Pricing a SaaS Offering for Sale to Large Enterprise
Inovia Growth Hacking Tip #613
Pricing a SaaS offering for large enterprise is more of an art than a science, at least in the early days when it isn’t yet clear how much money customers will be willing to pay. Pricing is probably second only to choosing a name for the company or product line, in terms of being both important and subjective. So, what is an entrepreneur to do when thinking about pricing? This article explores a number of factors that, while they cannot finalize an exact price, can at least help you home in on a constrained range within which pricing can be set.
It’s a long post, so here’s a map of the post to help you find the right sections to read.
Map of this Blog Post
- The wrong approach: “Please would you subscribe — it’s cheap”
- What must the price be in order for your business to be good
- What value does it bring to the customer
- What did it cost to modify the product for a customer
- What is the marginal cost of delivery
- Variable pricing to deal with different customer needs
- Base pricing plus layered options
- Basing pricing on direct competitors; how to consider indirect competitors
- Giving your product away to stop a customer buying from a competitor
- Asking the customer
- A word on desperate customers
The wrong approach: “Please would you subscribe — it’s cheap”
This approach is so common among technology-focused entrepreneurs that I am putting it at the top of the list. The wrong way to approach pricing is to say to yourself “Hmm, let’s make it so cheap that companies will be able to buy it without even giving it much thought.” It is tempting to follow this path though, because you might think that by making it cheap, you’ll avoid long sales cycles, and not have to develop a lot of sales skills that you (as a technology-focused company founder) maybe don’t yet have. But in reality, large companies don’t sign up because it’s cheap. They buy because the company solves an important problem for them. If your offering doesn’t do that, nobody will even spend enough time evaluating it long enough to worry about its cost. And conversely, if it does solve a valuable problem, pricing is likely to be the least of your problems in making a sale. Only in the situation where there are direct competitors with very similar product offerings, will price differentiation be an issue, in which case one might ask: Am I in the right business? It is difficult to make money in businesses where the product must be priced close to the cost of production of that product, which is what ends up happening where price is the only differentiator.
What must the price be in order for your business to be good?
Since the marginal delivery cost of most technology products (especially SaaS) is completely unrelated to the sales price, most high tech entrepreneurs have near-complete flexibility in selecting a price. However, let’s not forget that you’re running a business here, with real costs. One important method that all entrepreneurs should use to decide pricing is to ask what the pricing must look like for the business to look good. To get an idea what this means, look to Key Performance Indicators (KPI) for companies in similar industries, and include large public companies in the mix. Selling SaaS to enterprise? By all means, take a look at the SEC’s Form 10-K for the world’s most successful enterprise software companies such as Microsoft and Oracle, or SaaS companies such as Zendesk and Salesforce. In those 10-K forms, you’ll find ranges for the percentages of revenues spent on R&D, sales and marketing, support, general and administrative overhead, and so on.
You can apply these numbers to your own company too, to get an implied number toward which your own revenue must grow in order to have similar ratios. If you will spend $5m on sales and marketing, perhaps the implied revenue number in order for you to look “elite” among software companies is $15m. If your plan for the upcoming year sees you making 5 large sales, 10 medium sales, and 100 small ones, then perhaps the pricing needs to be: $1m each for the large sales, $0.5m each for the medium ones, and $50k each for the small ones.
Please note carefully: This kind of analysis says absolutely nothing about what a customer is willing to pay for your product. Your offerings may not be worth what this analysis says you need. But, if not, then you have still learned something useful from it — that you need to develop a more valuable product! Unfortunately, this applies to many companies, where heart and soul has been poured into development, but the resulting product simply isn’t valuable enough to support the personnel necessary to develop and improve it. Before putting in all that work, why not do this kind of analysis first, to see what value the product must have in order to be a good business. If you don’t get answers you like, change the product until you do, or change the business model so the money you can derive from the product properly supports the business. Then and only then, should you build it.
Summary of this approach: Analyze your costs and revenues against other companies’ KPIs, in order to derive the “necessary pricing” for the business. Use that, along with the other mechanisms in this post, to determine whether your product can support your business in the ways you will need, in order to get the market-respect you desire.
