Don’t Blindly Model Your SaaS Pricing on 37 signals

I talk with a lot of startups and many of them are B2B / SaaS startups. We also have a lot of B2B / SaaS companies who use our SEO platform to model their organic search traffic, discover missed opportunities and learn from their competitors. One of the topics that comes up invariably when discussing sales strategy is pricing.

Almost all of the time, the SaaS startups I speak with have very low price points (sub-$100/month for the majority of their plans with, perhaps, an “enterprise” plan that costs between $200-500 / month. When I ask the reason for such low pricing, I mostly get blank looks in return. I’ve realized that many startups are arbitrarily pricing their services based on what they think is “just the way you do things.” My theory is that 37signals (and maybe a few similar companies) is a big factor in this.

Understanding Your Model

37signals (now BaseCamp) is at least partly responsible for inspiring a generation of SaaS startups. They’ve shown that you can build quality products that focus on the core needs of customers willing to pay some fee and scale that business to something quite large. Everything from their pricing tables to their mantra of simplicity can be seen reflected (even on our own site) in the positioning of hundreds, if not thousands, of other startups.

The problem is when new startups blindly accept that the sales and pricing strategy 37signals uses is roughly appropriate for their own use. Pricing is hard but you can generally assume that you’re not charging enough for your product.

How do you know how to charge for your product? I have yet to see a better explanation than the one provided by Joel York, who runs the Chaotic Flow blog. He has a article on SaaS sales strategy and sums up the various strategies with this chart:

SaaS Pricing Strategy

As a startup, if you want to survive, you have to pick a model. Everybody starts off by thinking they are low on the complexity scale (“our product is simple!”) so they believe self-service is an efficient model for them. But complexity, in this discussion, has nothing to do with simplicity in the user experience (elusive in its own right) but the complexity of your user acquisition and total cost of service.

For the purposes of this discussion, it may be helpful to define some rough price points for web apps that fit into the three viable boxes. Keep in mind that these are totally arbitrary — they are useful only because they are common and easy to build cash flow models around (or discover where cash flow is going to be a problem).

  • Self-service: $10-$200 / month
  • Low-End Transactional: $200-$3,000 / month
  • High-End Transactional (“Enterprise”): $3,000-$6,000 / month
  • Enterprise: $6,000-$40,000+ / month

The Four Horsemen of SaaS

The four things that kill SaaS startups are: lack of sales and marketing investment, cost of customer acquisition, total cost of service, and churn. Two out of these four problems (cost of customer acquisition and total cost of service) can be partly balanced out by better cash flow. The way you get better cash flow in SaaS is in 1) by charging more and 2) by getting paid more, earlier (discussed below).

Low pricing works for 37signals because their customer acquisition costs are low and their reach is enormous. For starters, they have the entire Ruby on Rails project as a massive marketing engine. In this, they are pretty unique.

They have also said that it is part of their specific strategy to keep prices low in order to prevent any single customer from having too much influence over their products. This is obviously ideal from a product management perspective but is only realistic if you can acquire lots of customers for very little money.

If your startup is not able to leverage some platform to achieve similar reach (and there are many opportunities for this), then you already have one strike against you in the self-service model. Once you get a lead, if it takes even a single phone call to close them, you’re no longer doing self-service and Customer Acquisition Costs vs. Self-Service pricing is going to kill you. If you’re not doing that phone call and you’re also not closing those deals, you need to figure out of if you can solve the problem through conversion optimization or if you really do need to be speaking with customers in order to close them.

By now, if you are either a new entrepreneur or a somewhat green VC, you are totally grossed out. You don’t want to talk to customers on the phone to close deals. That doesn’t scale, right?

There are actually lots of SaaS companies that grow quickly because they talk to customers. Businesses, small and large, deal with complex problems every day. They are more than willing to spend a few hundred or thousand dollars a month of solving some of those problems, especially if it makes them money.

For all of these reasons and more, very few SaaS companies grow to a significant size in the self-service model. Joel York also discusses this on his blog.

SaaS Startup Evolution

SaaS startups tend to evolve from Self-Service into Transactional companies and, in many cases, into Enterprise companies. The reasons are numerous but it is largely a combination of realizing that you’ll die with too low of a price on customers that take money to acquire and the fact that companies are more than willing to spend a lot of money in order to get value out of something. It is critical that both entrepreneurs and investors understand this.

Consider Annual Pricing

Another thing to consider in your pricing strategy is if monthly revenue is really the best model for you. It works for 37signals because their customer acquisition / support costs are low and they have massive scale. But for many other SaaS companies, including most of the winners like Salesforce.com, Hubspot, and Marketo, annual pricing is a critical enabler of growth.

If you have to do any sales calls whatsoever, you’re eventually going to need to build a sales team in order to scale. That means, even if you raise a lot of VC money, your sales team is eventually going to need to pay for itself. So, take this example:

You charge $200 / month for your software. You hire a junior inside sales at a base salary of $45,000 / year. With overhead, you’re paying that person roughly $4,800 / month. In order to just break even on that rep (not even factoring commission at the moment), that rep needs to close 22 deals a month. And that is just to break even. (Edit: this is only talking about startup costs on ramping a new rep. Given that reps can take anywhere from 3-6 months to ramp, this number becomes really important, especially if you don’t raise money. Once they ramp, being able to close 22 deals a month at $200 a pop become very profitable. Thanks to facorreia on Hacker News for pointing this out.)

Now, instead of charging monthly you decide to charge annually and get paid up front. You’re now making $2,400 every time you close a deal. Now your rep only needs to close 2 deals a month in order to break even.

More companies are starting to realize this and I predict that we’ll see a lot more SaaS companies switch to annual billing in 2013. It’s one of those things you wish was taught more often.

It is Rude to Undercharge Your Customers

Another problem is that many entrepreneurs, especially those with an engineering background, tend to massively underestimate the value of the product they are creating. Your product, if it doesn’t help your customer make more money or deliver tangible value in some real way, will fail so, for the purposes of this discussion, let’s assume we’re talking about a valuable product. If it’s valuable, try to understand what that value means to your customer. Once you look at it this way, it’s easy to see that you’re probably not charging enough.

But the reason you want to charge more is not because you’re greedy. It’s because it is rude to undercharge your customers. Undercharging your customers leads to all sorts of problems. It leads to a degradation of your overall quality of service. It kills your motivation. It prevents you from growing and adding even more value. Get over the idea that you’re somehow taking advantage of your customer by charging for the value you’re providing. You’re creating the ability to serve them better.

Don’t Take Pricing Advice from Hacker News

Most entrepreneurs I know hang out on Hacker News. Hacker News is an amazing community but I often see comments from people who complain about high prices on software and services, somewhat like this one. Hacker News is comprised of lots of different people but there is a relatively large percentage of people who are either college students or entrepreneurs themselves. These two groups of people are very price sensitive, for obvious reasons. That’s fine — just don’t take their advice on pricing. They probably aren’t your target market and won’t have the perspective that your customers do on the value you’re providing.

Conclusion

These are things that wish somebody had told me two years ago when I was just starting out with Ginzametrics. Getting your sales strategy right early can literally save you months or years as you try to figure out how to grow your company. I’d love to hear from you if you have relevant comments or perspective.

Get updated information on the State of SaaS and SEO here.

Categories: Marketing.