Pricing in the SaaS world is particularly complicated. Pricing can make or break your SaaS company with its impact on both profitability and revenue growth – the two major indicators of company valuation.
SaaS pricing is a fast-moving target and every SaaS CFO should be re-evaluating their company’s pricing on a regular basis. As a SaaS company, you have to find the right balance between pricing for profitability versus pricing based on customer acquisition/retention and market share – sometimes it is a trade-off. Pricing strategy can vary depending on what stage your SaaS company is at—from entering a new market, to growth stage to defending market share from new entrants.
Pricing falls under the purview of both Marketing and Finance, impacting and influencing Sales and R&D as well. With accountability dispersed among the stake-holders, regular pricing management can fall thru the cracks. Once a pricing strategy has been agreed upon, it can seem too painful to revisit the complexities again. Many companies are moving to a Chief Product Officer who works with the CFO and reports to the CEO, with P&L responsibility and accountability for product pricing.
On the positive side, pricing is a dynamic tool for growth. With good data and a structure to analyze pricing, regular management attention can be paid to one of the most critical drivers of a SaaS company’s success.
Here’s a framework to evaluate some of the financial issues involved in pricing.
Profitability
Clearly, pricing directly impacts profits. Increase your prices and you should increase your margin between the cost to produce/deliver a product or service and the price you receive. Price too high, though, and you’ll reduce demand for your product. Price too low and you can’t cover your cost to deliver the product.
While basing your pricing on cost alone (known as cost plus pricing strategy) isn’t recommended in the SaaS world, you have to know your product cost as you build the right pricing strategy for you. The key metric to track and benchmark is:
- Recurring Revenue COGs (Cost of Goods)
SaaS COGs can be tricky to calculate, we’ve written a few blogs on some of the costs that go into it, but generally, it includes all costs associated with hosting your products, maintaining your customers and any after sales support.
Customer Segmentation
One important way to improve your COGs is to look at costs associated with different customer segments. How consistent are your costs when you look at varying customer groups? Customers are typically segmented by:
- Customer size,
- Customer vertical,
- Geography, or
- Even by year that you acquired them – you may find that customers acquired in your early years as a SaaS company are paying less than cost as your primary goal at that time was customer acquisition.
Another area to look at in customer segmentation is by sales person who completed the deal. Oftentimes, there is a pattern with certain sales people who somehow manage to sell (and get approval) for low margin deals – and conversely, some sales people always sell profitable deals. These kinds of patterns are important to recognize and use to optimize profitability and revenue growth.
Customer segments that are costly to serve can be addressed to help reduce your overall costs. Increasing deal size or retiring high cost-to-serve customers (or some combination) also helps reduce your overall costs. Sometimes complex customers are too costly to maintain, sometimes loss leaders (product sold below cost in order to gain entrance to a market or dislodge a competitor) continue to be sold below cost far beyond the time when the original loss leader goals were met.
A pricing structure that is easy for customers to understand but varies for different use cases and costs can help you to improve overall profitability.
Revenue Growth for SaaS Company
Pricing also directly affects revenue growth and customer acquisition/retention. Price too high and your customer acquisition and retention may stagnate or fall, even though demand is strong. Getting pricing right from a customer acquisition perspective requires doing competitive analysis, customer reviews and an understanding of customer’s perspective on ROI.
Almost every B-2-B product category suffers unrelenting competitive pressures today as the Cloud sector continues to grow. Customer understanding of product ROI is a moving target. From disruption via new technologies and business models, to competitors using penetration pricing strategies to move into a new market, it isn’t always straightforward to base pricing on a quantifiable ROI for the user. Huge value is being received by users from “free” or very low-priced technologies, while other technologies receive a premium price for sometimes limited ROI to the user.
In addition to price, other factors come into play as well. Chris Mele, Managing Director of Software Pricing Partners, the leading pricing practice for software and SaaS firms says, “while price levels are important, it is far more effective when considered along with licensing, and packaging that is aligned with how customers derive value.”
Pricing can affect these key indicators of revenue growth:
Months to Recover CAC: if pricing increases with no increase in CAC this metric will be reduced.
Sales Cycle: an improved pricing strategy reduces sales cycles typically means that you can sell more with the same resources.
Churn/Retention:
- Logo retention: an improved pricing strategy can reduce friction when customers go to renew subscriptions.
- Net $ retention: a variable pricing strategy which takes into account increasing customer usage helps grow subscription contract values with existing customers
- Gross $ retention: measures how well you are defending your original contract values from year to year and is an indicator of two things: the success of your pricing strategy as well as whether your sales organization is discounting renewals.
(all of these metrics are benchmarked by OPEXEngine for SaaS companies with revenues between $1M-$500M)
No single lever you can pull has a greater impact on value than your monetization strategy. This is particularly the case for SaaS businesses. Investors are increasingly demanding faster sales, solid margins, low customer acquisition costs and high retention rates. Either they’re investing heavily in companies that have that figured out, or they’re jumping on opportunities to capture the upside for themselves by forcing monetization improvements post-investment.
Chris Mele agrees: “this impact on valuation is why—whether you are in early-stage growth phase, pre-IPO, or enterprise expansion mode—today’s environment dictates that you address monetization sooner rather than later.”
At OPEXEngine, we certainly are not pricing strategy gurus, but there are good ones you can hire like Software Pricing Partners to find the right solutions for your products or use internal resources. The bottom line is that pricing is dynamic and should be a management imperative to review at least annually with the appropriate internal data and benchmarks to guide your strategy.
