Pricing is Marketing: Understanding the Pricing Process for Web Apps

By Lincoln Murphy, Managing Director
Sixteen Ventures

“Quality in a product or service is not what the supplier puts in. It is what the customer gets out and is willing to pay for.” – Peter F. Drucker, Innovation and Entrepreneurship

SaaS and Web App companies often charge their customers based on usage in an ongoing or recurring fashion. This can be subscriptions, usage, credits, etc. and is generally their primary revenue stream. This is the typical “pay as you go” model everyone is familiar with.

It is recurring revenue that is primarily responsible for Software-as-a-Service or SaaS becoming so disruptive against legacy software companies and their outdated licensing and pricing models. The ability to pay for a product or service over time makes it more attractive to the customer and results in more predicable revenue for the company and their investors.

(Recurring Revenue is only one of seven different revenue streams available to SaaS & Web App vendors as identified by Sixteen Ventures – download the 7 SaaS Revenue Streams PDF for details on the other six).

To make recurring revenue work, what a SaaS or Web App company charges the end-customer must be aligned with the market position of the company as well as with the end-customer; how they buy and what they’ll pay. Unfortunately pricing is one of the least understood elements within a SaaS or Web App company. For startups with no time in the market, it is even more difficult to figure out since there is no historical transaction data to analyze.

One common non-market or non-value driven method for developing a price is the bottom-up method. Using this method a company will figure out their cost and try to apply a profit margin to come up with pricing. To illustrate why this isn’t ideal, consider the incredibly simplified idea of trying to get to a 35% net margin because you heard that is a good margin for a SaaS company.

If it costs you one dollar to acquire and support the customer and you add 35% to that, you’ll meet your margin goal. Now scale that up in your spreadsheet and you’re in business, right? No. You’re missing a big piece and here are a few scenarios to illustrate the point:

  1. You charge $1.35 for your service knowing you have a built-in 35% net margin and find that no one will buy your product. It turns out the market will only pay $0.85 for what you have to offer. And they don’t care that it costs you $1.00 to land a customer (Customer Acquisition Cost) and to support them. They will only pay $0.85. How do you deal with that knowing that your cost is $1.00?
  2. You charge $1.35 for your service knowing you have a built in 35% net margin and find that everyone buys your product. It turns out the market would have paid $5.00 for what you have to offer. Since you consulted your spreadsheet and not your market and potential customer base, you left a lot of money on the table and positioned your company as the low-price leader.  Many people think that you can just raise prices, but how does your self-created low-end market position affect your ability to do that?
  3. You charge $1.35 for your service knowing you have a built in 35% net margin and are in-line with how your competitors have priced their solution. But you find that no one will buy your product. In this case you consulted your spreadsheet and the competitors’ websites, but again, not your market and potential customer base. How will you deal with this misstep?

These scenarios can play out all day long. The lesson from all of those is to not only rely on spreadsheets, formulas, or competitive intelligence to come up with pricing. You need to know how your customers will buy, what they’ll pay, and how they’ll pay. If you don’t know those three things intimately, everything else, including your financial modeling is worthless.

Rule number one about pricing: it is marketing. Pricing is one of the 4 P’s that make up the traditional Marketing Mix, along with Product, Promotion, & Place (distribution). This means that your product or service pricing must be part of an overall pricing strategy, which must be part of an overall marketing plan. An effective pricing strategy must go beyond simple financial modeling and include distribution, sales methods, positioning, market segments, etc.

For a SaaS or Web App company that uses an automated sales process where marketing, e-commerce, and application functionality are tightly-coupled, getting your pricing right is even more important since there is not a sales person to negotiate, convince or otherwise defend your pricing. For those companies, the Pricing Page is something by which their company will live or die. To that end, we have recently introduced our Pricing Page Tune-Up™ service to help SaaS & Web App companies optimize the most important page on their marketing site.

The keys to increasing the effectiveness of a pricing strategy are to know and understand the following items before you develop it:

  • Your Pricing Strategy Goals – Market Position, Hyper Growth, something else?
  • Ensure Market Alignment – Know how they buy, what they’ll pay, and how they’ll pay
  • Market Segmentation – Do you have one-size-fits-all pricing, is that the right strategy?
  • Distribution – Will you sell direct or through channel partners or App stores?
  • Sales Model – Do you have a sales force or will you use an automated process?

