SaaS founders often ask us for product pricing advice and from our experience, providing optimal product pricing practices is usually very difficult and can only be done on a case-to-case basis. While every pricing structure is different, we outline key themes with top questions that every SaaS founder should think about when determining the best product pricing strategy for their business:
Fundamental Frameworks: Generally most product pricing methodologies are centered on either value pricing or cost pricing. Value pricing refers to basing your product price on how much perceived gain a client can receive from using your product. Cost pricing refers to marking up your product cost by a margin in order to make long-term profitable sales. While both frameworks can be utilized, value pricing is the preferred method as this is generally a more robust reflection of the market’s willingness to pay.
Identifying Metrics: This is just to be clear on what function your product pricing will be based on. Having a clear understanding of what metrics you are structuring your pricing plans around is a prerequisite to considering the other themes below. Questions to consider: What metric will the product function be based on? Are you measuring product usage per user, per department, per storage space, or per time spent online? Are you going to price using monthly, bi-annual, or annual contracts? Will you charge based off of a fixed price (i.e $/users/month) or percent on the ROI generated by your client (or a combination of these two)?
Price Options: This addresses whether or not to offer more than one product pricing option (different pricing tiers) and is more common for subscription based products. The simple fact is that the amount that a customer is willing to spend varies significantly from client to client. Thus, while gauging whether or not to have one or more pricing tiers, you should understand how to optimally bundle your product so that it can best address the target customers you are selling to. If you are going for a value pricing methodology, understand what features of your product are bare minimum and then look at more advanced capabilities. Having different tiers gives customers the option to initially commit less on a lower tier and upgrade over time as they become more attached to the service. At the same time, you want to structure tiers so that there is not an overwhelming amount of options that may confuse a potential client. Typically, subscription SaaS businesses have approximately three to five price tiers per product and try to make the process selection as simple as possible for any browsing customers.
Identifying Target Market: Understanding what segment of the market you are targeting is integral for coming up with the best product pricing strategy. If you are targeting SMBs, your product pricing should obviously reflect the budget capabilities of small businesses. While identifying potential clients/segments, you can quickly develop an understanding of their level of “willingness” to pay for your product based off of demographics, margins, and business priorities. Questions to consider: Is your product going to be on the low-end, average, or high end of the market? Is your product catered towards SMBs or large corporations? What is your ideal customer profile? What is the customer base size of your target market? What are the average margins of your target customer segments? What are the biggest, most common problems within this market?
Quantifying Value of Product: This is a follow-up to after identifying the target market. While determining the best product pricing, understanding how valuable your product is allows you to better recognize your customer’s willingness to pay for your solution. A quick way to quantify your product value is to run a mini market sizing analysis. You can determine value from a cost-saving perspective and/or revenue-enhancer perspective. For example, if your client can save $2MM by reducing payroll from using your software, that would be a cost-saver. If your software generates 20% more leads for your customers and increases conversion rates by 10% that would be a revenue enhancer. Sometimes, products may not have quantifiable value; for example, public relations solutions may not have a quantifiable effect in the short-term so pricing these products are trickier and will be more focused around cost-based/competitive pricing methodologies. Questions to consider: Is the value generated from your product quantifiable? What problems are your product solving? Are these problems priority challenges to solve on your target customer’s list? How much is your customer going to save from using your product? How much is your client’s revenue increasing from using your product? How much more value is your customer going to get out of your product vs. using a direct competitor’s solution? How much should the product price be discounted from the value generated in order to convert the client?
Understanding Operational Costs: As mentioned above, while it is generally preferred to use a value pricing methodology, you are ultimately running a business that needs to become profitable in the long run. Your product will have different features, qualities, and naturally different costs from other alternatives so it is necessary to run your own cost analysis so you can understand product pricing limits. You want to cover a substantial part of your COGS and even price your offering to mitigate any threats that may affect revenue. For example, low average selling price (ASP) products tend to have higher churn rates but lower sales cycle (but higher sales velocity); therefore you might want to consider offering discounted annual deals to incentivize clients to lock in a longer contract- this will naturally reduce churn rate as clients now only can churn annually rather than monthly or quarterly. This can be important because high churn rates will destroy a business that has higher CAC, so implementing these mitigation tactics may make or break a startup. Pure cost-based product pricing is often seen in commodity based offerings such as Box or Amazon Cloud, where online storage space is sold as a marked-up commodity. Questions to consider: What is the estimated average contract value? What is your customer acquisition cost? What are your general COGS? Do you need to hire experienced, specialized salespeople (typically for differentiated, premium products)? What is the average contract length? What is the estimated churn rate?
Taking into Account Competitors: There are countless ways to determine best product pricing around competitive landscape – notable strategies will be covered below. However, most importantly, running a quick competitive pricing analysis will provide a rough industry benchmark for your product pricing. While doing this analysis, you should gauge your product position (lower quality vs. premium) within the market and understand how appropriate your pricing is relative to that position. Questions to consider: Are you offering better features than competitors? What are your product differentiators? Do those differentiators cause significantly higher/lower costs? What are the estimated margins on direct competitors? Are you running a business that can sustain those margins?
Common Product Pricing Strategies:
1. Freemium/Trial: This is the most popular strategy for low-medium ASP subscription SaaS products. Offering a product with limited functionality or free trial can quickly accelerate user growth and allow the business to either up-sell upgraded functionality, cross-sell complimentary products, or convert users after the time limit is up. If you are interested in pursuing this strategy, be sure to check out our best free trial practices for B2B SaaS enterprises. Hubspot, Evernote, and Dropbox are companies that have released limited offerings to build a strong customer base.
2. Skim: The provider charges a premium for a high quality software package, sets a high price, and targets larger contracts. This tactic allows the provider to capture a small part of the market first and then slowly reprice/repackage their product to take the rest of the market. This strategy is found mostly with transactional and high ASP companies such as Tracxn ($24000-$96000/year) and OutMarket ($30000/year) servicing medium plus size customers as larger clients will have the budget for these types of premium products.
3. Penetration: Pricing the product competitively (or even lower than average) with a high quality product. New entrants and smaller SaaS firms typically use this as a strong go-to-market execution tactic. The goal here is to quickly capture a large segment of the market and then up-sell other features to a large customer base. Companies such as Zendesk have initially priced below the market to accelerate initial growth.
4. Broad Targeting: The provider has tiered price packages (with no free trial/features) to target multiple customer segments and reach a broad customer base. Companies such as Salesforce and Adobe have a good understanding of how each product features appeals to different customer segments and how they can package products optimally.
5. Free Offering: The provider releases a free product to quickly capture a large chunk of the market. The goal is to cross-sell complimentary features or enhancers once a large customer base has been established. The SaaS business can also monetize the customer base in other ways such as selling customer data to third parties (i.e marketing firms). A good example is Wave, which offers free invoicing/accounting software but provides customer data to advertisers. This follows a similar line of thought as the freemium model with the only difference being that a product with complete functionality/features is given out for no charge in the free offering model vs. a product with limited functionality is released in the most basic tier in the freemium model.
It is challenging to provide exact benchmarks for optimal product pricing because 1) Every SaaS startup is different which makes it difficult to find complete comparables and 2) Because every product is different, the perfect product pricing framework will depend entirely on the individual case. While pricing should be uniquely catered to the specific offering, we provide common themes and questions that need to be considered while determining the best product pricing structure for your company.