The Dynamics Of SaaS Pricing

Bhomik Pande and Meenal Prasad

Imagine your team is launching a new product; you have figured out the minimum feature set and are working with the following teams to validate the minimum viable product (MVP) in the market.

Development, quality assurance, and DevOps: You work with this team to have the basic features developed, tested, and shipped to market.

Go-to-market (GTM) team: You work with this team to have sales collateral ready along with the right trial customers with the right regional mix to have inclusive feedback from customers. The feedback from initial trial customers will validate the product and highlight its strengths and weaknesses. Early, honest dialogue with initial users will be helpful for the product’s future roadmap.

Contract management team: You work with this team to have trial agreements and contracts in place.

But, do you have a pricing strategy?

If the answer to the above question is “No, not yet,” “We will figure it out,” or “We have not thought about it,” then you are missing out on the most important lever responsible for the success of your product.

Product managers spend considerable time on planning, development, shipping features, quality assurance, GTM, and customer acquisition. An equal amount of time should be invested in setting the right price from the start. Price defines the tangible value of the offering. It is the numeric representation of the value that customers see in the product or service. Pricing, in fact, is the primary driver for growth. Growth means an increase in revenue, and pricing is its most important multiplier, as it also affects the other variable: the number of customers.

As you navigate pricing, think about fundamental questions around positioning and packaging:

  1. What is the problem your product is solving?
  1. Who is your buying persona or target audience?
  1. What is your market segment?
  1. What is your initial geographic focus?
  1. What is the unique value you are providing, and how do you differ from competitors?

Answers to these questions can help lead you towards the right pricing approach. It is important to have inputs from key stakeholders, such as product management, regional sales, analysts, finance, and GTM. The group can take early feedback from the market, competitor pricing, sales, and trial customers – and their willingness to pay during the discovery process. A thoughtful approach, based on the intersection of inputs from the pricing group, can help achieve better product-market fit, thereby increasing the adoption curve.

Here is a two-step approach to consider:

  1. Cost plus margins: This is the most widely used approach to calculate the initial price point. Calculate all possible costs involved, including inputs from development, marketing, support, and operations. It is important to factor in the future costs that may arise while scaling the product. Append the total cost calculated with expected margins in the category to get the starting number (say $X per month).
  1. Competitor comparison: Compare the derived value from step 1 with existing competitors in the market. If $X is greater than the competitor’s price, then discuss all possible reasons for overpricing with the group. Similarly, if $X less than the competitor’s price, then it may be a good idea to increase X and evaluate the reasons for underpricing.

Another important approach is value-based pricing, i.e., pricing based on the target customers’ perceived worth of the product. Unlike the previous approaches, this one is more customer-centric. Customers expect value from your SaaS offering, and renewal decisions are based on the outcomes delivered.

Here are some steps that can be followed to derive the price point using value-based pricing:

  1. Meet customers during the MVP stage and understand their willingness to pay.
  1. Identify segments of customers (e.g., small, mid-market, and enterprise).
  1. Quantify the benefits you are providing to the customer (e.g., cost savings, increased productivity, or improved outcomes).
  1. Derive a price combining the inputs from previous steps.

Value-based pricing can be very effective for scaling and increasing margins. As the product scales and provides more value, pricing may be revised to match the new realized benefits provided by the SaaS offering.

This pricing approach needs to be seen in context with the group’s final pricing model. Here are some of the pricing models that are frequently used in the SaaS space:

1. Freemium

The freemium model gives a basic service with limited functionalities to customers for free. This model helps in quick customer acquisition and establishing early customer relationships. Additional functionality can be charged for as advanced features. The primary advantage of this model is that it can quickly increase initial customer adoption. However, most users may prefer to remain free users, thus impacting revenues.

2. Per-user/seat pricing

This is a widely used SaaS pricing model where the customer pays based on the number of individuals using the software (e.g., $X per user per month). One version of this model is per-active-user pricing (i.e., usage is billed based on the number of active users). This model can deliver predictable revenue streams, but customers may not go beyond the 10 to 100 users bracket due to higher costs for the same service.