After you’ve come up with those items and dive back into your spreadsheet to work on your financial model, keep the following in mind:

  1. Pricing is Marketing
  2. The market doesn’t care what profit margin you want to make only what they’ll pay
  3. Don’t copy 37Signals pricing page
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Lincoln Murphy (@lincolnmurphy on Twitter) is Managing Director of Sixteen Ventures, where he works with SaaS & Web App companies on Business Strategy, Revenue Modeling, Distribution and Pricing Strategy – including the new Pricing Page Tune-Up™ service.

Comments

  1. You’re saying that pricing your products is part of marketing, and shouldn’t just be derived from costs + desired profit per sale. I get that, and thats pretty obvious (to most entrepreneurs), and so I kind of lost you on the rest of this post.

    You end up pitching your product, but you fail to answer any real questions about what your framework is for getting to a better pricing model, and you also fail to establish any credibility around why you’d succeed at this. Most importantly, its not really clear what you’re even selling: are you going to talk to my customers? Do I get to talk to you (an actual person) or is this an automated wizard that gives me some generic recommendations? Do I get to probe you on your process?

    My overall feedback is that from so called “experts” in pricing, I expected some content here that was original — not stuff that comes out of most marketing books.

    I’d really encourage you to do a follow up post on how you go about analyzing a pricing page, common mistakes people make — instead of saying something like “Don’t copy 37Signals pricing page” — which I think is bad advice. Considering they’re one of the most successful SaaS providers in the space, I would think their page is the first page you’d want to start your experimentation on.

    I’m pretty passionate about this, because I think pricing is an integral part to any startup — I’ve even done a ton of research into this and tried to distill my own principles on how to go about defining my pricing tiers: http://www.tawheedkader.com/2010/03/principles-behind-a-freemium-pricing-model/.

    Looking forward to hearing some real substance next time.

  2. Well said, as always, and down to earth SaaS advice, especially for start-ups to consider. The quote from Drucker is a great one and timeless, we should engrave that on all our heads. It’s related to value=benefits – cost, which often people don’t understand, along with not understanding the difference between features, advantages, benefits and value.
    Walter Adamson @g2m
    http://xeesm.com/walter

  3. Tawheed, read your comment and your post at your blog. Disagreement adds to the value of the discussion. From your own blog you’ve given a prescription. What I see in Lincoln’s post IS more a method although you dispute that. The items outlined at the bottom of the post outline process steps which have to be gone through, in a workshop setting with a customer – he headlines 5 segments of that potential workshop, and the paragraph before reinforces the reasons. Perhaps your a much more savvy potential SaaS provider than we see but most don’t get those basics and need education, far be it training. That comes after they get the message, which you find obvious and I agree with you that when you understand it it is obvious and “Marketing 101″. How many times have you heard “Cloud 101″, but that’s where 90% of the market is. Re the reference to 37signals I take that as a teaser to get the participation going – personally I think that’s smart of Lincoln.

    Walter
    http://xeesm.com/walter

  4. Tawheed – First off, I can tell you’re passionate about this subject. I am too; that is why I wrote this piece for you and dedicate my entire business to helping SaaS & Web App companies with their Pricing and Revenue Modeling. To your point, this post is definitely just a start if Bob will have me back… After nearly 1000 words I thought it was a good place to go ahead and call it a post. I’ll add another 1000 or so here.

    I am trying to bring the message about Pricing to the startup community since it is obviously missing. And if that means I get to tell you about some services we offer, so be it.

    As Walter stated, I wrote this post because these things are clearly *not* obvious to many entrepreneurs. I’m happy to hear that you are so many streets ahead of everyone else, but there are still a lot of very intelligent folks out there who have built great products but really have no idea how to get started pricing them. So what they do is Google for answers, read blogs of startups that are trying to figure out pricing, look at people showing off pricing page designs or showing how the pricing pages have changed using the Internet Wayback Machine. Then, finally, they pull out a spreadsheet and start running numbers to get to some profit margin that will please investors or just their wife.

    I think this post is a great addition to all of the other work we’ve done at Sixteen Ventures. As we’ve seen lately, there are a lot of entrepreneurs posting about their journey through pricing and it tells me there is a huge demand for information on how to do it right. Unfortunately, many of the posts that I just cited add little value and in fact, send people down the wrong path.

    I did read yours and I would put your blanket statement about what “pricing tiers” everyone should have as one of those posts. It might work for you, but please don’t say it will work for everyone. In fact, I encourage anyone posting about their experiences to remind people not to copy their work without doing their own homework. This was the basis for the creation of our services aimed at helping startups. And the feedback has been wonderful.