What value does it bring to the customer?
This method of pricing is perhaps the most difficult to quantify, for two reasons. First, it involves a little bit of mind-reading — figuring out what someone else wants, and how badly they want it. This is never easy, but to make matters worse, it’s not as if all of your customers will value the product or service the same way. To some, it might have huge value. To others, almost none. And as a further complicating factor, many technically-oriented entrepreneurs tend to undervalue their own (or their company’s) expertise. This makes them wonder if the product can have much value at all to any customer, because it’s so simple — I built the basic guts of it in a weekend.
Still, it’s worth remembering that a scalable product is one that is offered without much modification to many customers. So the challenge is to find the sweet spot of pricing that allows many purchasers to see and feel the value proposition, and therefore commit to writing a check. In order to find that point, look to a representative group of potential customers, and evaluate their alternatives — what will they do if they don’t purchase your product.
It might be very tempting to think that the customer, if she doesn’t purchase your product, will purchase something similar from one of your competitors. However, this line of thinking ignores the most potent, most powerful, and most frequently occurring competitor of all — the status quo. Yes, the place to begin thinking about alternatives to your own product is to analyze what happens if the customer buys no product whatsoever, and instead simply continues what she is doing today. Sure, your product might be a great leap forward, but the customer is already making money doing what they are doing now, without your product. Could you save her some money? Perhaps, but to her, there is always the risk (both to her company and to her career) of something going wrong during the rollout of your product, or worse, once your product is integrated into the customer’s own revenue chain.
Truly, it’s not easy for a career-minded manager to take a risk on a startup product, unless that manager (or the company) is desperate. It’s worth thinking about that for a moment — non-desperate prospects are much more likely to stick with the status quo than to stick their necks out on something new. So, to be successful as a startup, one must seek out desperate prospects, for they are the ones who will ultimately become customers. The non-desperate ones will wait until one of their major current suppliers (Cisco, Microsoft, Oracle, and so on) cobble together (or acquire) a similar offering, in order to avoid the risk of failure.
Although that might sound depressing, there is a silver lining to that cloud. Desperate customers are willing to pay high prices for solutions, because … well … they’re desperate. Perhaps they are encountering some new government regulation (those are great sources of desperation), or are losing ground to one of their competitors, or are finding that their own market is shrinking, therefore they need to enter a new one. Whatever the reason, if they are desperate, they are good prospects for startup companies, and we need to keep the price high for them, or else we’ll not bring in enough revenue to keep our own doors open. And, to the desperate customers, that line of reasoning can be used, if one is asked why prices are so high. “Ah, yes, well, if we didn’t charge that much, we wouldn’t be able to operate our own business within the norms of our category competitors, so these prices are necessary in order for us to continue offering you great service.”
What did it cost to modify the product for a customer?
A few times in my career, there have been key customers that I have been desperate to close, especially in the early days of bringing a product to market, where customer success stories are few and far between. But frequently, these customers require some kind of customization in order to widely deploy the software. Sure, ultimately, your software will be feature-rich enough and flexible enough to accommodate most such requests. But in the early days, when the stuff barely works, it’s going to need customization. So, how much to charge for that?
Generally speaking, your customization efforts should be a profit center, not a cost center, and should provide reasonable margins to your business. If they don’t, your revenue number might well be high, but your business model will suffer due to excess expenses. Any business model extrapolations from data collected in these early months and years will show a poor or marginal business — one unlikely to obtain financing. But if the customization can be viewed as a profitable consulting revenue stream, that helps rather than hurts the business model. Even though the argument can be made that ultimately, this consulting revenue might need to be spun out or sold off to a systems integrator, a profit center will be viewed as easily saleable.
So, if it will cost you $100k in R&D costs to customize something, perhaps you should aim to charge $200k or (better yet) $300k for it. And, if that sounds like a lot, remember that your customer is likely a large corporation with huge overheads associated with every project. The customer is probably used to receiving bids from companies such as IBM and Oracle for customization. Trust me, whatever you decide to charge, it will be less than what those companies regularly propose. My point here is that if you can make customizations pay for themselves and also subsidize regular development, you’ve done a good thing. And for desperate customers, this is very often doable. And for non-desperate customers — well, those are very difficult for a young startup to close anyway. So, assume desperation, and go for it!
