about your business.
Again, it's not about nailing it the first time, it's about really understanding what it is, getting directionally close, and then making the refinements as you go.
For people who are newer to the business, MRR and ARR, are monthly recurring revenue and annual recurring revenue. So if you sign a deal, as I mentioned, $10 a month, that'd be a $10 MRR deal, you could also call it a $120 ARR deal.
Do you want to measure on a monthly basis, an annual basis? That's really a personal preference thing. In SaaS, you can only from an accounting perspective recognize the revenue as you deliver the service.
So if you sign a one-year contract, and it's $100 per month, you can't say, "Well, we're going to recognize $1200 in revenue", you'll be able to recognize $100 for this month, the next month, another $100, incrementally.
The MRR/ARR numbers are a bit divorced from accounting but are very useful for helping you understand the health and growth potential of your business.
The other thing you want to think about is your cost to acquire a customer. This is known as CAC. Even if you don't have a sales team, you might have a team of amazing social media influencers who are doing all the marketing for free just because they love you.
Great, your CAC might end up being something pretty close to zero. In reality, whether you're a sales-driven org or a marketing-driven org, or as most SaaS businesses are some combination, you're going to be investing, you're going to be buying revenue.
This is going to be especially true early on. CAC will typically decrease over time as your brand gets out there, as the sales process gets tightened, etc. But you want to think about how am I going to acquire customers, what's it going to cost me to get a customer? Talk to people who have sold similar style products in similar types of companies.
This is the number of customers you lose every year, this will also impact, obviously, how much money you're making. Now there's this concept of negative churn, which means you might lose some customers, but the customers you keep are expanding.
So the customer who paid $1,000 last year, maybe he's paying $1200 this year, that would be negative churn.
Finally, the LTV, the lifetime value. If you get a customer, and they spent $1,000 a year and your typical customer last three years, that's $3,000 in lifetime value. This is going to be very difficult for you early on, but you have to decide whether at the very least you're going to need a business where you're going to be more transactional.
Maybe you offer a service for startups to help get themselves launched, but the value of your products after launch goes to zero. You know you're not going to have much time with these customers, it doesn't mean it's a bad business, but the LTV is going to be determined by how much money you're making and how much time and in this case, time would be compressed.
Meanwhile, if you have another business like accounting software, you might get a customer and have them for 10 years.
The golden rule
In terms of these numbers, the golden rule here is an LTV to CAC ratio of three to one. You don't need to on day one recoup all of your sales and marketing costs. If it costs you $300 to acquire a customer who pays out $150 a year, and you know you're going to keep that customer for three or four or five years, that's good.
Yes, you will lose money in the beginning, but it's not about losing money in the beginning, like the Viagra example. Invest the money in the beginning and relish the margin over time. That is the general rule of thumb.
It is not something you need to hew to rigidly, but it is a good benchmark for you as you're thinking about these things. Obviously LTV as well as CAC, you're going to make your best guesses early on, and then you're going to use actual real data to fill in the gaps.
So, how do I price my product?
Let's think about what we've got to do. I like to think about this both bottom-up and top-down.
I never want to be in a position where I am losing money in perpetuity on a customer. So if it costs me $1,000 a year to service a customer and that customer pays me $500 a year, I'm in a bad business.
The customer acquisition cost is fleeting, you pay it, and then it's done.
What you can do is think ‘what does it cost me?’ and apply a margin of 30/40/50/100%, and say that's my pricing.
That's cost plus, you typically want to stay away from it, but it's a good exercise to figure out what your costs are. It's also a good exercise to go out and see the competitive landscape.
How do we want to sell our products?
You want to figure out what it is you're selling. How are the people going to buy it? Are they going to just come to your website and sign up? Are you planning on having a bunch of SDRs and account executives who are doing demos and running through a three/six-month sales process and one-year sales process?
You might have both, you might have one in the beginning and then multiple over time. But you want to at least really think about how you want to sell this. Because this is going to change the pricing, obviously. You change your go-to-market, your CAC is going to be radically different if you take path one versus path two.
And if CAC is different, then you need to optimize your LTV for your CAC.
How will we measure usage?
This is an interesting question. Almost all SaaS products are usage-based in some way. Usage might be per user, it might be per volume of usage, that might be storage or transactions or something else.
What will happen to our costs as usage increases?
Think about what that is, think about how you're going to scale the usage with your pricing and to your costs also.
So if people are doing more transactions, do you say that doesn't really matter, I have a server, the server will accommodate millions and millions and millions of transactions, my typical customer's doing five a month? So my cost moves up very slowly, but I have an opportunity to move my price up more quickly.
What do our competitors charge?
And then again, what do our competitors charge? I talked earlier about doing competitive analysis, that's what you want to see, just so you can get some grounding in the market.
It'd be weird if you said "Oh, we sell these widgets they're $45,000" and you find out there are a bunch of other companies that sell effectively a very similar widget, and it's $3,000. You'd be way out of the market.
Similarly, if you go down too low, that can also in some cases, oddly, work against you. People will, in some cases, associate low cost with low value. You have to work through those biases and that's something else when you do some experimentation early on with your pricing, where you can get a flavor for this.
Let's talk about working forward and establishing the ceiling.
What is value-based pricing? I'm not going to charge you based on what my costs are, what my competitors charge, I'm going to charge you based on the value that you're getting from my product. This is very, very difficult to establish, especially early on.
It will usually take some measure of experimentation, there are other things that you can do to supplement that experimentation to move things along more quickly. There are even companies that will help you do this. But it is really the holy grail.
You want people not to think about this as, "Oh God, it's going to cost me X", you want them to think "I'm going to get this value, which is so much bigger than my cost."