3. Usage-based pricing

This model is based on the amount of consumption of your offering. Customers are charged for the number of transactions/API calls or data used. Usage-based models can be charged in the following units:

  • Transaction or API calls: When APIs are the core offering, pricing based on number of API calls is becoming prevalent in the SaaS space. It also appeals to developers who are mostly end users, and in turn, helps in adoption of the product by the developer ecosystem. For example, a block of 100,000 API calls costs $X per month.
  • Per-storage pricing: This pricing model is based on the amount of storage customers use (e.g., $0.04 per GB per month). This is mainly applicable to companies offering storage-based services. The advantage of this model is that it accounts for large usage of the service. However, it can be initially difficult to predict revenue on an annual basis, since usage can vary from month to month.
Customer Segmentation Features/Functionalities Tier Pricing
Mid-market A, B $Y
Enterprise A, B, C $Z

4. Tier-based pricing

Tiered pricing models define a price per unit within a range according to need. This approach allows you to offer different feature sets to different target personas at incremental price points. The advantage of this pricing model is that it appeals to different segmentations. However, if there are too many tiers, it can become confusing for the customer.

5. Flat-rate pricing

Flat fee is the simplest pricing structure since it charges a fixed fee for the offering regardless of usage. The biggest advantage of this approach is that it simplifies communication with customers. However, it doesn’t consider features that will be added later nor customer segments. For example, a large enterprise client will pay the same flat price for your product as a small startup.

Scaling the pricing journey

The pricing group can use a combination of the above models, depending on the hypotheses developed around positioning and packaging.

After the pricing group has finalized the approach and pricing model, it is good practice to maintain a profit/loss analysis of the product and forecast for at least the next two years. It can then be tweaked, according to customer segmentation addressed by the product and the final pricing model.

During the scaling journey, the effectiveness of the derived price point and finalized growth model can be measured by tracking key metrics such as annual recurring revenue (ARR), customer lifetime value (LTV, or earning from each customer over time), customer acquisition costs (CAC), and churn rate. These metrics are calculated in the following manner:

ARR is the value of contracted recurring revenue components normalized to one year.

Net revenue retention (NRR) is the percent of revenue from current customers retained from previous years after accounting for churn.

Pricing is responsible for ARR, and revenue is the best way to demonstrate product-market fit and signal growth. Growth is important, but during scaling, avoid overspending on sales and marketing, as it can disturb the unit economics. You should observe all the above-mentioned metrics holistically for product success and growth.

ARR growth of over 100% may not be a good sign if NRR is in two digits.

Topline growth will eventually be affected if retention rate is poor; in this case, you should not spend much on customer acquisition but rather work with customer success and support to explore ways for retaining customers. If the retention rate is healthy and in triple digits, then it makes sense to spend more on acquisition and grow the market share.

Sustainable growth is important, and the ratio between customer LTV and customer acquisition growth can be another metric to monitor on a continuous basis. For a profitable business, it should be greater than 1. This ratio is the return you get for every dollar you spend on your product. It can vary for different customer segments, such as large organization vs. early-stage startups.

For SaaS, understand that customer acquisition costs are absorbed upfront and the realization of LTV takes time. The right pricing can help in further cross-selling and upselling, thereby increasing the LTV. It can be increased in the following ways:

  1. Increasing the numerator by raising ARPU: Give your customers more value with add-ons and services that augment the core offering.
  1. Decreasing the denominator by reducing churn rate: Give your customers a true experience with the help of your customer success team.

Continuous review of pricing with the pricing group can help achieve better unit economics and growth. Although revisions in pricing may not be feasible in large organizations, a quarterly review can help in understanding whether the current pricing is meeting market expectations.

Learn more: “Next Practices For The Intelligent Enterprise Tech Company.”

This article originally appeared on Egomonk insights.

Bhomik Pande

About Bhomik Pande

Bhomik Pande is Senior Operations & Strategy at SAP. He wears multiple hats within SAP Digital Interconnect business unit & drives innovation related topics as part of Products & GTM team. He has numerous years of experience working with SAP across different line of business and has been a CRM Consultant in his previous role. You may follow him on Twitter at @bhomikpande

Meenal Prasad

About Meenal Prasad

Meenal Prasad heads the SAP Digital Interconnect enterprise product portfolio. In this role, Meenal leads a team focused on creating value-added products that enable SAP Digital Interconnect customers drive higher engagement and streamlined communications with end consumers, as well as employees and stakeholders through intelligent multichannel interconnect services.