Four Principles for SaaS Pricing, Part I

"I want you to be very careful, because no single decision will impact your company's valuation more than the one you're about to make on pricing." That's Ben Horowitz as quoted on the A16Z podcast on pricing. As the podcast explains, pricing isn't intuitive, and the partners at funds constantly push their entrepreneurs to raise prices. 

Unfortunately, higher prices don't automatically lead to higher valuations. There will always be a price/quantity struggle especially as you start having competitors, as I explained in my previous post on auctions. And if you don't get enough people to buy at the higher prices, your revenue, and hence, your valuation suffers. 

In that vein, I've designed a framework for deciding on how much to charge for your SaaS product. This framework could work for any product, but the first tenet deals specifically with subscription services. Another caveat: this framework applies well to companies operating in post-chasm industries. That is, once the early adopters have embraced a new technology and competitors have entered the market, this framework can be used to set pricing in relation to your own costs and prices of your competitors.

The Four Principles are to price so that you:

1. Cover Your Costs
2. Increase Your Valuation 
3. Grow Customers 
4. Signal Appropriately 

In Part I of this blog post, I'll cover principles 1 and 2, Covering Costs and Increasing Valuation.

1. Cover Your Costs:

Sure, this sounds backwards, but stay with me. Most start-ups worry about how much they can burn given how much cash they have. Covering your costs, however, proves to be an interesting thought exercise, especially when you look out into the future. And the exercise can yield an excellent benchmark. In two years, when you've acquired the number of customers you've predicted, what will your costs be? How should you price to cover those costs? Let's dive in a little deeper.

When the early majority begins adopting a certain technology and slew of companies begin offering solutions to a specific problem (even if the solutions are differentiated), the market begins to resemble monopolistic competition. I wrote about monopolistic competition in my post on newspapers. With low barriers to entry in starting a software company and product differentiation, each technology can set its own prices (as in, they aren't price-takers), but the industry provides a guideline. 

Economic theory in relation to monopolistic competition would tell us that firms need to price so that average revenue is greater than both their average total costs and marginal costs in the short-run to make an economic profit. In the long run, average revenue will equal average total costs. Both graphs are shown below. 

But when speaking of revenue covering costs, pricing subscription products gets tricky. For the most part, costs related to selling the product will exceed the first month's revenue if you're expecting the lifetime of the customer to be several months to several years. So here's how I would think about covering costs. 

COGS: The first thing I would say is that your price every month NEEDS to cover costs of goods sold (COGS). Those are direct  incremental costs that are incurred every time the technology is sold. Usually, the biggest component of COGS for a SaaS business is hosting costs, but can also include set-up fees or platform fees. So, never price so low that the respective monthly hosting costs aren't met by what the customer is paying you every month. I've seen too many companies fall flat because they have negative gross margins; it's hard to price yourself out of that kind of a hole. 

CAC: When considering how much to price in relation to your customer acquisition costs (CAC), which is more of an indication of your sales and marketing costs, a payback period is a good way to think about it. Tomasz Tunguz at Redpoint points out that a median start-up has a payback period of 15 months on a gross margin basis. That is, it takes 15 months of gross profit dollars from a particular customer to cover the sales and marketing costs of a new customer. In terms of revenue, he notes that CAC is typically 11 months of revenue. I think those are good benchmarks to work against, and as Tunguz points out, the faster your payback period, the more working capital you free up for other initiatives. For more on the right way to calculate CAC (using full cost of customer acquisition), check out Andreesen Horowitz's "16 Startup Metrics". 

Total Costs: Lastly, I don't hear much discussion about total cost of operations in relation to revenue. The question many managers ask is, "How much can I burn given the amount of cash I have raised and have on the balance sheet?". And while that mentality is important to insure against insolvency, that burn number usually doesn't factor into how much to price your product, and I think it should. 

When it comes to covering total costs, it is helpful to project yourself into the future, as I mentioned above, and think about what your costs will be when you reach a certain number of subscribers. For example, if you forecast having 100 subscribers over 2 years, how many sales people will you need to get there? 5? 10? 20? What will you have to pay each one? Will you need a Chief Revenue Officer? What will your marketing division look like? Who else will be on your payroll, and what will your rent be? Build a financial model for just the costs, which will help edify how much revenue you will need to cover those costs or make a profit. Once you have the revenue number, you can divide that by the number of subscriptions you anticipate having (in this case, 100), to get to your price. Of course, you don't have to price exactly there, and pricing may actually differ from customer to customer depending on negotiations and how early you are in the process (your earliest customers will likely get a great deal), but this will give you one benchmark to enlighten your process. 

A quick aside on measuring total costs using financial models: I've had some cognitive dissonance here. My accountant side likes Statement of Cash Flows, my investor side likes EBITDA, and my economist side prefers Net Income (to include non-cash costs). I've reconciled all of those to find that EBITDA minus Capex minus Interest Expense is the best proxy of how the core business is doing. It takes out the noise of non-cash items, such as depreciation, and exogenous cash items, such as capital inflows/outflows for debt or equity. If you want to measure just the expenses, take out the revenue line on the EBITDA, subtract capex and interest expense, and you'll be left with just the costs of running the business. Those represent the total costs you'll need to cover. 

2: Increase Your Valuation:

In the second tenet of my framework, I am deliberately eschewing saying "Increase Your Revenue", knowing full well that revenue serves as a large component of valuation. But as an example, Company A with revenue of $100MM with 80% gross margins is very different from Company B with revenue of $100MM with 50% gross margins. Company A deserves higher valuation. 

A step further, Company C with revenue of $100MM with 80% gross margins and 80% annual retention rate is very different from Company D with revenue of $100MM, 80% gross margins and 50% annual retention rate. Company C deserves higher valuation as it likely has lower sales and marketing costs needed to replenish its churn. 

Bill Gurley wrote an article called "All Revenue is Not Created Equal: The Keys to the 10X Club", and I think it is worth a read in its entirety. He discusses the distinguishing factors between high quality revenue companies and low quality revenue companies. Some of the characteristics that warrant a higher revenue multiple, in his opinion, are:

• Visibility of revenue
• Defensible nature or sustainable competitive advantage
• Customer lock-in or high switching costs for customers
• Gross margins
• Scalability or marginal profitability 
• Organic demand versus high marketing spend

So when it comes to pricing for valuation, you want to ensure that you're not squeezing gross margins in order to obtain higher revenue or market share. That is, don't price so low that you're not making any money. Some startups think that once they dominate the market, they will be able to raise prices. That works in some cases (Opentable for example), but you really have to understand the elasticity of demand of your customers, as well as your competitive landscape.  If, in the process of gaining market share you also build up solid network effects, then you are more likely to succeed in raising prices later.

On the other hand, don't price so high that your customers can't afford the product in the long run, and you're constantly spending more on sales and marketing to replenish your customer base. It's a balance.  

In Part II of this blog post, I'll explore the other two tenets of this framework, Grow Your Customers and Signal Appropriately. As you'll see, growing your customer base can come in conflict with covering your costs. Keeping in perspective (i) maximizing valuation and (ii) signaling appropriately to both your customers and competitors, however, should help define your customer acquisition strategy in a cohesive way.