Chapter 16: Pricing

When you have to prove the value of your ideas by persuading other people to pay for them, it clears out an awful lot of woolly thinking.

Tim O’Reilly, Founder of O’Reilly Media

Pricing isn’t easy, but it doesn’t have to be complicated either. You don’t want to scare away potential customers by charging too much, but if you charge too little and leave money on the table, you’ll have fewer resources to put toward improving your appli- cation. How do you decide how much to charge? There are a few schools of thought and a handful of factors to consider.

Charge Money

Revenue is how businesses stay alive. So first and foremost, charge money. Many people will tolerate a sub-par product if they don’t have to pay for it. But once people have to start paying for a product, their standards rise dramatically. From what I’ve seen around the web, products with a free plan generally see 1–3 percent of their customers choosing a paid plan. Charging money helps you discover if people truly value your product.

I had originally planned to open-source Sifter. When Keith first suggested that I create a business out of it, I unequivocally dismissed the idea — I thought that making it a business would be a lot more work with a lot more risk. But I can say in hindsight that if I hadn’t created a business out of it, Sifter would undoubtedly be a shadow of its current self — it probably wouldn’t even exist. Charging money isn’t about being greedy; it allows you to spend time on your idea. As Walt Disney once said, “We don’t make movies to make money; we make money to make more movies.”

Be Wary of “Free” and “Unlimited”

The words “free” and “unlimited” should scare you. They may sound nice on the surface, but they can set unrealistic expectations. If you use these words anyway, you need to be cautious — and you should ask yourself whether you might regret that decision down the road. For instance, touting “unlimited” file storage with your most expensive plan could lead to a difficult conversation if you were to have a customer who took that literally. I’m not saying that you should never use these words — although that’s just about what I’m saying — but if you were to use them, you should stop for a moment to make sure that you mean it.

Cover Your Costs

With hosted web applications, there are quite a few nearly invisible costs that you need to factor in to your pricing. If you charge $29 a month, you’re not going to see $29 in your bank account. You’re going to see what’s left after you pay for your credit card fees, hosting, file storage, email, and other infrastructure costs. Selling software for a loss or low margin won’t scale.

Thankfully, with hosted software, your costs are usually cheap enough that most of your price points will make money. But if you’re thinking about offering any plans less than $10 a month, your margins will likely be so thin that you’ll do little better than break even once you factor in customer acquisition costs. That’s not to say that you shouldn’t offer less expensive plans, but don’t expect a bevy of sub-$10 plans to get your bootstrapped business off the ground.

Pricing Structure

In conjunction with choosing how much to charge, you’ll also want to think about how to charge; that is, do you charge for features, resources, value, seats — or something else entirely? How many plans do you want to offer? Do you want to charge monthly, annually, or offer both? Since we’re focusing on web applications, we’ll assume that you’ll be charging a reoccurring fee; the following discussion relies on that assumption.

A product’s value is one of the best ways to determine its price. For instance, if your product were to save a business $50,000 a month, you’d be selling yourself short if you were to only charge $15 a month. That’s not to say that you should try to charge $10,000 a month, but you want to make sure that your pricing stems from the value that you provide.

Many companies base their pricing on seats or users. This can be a good approach if your product offers equivalent or consistent value for each user; it’s profitable and ensures that your revenue grows with your customers’ usage. But it can also implicitly become a participation tax; if your so ware is designed to help people collaborate, companies would have to pay more as they increase the number of participants.

Alternatively, you could base your pricing on a limited resource. For instance, Sifter’s pricing hinges on the number of projects that an account has. When our customers have more projects, that brings with it more profit and more team members—and they receive more value from Sifter. In addition to limiting projects, we also limit file storage. As long as your pricing scales with your costs, you can be confident that you won’t be in a situation where you’re losing money.

In some cases, you can implicitly create seat-based pricing by limiting the number of user accounts or the types of user accounts. For instance, if you were to have a help desk, you could allow unlimited user accounts but only allow a certain number of support staff. The catch with these types of limits is that it can sometimes be a little frustrating for your customers when they add that one additional person to their team and find that they’ve been bumped into your next pricing tier.

Another option to limit is features. For instance, you might allow only certain pricing levels to have file uploads or email integration. This can help increase upgrades, but it can also be tricky to choose the right balance of features. If you limit access to a feature that your customers perceive as core or baseline functionality, you might be inadvertently turning away customers.

You also need to figure out how your plans or tiers are structured. Tiers are useful because they help cover your customer’s varying budgets. For instance, if you were to offer only one plan at $50 a month, but if there were to be a handful of customers who were willing to pay $100 a month, you’d be losing out on potential revenue. Similarly, if you were to have some customers who could only a ord $25 a month, they wouldn’t be able to afford your application at all. By offering tiers, you can help ensure that you’re maximizing your revenue. But you don’t want to get carried away—if you offer too many options, you might overwhelm potential customers and they might not buy anything at all.

Know That Change Is Okay (If You Grandfather Your Customers)

If you do all this and still make a mistake, don’t worry—changing your pricing isn’t the end of the world. It may not be ideal, but it can be done and plenty of businesses have done it. You shouldn’t adjust your prices too often, but don’t be afraid to admit that you don’t know how much to charge. You can always change your pricing later. Changing the price is one thing—changing how you price is a different story.

I can’t stress this enough: if you change your prices, you should grandfather in your existing customers unless doing so would put you out of business. If you don’t, you may find yourself facing a painful distraction. You’re better off honoring your customers’ current pricing than squeezing a few extra dollars out of them. More importantly, they deserve it.

Starting out with higher prices may seem scary—because that could scare away potential customers—but just remember that it’s always easier to lower prices than to raise them. That said, you shouldn’t be afraid of raising prices if you need to.

Anecdote: Removing the $14 Plan from Sifter

Some time after our launch, I realized that our $14 plan wasn’t practical for the level of service that I had wanted to provide. I can’t speak for other apps, but the majority of our communication with a customer usually happens in their first month. Whether feature requests or questions about how things work, it takes time to answer these emails. We saw the highest turnover with our $14 plan, and with its low price, the lifetime value of those customers was significantly lower. (Figure 2.17) Moreover, the customer growth on our $14 plan had slowed significantly compared to our other plans. So we decided to focus on our more expensive plans.

Figure 2.17: Given our customer churn and the plan’s lower price, the average lifetime value of our $14 plan was significantly lower than our other plans.

What effect did this have on our bottom line? Our visitor-to-trial conversion rate immediately dropped—that is, fewer people were signing up for free trials. But the number of customers signing up for our $29 plan skyrocketed. (Figure 2.18) Our original theory was that this would be a break-even decision—that half of the people who would have signed up for our $14 plan wouldn’t sign up at all, and the other half would sign up for the $29 plan. (So that for each potential customer that we would lose, we’d gain one who would bring in twice the revenue, covering the difference of the lost customer.) But by gaining so many more customers on the $29 plan, we actually came out ahead.

Figure 2.18: Removing our $14 plan ended up being a boon to our overall revenue and didn’t hurt our growth in the slightest.

Related Reading

Doubling SaaS Revenue by Changing the Pricing Model — Patrick McKenzie provides a great real world example of how adjusting your pricing structure can have dramatic impacts on revenue. There are some gems in the comments too.

Continue to Chapter 17: Billing & Payment Processing

This is a chapter from the first edition of Starting + Sustaining, a book about bootstrapping a successful hosted web application business. The second edition, a massive update, will be out in Spring of 2017. You can subscribe here to be notified when it launches.