How To Shape Pricing Strategy of a SaaS Product

Learning the Unit Economics of Pricing

Every price is a number—and it can be derived from other numbers. First of all, we need to understand the basic unit economics of good pricing. Doing so will help us understand whether we can calculate a proper price or we should follow a gut feeling.

While some companies prefer not to stress over pricing too much in the beginning—like Google when they decided to offer one price of $50 per employee per year in half an hour—I’m going to advocate a data-based approach.

Measuring Customer Acquisition Cost

Customer Acquisition Cost (CAC) is the cost associated in convincing a customer to buy a product or a service.

CAC = total cost of marketing and sales / # of customers acquired

In some cases, calculating CAC may not be straightforward as it depends on your definition of the “total cost” of marketing and sales. For example, measuring advertising spend is relatively simple—but should you also include the cost of the engineering team building the latest batch of new viral features? How do you track that on regular basis?

It’s always better to look at product and marketing as a whole and include that cost. Calculating the real cost of marketing-oriented engineering may be difficult, but I had some success with training engineering teams to estimate projects in terms of budgets instead of hours or story points.

If your estimate is that a project will take $10,000 instead of 10 story points, it’s much easier to include engineering projects in your CAC. (As a sidenote: budgeting estimates are also easier to prioritize. Making a choice is easy if you know that project A will cost $5,000 in order to bring a projected value of $6,000—and that project B will cost $7,000 but bring $10,000 in value.)

Measuring Lifetime Value

Lifetime Value (LTV) is a prediction of all the value a business will derive from its entire relationship with a customer. Long story short:

LTV = ARPU / churn rate

ARPU is Average Revenue Per User. Churn rate, when applied to a customer base, refers to the proportion of customers or subscribers who leave a supplier during a given time period—for example, in a single year.

The appropriate time period depends on the stability of your business. Older companies can safely track long-term churn. Startups will want to focus on short-term time periods like quarters or, sometimes, even weeks, depending on pace of execution and changes in strategy.

Measuring the LTV:CAC Ratio

To run a successful business, you need an LTV:CAC ratio of at least 3:1. That’s because sales and marketing aren’t the only expenses LTV has to cover in order for a company to function, and a LTV:CAC ratio of ~1:1 leaves no room to grow. And growth requires investments.

Ideally, we’d all aim for the highest possible ratios. But in the real world value is in the eye of the beholder—the customer. Products with great brands, like Apple or Nike, can force higher margins without reducing demand for their products. They can act like they have inelastic products. (Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.) Thanks to their brands, these companies aren’t selling bare items such as shoes or phones. Apple sells status; Nike sells you a better, healthier image of yourself. Self-confidence is worth much more than electronics or clothes alone.

Every company must figure out the right margins on its own based on its products, customers, and brand. In fact, branding is often touted as the new great startup competency and a predictor of future success. As VC capital becomes increasingly abundant, brand stories, which take more time and skill to develop than brute force acquisition methods, are getting more and more important. If you want to be like Apple or Nike, start with asking yourself: who do you want your customers to become? Here’s Nike’s answer, for example: “if you have a body, you’re an athlete.” The rest of their brand story reinforces their answer—you, too, can build on top of yours.

Qualifying Variances Across the Metrics

Metrics bring science to the art of marketing. Unfortunately, many early-stage companies only measure their average CAC and LTV. A macroscopic view may help in making high-level decisions, surely, but a low-level view on CAC and LTV will let you understand the overall picture, just as qualitative research aids quantitative research.

Let’s talk qualifying variances across the metrics. We’ll discuss two ways to do so:

1. tracking variances in metrics across channels

2. tracking variances in buyer personas

Tracking variances in metrics across channels

In business, a channel is the pathway through which goods flow from producers to consumers. Since there can be many different paths for a customer to learn about a product, and each path can be more or less difficult to go through, it stands to reason that each channel can have its own CAC.

Channels dry out over time. Given two channels with comparable bandwidth of potential customers, a fresh channel can yield more new customers than the older channel simply because the marketing department might have already acquired most of the customers through the older channel.

When channels dry out and the average CAC goes up, companies can look for new sources of growth either by releasing new products or by finding new channels to sell their existing products. Early-stage startups usually have to do the latter as they’re simply not old or popular enough to run out of potential customers. Small companies often start with small and cheap channels which dry out quickly.

As a startup gets more traction, it can move up to bigger and more expensive channels thanks to first sales or VC funding. Traction, a book by by Gabriel Weinberg and Justin Mares, describes 19 different channels early-stage entrepreneurs can use, as well as a framework to help you replace underperforming channels with fresher ones in a lean, experimental manner.

But as new opportunities arise, big companies sometimes find new channels, too. In 1998, for example, Apple introduced an online store for their computers—a direct channel for customers all over the world. They’d sold more than a million dollars’ worth of computers in just six hours. “That’s great,” said Steve Jobs according to one of his biographies. “Imagine what we could do if we had real stores.” The first physical stores opened in Tysons Corner, Virginia, and Glendale, California, in May 2001. Back then, opening real stores wasn’t an obvious move—but in the end they turned out to be a great source of new revenue, persuading unconvinced customers to buy themselves a Mac.