How do you measure the value you're bringing them?
If you have an automation platform, you might be saving somebody a lot of time, you might be saving them time and money, you might be delighting them and making them happy in any number of ways.
What’s the qualifiable value?
The thing is, you have to figure out what the qualifiable value is that you're delivering, and then you're going to try over time to turn that into quantifiable value. "We're going to deliver XYZ ROI", that sort of thing.
Are we on the same page?
The important thing is you have to be on the same page with your users when it comes to this. If you're telling them "This is awesome, I've automated away so much of your time" and they said, "Well, great, now I'm out of a job because you've effectively rendered me useless", they're not going to be super excited and recognize the value the same way.
However, if you automate away parts of their jobs that allow them to do other things that are higher value, and more strategic, these people are going to be your fans and your champions.
They will really realize the value they're getting, these turn into case studies and everything else, which is great, but they also become very interesting discussions for you to have. So you can tell your story, and that helps you justify the price.
What's the cost of not using the solution?
I'm in a business where we are oftentimes competing with manual processes, people use Excel and Word, etc. There is time that it takes when they're using a product like that, there are outside risks they're taking because it's not inside a single system, etc.
That's the other way you want to think about it - what are the pros, what are the cons?
At the end of the day, if you can really get it, if you really figure out what your pricing should be, your customer is going to pay for the value they're getting and what they're willing to pay.
You don't want to rip them off but at the same time, you don't want them to think "I'd pay five times as much for this software, it's amazing". Because if you're doing that, you're leaving money on the table. We don't want to leave money on the table.
So it's going to take you a little bit of time.
Three stages of pricing
I like to think about this happening in three stages.
Stage 1: Be willing to lose money
In the first stage, you are a young, scrappy SaaS company. Be willing to lose money, I said this earlier, the most important thing, in the beginning, is getting customers, you just need customers, it's not about maximizing your revenue.
No venture capitalist or serious investor is going to expect you to be profitable for quite some time if you're a SaaS company. Really, what you want to do is get people using the product, because nobody wants to be first, it's a high-risk proposition for those people, etc.
I'll tell you one other thing, you may well, and I've done this, and most of my friends in the space have done this, given those early adopters, most favored nation pricing basically in perpetuity, because the value that you get from them is far more than monetary value.
And you can pay that back to them over time, by keeping their pricing separate and distinct from what you've done if the rest of your pricing has gone up.
Stage 2: Be willing to lose deals
Once you have a bit of traction, you can start to play with the price. If you've been selling your product for $50,000 a year, and you think it's a $100,000 product, throw a quote out there at $100,000. See how people react to it - are you going to lose deals?
If you have nothing in your pipeline, that's going to feel very, very scary. You might want to go up more incrementally, you might want to go 2X, the faster you go up, the faster you'll get the data.
The other thing you can do, either yourself or using a firm, is run lots of surveys to people in your space and collect data that way. I find that tends to be useful and interesting in getting you some level of refinement, but there is a difference when people talk about something theoretically and when they actually have to sign a contract and write a check, that's where the rubber meets the road.
Stage 3: Be willing to lose tradition
What I mean by that is just because you priced it one way doesn't mean you need to price it that way indefinitely. Maybe you were doing per-user pricing, and you want to move away from that, maybe you had a freemium model and now free doesn't make sense for you ever, and you just want to get rid of it.
It's totally fine. Your pricing should evolve with your business.
Oh no, I’ve screwed up my pricing!
If you think you've screwed it up, this should make you feel good because it's not necessarily a screw-up, it's just the first step.
Pricing is a moving target
No one's expecting you to nail it right away. This is a moving target, you're going to figure it out. I am generally on the side of starting low, and then increasing the prices. Again, for the earliest customers, I'm not necessarily a huge fan of raising prices on them.
A quick anecdote
In my first business, we started our pricing at $100 a month, we ended up with hundreds of customers and I did the math and I realized it was going to take us a long time to make money.
Now we had a non-normal distribution, where we had 10% of our customers driving the bulk of our revenue. So we increased the price to $500 a month, the entry point, the larger customers were not impacted, and we lost about 50% of the remaining customers for whom we raised the price.
That was great for us, our support cost was cut in half, effectively, and we made two and a half times as much money. So you will lose customers, but sometimes in that case you will lose customers who are not the ideal fit for you anyway. That's why I say it might not be a bad thing.
You can also go down. As I mentioned, this sounds great, my addressable market got huge. But imagine the world I was in, maybe I started at $1,000 a month, and I'm like, "Oh, I need more customers".
I could have ended up getting five times more customers at 1/10 of the price. I would be upside down there and then on top of that I'd have all the support burden. So just be thoughtful and iterate.
Pricing and product
What are the things that are going to influence price?
- Competition coming into the market.
- Commoditization, aka, this tool is just readily available.
- Product rot - If you are not actively working on your product, you might not be able to charge as much for it.
- Maybe your existing customers are locked in, but if the rest of the market is passing you by because you're not actively improving what you offer, then you will not be able to charge as much.
- Misfocused - If you're focused on the wrong stuff, you're solving problems A, B, and C, but people are willing to pay a lot more money for D, E, and F, it's going to hurt your pricing.
- Then also if the problem set changes or disappears. If you're selling year 2000 software to help with the transition from 1999 to 2000, that market effectively disappeared literally overnight.
On the other side:
- If you establish market leadership.
- More high-value features - If you are investing in more features that are addressing specific pain for people.
- Growing problem - If the problem in the market is growing, a great example of a growth market over the last year and a half is remote conferences and software to power them.
- Building an ecosystem, so other people are tethered into your product.
- And also criticality, how hard is it for someone to let go of this?
I hope this was helpful.