What is the marginal cost of delivery?
It always costs some amount of money to deliver a product or service to a customer. Whether it is the cost of operating a web site, the cost of delivering training needed for the customer to obtain value from the product, or the cost of installation and setup, there are always costs. In order to be a good business, the price of the product being sold must at the very least cover the costs of manufacturing and delivering that product, so it behooves any founder or CEO to understand those costs. But of course, the “revenue engine” also has to cover development costs, support costs, sales and marketing costs, management overheads, rent, taxes, and all other expenses. Eventually, once the company is mature, the sale of its products will need to also provide a profit, though this is hard when all inbound monies are being redirected into high growth.
In general, understanding how the entire costs of the business can be amortized across every sale, helps to provide a baseline price at which that sale makes sense. Sell for less than the marginal cost of delivery, and it doesn’t matter how large you grow, it will never be a profitable business. Sell for close to those marginal costs, and it takes a lot of future growth to reach profitability. Best, of course, is to sell for much more than the marginal cost of delivery, so that profitability can be reached quickly, with only modest growth.
Variable pricing to deal with different customer needs
Our product might be worth $1k per seat to one customer, and $10k per seat to another. What a shame it would be to leave any of that money on the table when making sales. So it becomes necessary to have different prices for different customers. Sometimes it is as easy as tiering the features, having “light”, “regular”, and “power” versions of the product. But other times, even the exact same functionality brings hugely different value to different customers.
Discounting is commonly used to bridge the gap between a high price and a low provided-value. But since one must assume that customers do talk to each other about pricing, there should always be some kind of defensible justification for substantial discounts offered to one company but not another. Such justifications include:
- Strategic value
- Early commitment
- Being “beta testers”
- Displacing a direct competitor
- “Change in policy — we would not offer that pricing today”
- Opening a new vertical industry segment
- Offering to be a reference customer
- Being subject of a case study
Ultimately, what is important is to find, with each customer, the point at which the greatest ongoing revenue stream can be obtained, while still providing that customer with good value.
Base pricing plus layered options
As mentioned earlier, sometimes a product has vastly different value to different customers, even on a per-unit or per-seat basis. But for the customers who really derive significant value from the product, it is imperative to obtain some of that value from them in the form of license payments or subscription fees. It may be that 80% of customers could not justify more than $250/mo for the product, but the 20% of customers in the “sweet spot” might justify $1000/mo. Following this math through, for every 100 customers, 80 at $250 each would provide $20,000, while 20 at $1000 each would provide $20,000. True, the 20% provide half the revenue, but we certainly wouldn’t want to leave the other half on the table by only offering a product at $1000/mo. Similarly, if we sold to all 100 customers at only $250/mo each, we’d get $25,000 instead of the $40,000 available — leaving too much money on the table.
Having a layered pricing model means everyone can get use from the product at a basic pricing level, but the power users can get what they really need through separately-priced optional add-ons. It is tricky to get these layered pricing levels right, because nobody will sit down and tell you “oh, if you price this way, 80% will buy the basic features, and 20% will buy the fully loaded package at four times the price.” Instead, people will say “Well, what do you think you should price at?” My advice is as follows: Look to competitors, look to the current status quo, look to other (even dissimilar) SaaS offerings that your customers are subscribing to. Use all of these as pricing sources, then use trial and error with your own customers to find what works.
Basing pricing on direct competitors
If you are lucky (or unlucky) enough to have competitors producing very similar products to yours (these are direct competitors), then customers are likely to select based on price, or at least, based on a preconceived notion of what “the right price” is. If you are charging double what your competitors are, that’s fine if you can justify it, but if you cannot provide good reasons, the sale will not go to you. If you don’t like the pricing of your competitors, it is only the differentiators that are important to your customers that can help you reset the price point higher. For example, if your product is “better” because it runs twice as fast, but the customer doesn’t perceive the competitor’s product as slow, the customer will not pay more for your speed. Customers don’t buy the best product, they buy the one that meets their needs at the lowest cost, even if it is ugly or inelegant. Misunderstanding this motivation trips up many technology-focused entrepreneurs.