Tracking Variances in Buyer Personas

In user-centered design and marketing, a buyer persona is a fictional character created to represent a user type that might use a site, brand, or product in a similar way. If you have a User Experience department or a marketing department, your team is probably already using buyer personas. What you might not be using are quantified buyer personas.

Qualitative buyer personas take the target market and break it down by point of contact. Then, they describe the point of contact with different features, like what their needs are, what their budget is, and more.

In the example above, Enterprise Ed brings $900 more revenue than Startup Sally. Surely, it means that, given chance, we should pursue an Ed instead of a Sally, right? Not exactly. If we measured variances based on the LTV:CAC ratio, we’d see that Startup Sally has a tremendously high 5:1 ratio, and that Enterprise Ed has a lower-than-expected 2:1 ratio. Given that we’re looking for at least a 3:1 LTV:CAC ratio, acquiring Enterprise Eds would actually slow us down in the long run, as they are extremely expensive. We can acquire 25 Startup Sallies at a cost of a single Enterprise Ed—these Sallies would bring in $2500 in revenue, while Ed would bring in only $1000. That’s 2.5x more money—money you can spend on further growth.

Now that you decided on your qualitative buyer personas and measured their CACs and LTVs, you can move on to packaging: the features of the product your customers are ready to pay for.

How to choose the right packaging? Often, it’s not up to you; it’s up to your customers—they can tell you what they need. However, you must be extremely aware of the fundamental difference between supply and demand in software.

Features aren’t demand; they’re supply.It should be your job to define features (solutions). Customers should only define their challenges and problems. Henry Ford famously said that "if he had asked people what they wanted, they would have said faster horses." Tech visionaries use the quote as a beaten-to-death excuse for ignoring customer feedback. I think that customers clearly told Ford what they wanted—they signaled that speed is the key requirement for transport. But because they weren't engineers, they weren't able to say that cars would satisfy that requirement.

In product design, there are three different areas of systems: zone of control, sphere of influence, and external environment. The zone of control includes all those things in a system that we can change on our own. The sphere of influence includes activities that we can impact, but can’t exercise full control over. The external environment includes the elements over which we have no influence. Moving to demand thinking is like moving from the zone of control to the sphere of influence by understanding the external environment. Features are in the zone of control. Usage is something designers can influence. Demand is always external.

In order to figure out the perfect packaging, you must examine a customer’s problem up to the point where, paradoxically, you can’t fix it—only they can. For example, to determine whether we have to add a permissions system to our packaging, we must examine demand up to the point where we can understand the organization models of our customers. We can’t change the way our customers organize their companies into departments or branches—but only if we understand how they do it, can we supply an appropriate solution.

Finding Your Positioning—a Case Study

Qualitative metrics will help you decide who the most profitable customers are and who is not worth the effort. The choice can be more strategic than just numeric. The resulting strategy will become your positioning—the place that a brand occupies in the mind of the customer and how it is distinguished from products from competitors. By designing the right packaging based on qualitative buyer personas, you’ll help some customers decide that your product is for them, and others—that they shouldn’t buy it.

Basecamp is an interesting case study. Before 2016, they offered three monthly price tiers: $19, $39, and $59. In 2016, the tiers were $29 or $79 monthly, or $3,000 for a year with added personal support. 2016 was also when they publicly announced “if you’re a big company with special demands, we don’t want your money”, advising “not to let anyone overpay you.” They must have taken their own advice to heart, because soon Basecamp dropped the $3,000 a year tier, as well as the $29 tier, and increased the last price left to $99 a month—the current pricing.

 You can observe two important strategic choices there:

1. By deciding to drop two customer groups, Basecamp was able to focus and streamline their development efforts on the low-maintanence middle tier. If they kept the $29 tier, they would face constant growth obstacles from competitors with cheaper prices or freemium business models, such as Slack—as they would always compete for the same customers. If they kept the $3,000 tier, they would be creating a special interest group—one that might feel entitled to dedicated features.

2. Basecamp decided to implement a flat pricing model. Their end-to-end software costs $99 no matter how many users you have. Even though competitors such as Slack or Asana may seem cheaper at a first glance, they do not offer the same full functionality as Basecamp and need to be supplemented with other SaaS software, making the final monthly cost skyrocket.

Even though developing an end-to-end platform is much more expensive than maintaining only a chat platform or only a file storage platform, Basecamp is able to live through the costs because they dedicated their service to a single customer group, all of which they can charge $99 per month. Therefore, Basecamp’s streamlined positioning results in, paradoxically, lower software development costs, lower support costs, and higher margins.

Summary

That would be all for now. If you want to dive deeper into pricing strategy subject, Openview prepared a great whitepaper on mastering SaaS pricing on different growth stages. But with this article at your fingertips, you're ready to go. We’ve gone through all the basic aspects of pricing a SaaS product. We talked about the necessary unit economics of pricing such as CAC or LTV; we discussed how to track the metrics across channels; we saw how they can influence buyer personas and positioning. What’s left? Only practice, I’d say. Good luck!