What about indirect competitors
Oh, how many times have I heard an entrepreneur say “We are the first and only XYZ in the market”, as if that were a good justification for whatever price they wish to charge for their product. What many entrepreneurs miss, is that all of their potential customers are currently managing very well without using their XYZ product at all. In other words, even in a market without a direct competitor, the customers have a process in place today that is letting them be successful at making money. If they didn’t have, they wouldn’t be good customers, because they wouldn’t have any money with which to buy products. So, usually, by far the most formidable competitor against any new product is the Status Quo — whatever the customer is doing now instead of using the product.
Once one has an understanding of this basic point, the question can be asked: What does it cost the customer to do whatever they do now instead of using my product? And that, essentially, is the value of the new product. If it is priced higher than the cost of the status quo, it will not be perceived as having a good value. And if priced lower, it will be perceived as maybe having a good value, if everything about it can be trusted. So understanding the costs and risks associated with the status quo turns out to be very important, especially for “first and only” products.
Of course, your new product might bring goodness to the customer over and above whatever the customer is doing now. For example, it may not only save money or time, but it may also open new opportunities for the customer. As valid as these additions are, it turns out to be difficult to educate customers on how they can change the nature of their business. In no small part, it is because of this simple fact: While we, as technologists, understand the technology better than any customer, they, as business operators, understand their businesses better than any technology supplier. We may try to educate them, but they have many long years of experience that acts as inertia against such change. Best to focus on saving them money, something they will always be open to.
Giving it away to stop a customer buying from a competitor
No entrepreneur likes to hear that a prospective customer has decided not to buy. But even worse, is hearing that the prospect has decided to buy from a competitor. It is worse because while losing a sale weakens the entrepreneur’s company, losing it to a competitor also strengthens the competitor. I always encourage entrepreneurs to make sure that no customer ever buys from a direct competitor, even if the entrepreneur needs to literally give away the product to prevent the competitor from closing a sale. Give away? Yes, though it doesn’t need to be permanent. Imagine saying something like: “Oh, you’ve decided to buy from our competitor. I’m very sorry to hear about that conclusion, but rather than doing that, perhaps you can use our product for free for the next year (or whatever timeframe makes sense), in order to get a better perspective on it.”
What has this got to do with pricing? Sometimes it isn’t clear what the product pricing has to be in order to close the sale. But once a customer has gone over to a competitor’s product, it’s really hard to undo that inertia and win them back again. Better to prevent the competitor from becoming stronger, even if your own company doesn’t make any money. You can always mess with the pricing, features, and so on, in the future, and once the customer is yours, you won’t have to work hard to “win them back”.
Ask the customer
Sometimes, it’s simply really really difficult to price a product. In some cases, especially with the first few customers, a good approach is simply to ask the customer what it should be priced at in order to be a good value. Of course, this depends on your customer contact being a decent person, but I have found over the years that most customers at large corporations are quite decent. It may be helpful to remember that only a part of the risk that your customer is making revolves around price. The larger portion of the risk revolves around the customer selecting a product that later turns out to be unavailable due to the failure of a startup. Believe it or not, most customers at large corporations would rather pay you more money up front, ensuring your ongoing survival during their tenure at the company, and reducing their career risk. Would they like to get “something for nothing”? Sure. But not if it increases their future career risk.
Finally, a word on desperation
The only customers who are likely to take the risk of integrating your product into their company’s critical path operations is if they are desperate. Non-desperate customers are far more likely to simply wait for a larger provider to make a similar product available. Why is this important? Because if the customer is desperate, the customer will tolerate a much higher price than one that isn’t desperate. And since the only ones you’ll likely sell to in the early days are the desperate ones, or the ones who view new technology as a “hobby” or “special interest” of the company, likely the price they will tolerate is higher than you otherwise might think. The moral of the story is: don’t be afraid to ask a high price, since the only customers likely to buy from you at all are desperate enough to pay it.
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