    Again, Walter was right that there is a process listed in this article and I think it is far more powerful that it looks on the post. When you pull it out and start exploring those items, it can change the way you think about your business forever. But the other thing, the item that you called “bad advice” is “don’t copy 37Signals pricing page”. Why would I say that? To get people to pay attention. Its a gimmick; and it works.

    You see, we do a lot of pricing page analysis and I can assure you, most people don’t even go as far as to completely rip off the pricing page for Basecamp. If they did, they’d probably be better off than they are. But why I say that, other than to get readers to react, is unless you are building a horizontal collaboration product in the same market, and have the same market position as Basecamp, aside from that you just shouldn’t do, it makes zero sense. The Basecamp pricing page might work well for them, but you need to know what you want to happen and then design a page around your goals and your market. Taking their layout and drop shadows is one thing; I’m talking about using them to figure out your pricing strategy.

    Something I’ve written about a lot in the SaaS world but realize I’m talking to a new audience here is to your point of 37Signals being “one of the most successful SaaS companies.” Remember this, SaaS is not a market; its a business architecture, delivery method, business model. Whatever you want to call it, but its not a market. Collaboration, CRM, ERP – those are the analogs. The markets are Construction, Healthcare, Automotive. So, if you have a SaaS Automotive ERP and are competing against Plex, you should look at their pricing to know what the market expects; and then come up with your own. This is the problem when you think “they’re a SaaS company, I’ll just copy what they do.” It doesn’t work that way.That is what I mean by “don’t copy 37Signals.” Can this be argued against? I’d love to hear it.

    Finally, thanks for the feedback on “its not clear what I’m selling” – hearing that makes me eager to go back and see where we need to be more clear on our marketing. Thank you. I don’t want to go into it too much in case it looks like I’m pitching our services, but yes, we can help you with your pricing including talking to your customers, although it is usually best if you do that with our guidance. Our Pricing Page Tune-Up service is not automated and certainly does not spit out generic results. It is just our pricing page review service that we’ve done for many consulting clients in the course of a greater pricing strategy that we packaged up nicely in an affordable and scalable way and spun out of our consulting practice. We’re pretty transparent about the process so that you can easily fix the problems that we identify. Probe away.

    Thanks for reading!

    - Lincoln

  5. Lincoln,

    Excellent post. I like your idea of using an analytical framework (the five bullets you present late in the article) to make sure that no important considerations have been left out of the pricing discussion. The discussion itself can be a very useful exercise as it forces you to think of what sorts of customers you have (and want to get) and what sort of features you have (and want to have) to see if customers and features overlap.

    With respect Tawheed’s comment, I do think that adding some concrete examples of poor pricing would be really interesting and make a good follow-up post. On Tawheed’s post that he links to, though, I would have to say that what Tawheed says are principles are really specific pricing tiers that may or may not work for your specific business. The 7 SaaS revenue streams article linked from the post provides several different models besides the ones laid out in that post.

    Three concrete examples from two of the most successful web service companies and a newer service will illustrate the point. Hotmail’s (HoTMaiL when I signed up) web-based email application and Google’s web search both fit the SaaS model and are both pretty much entirely ad-based (though both have corporate versions that are not free). Google App Engine is another example where the cost is not tiered but based on usage. Dropbox has tiers but they are based on size and has an extra option if you want backups (the “Packrat” option) that you can add to either paid version.

    My point is that pricing of SaaS has a lot more successful options than simply the tiers laid out in Tawheed’s post. At the same time, the tier system Tawheed describes is a good model for many SaaS companies and he does describe the tiers and the reasons for them nicely in a concise blog post.

    On your marketing message, Taweed has a very good point, it is not at all clear what you get out of the pricing analysis. Further, for $99 or $149, I would expect the process would be almost completely automated – for me the pricing indicates that the amount of human interaction would need to be low given the low cost so I would think that the process would mostly be automated with maybe a custom report and some whitepapers thrown in. If you are trying to target companies where their management needs some education I would think that you would need discussions, meetings, follow-up meetings, maybe some market research, etc. and that means $149 is far too low.

    I’d actually be quite interested in a follow-up comment that was you pitching your services. From the blog post and comment (but not your site’s home page given, ironically, its pricing model) it seems like you know what you are doing and have a valuable service. I’d love to hear a pitch here that was customized.

    Thanks – Doug

  6. Doug – Thanks for your feedback. I am very happy with the passion that the commenters bring to this post. I will definitely come back with follow-on posts that break down the five points one-by-one and will certainly include some specific examples. I am also going to start blogging about the Pricing Page Tune-Up service in more detail on the Sixteen Ventures blog, going over each point and giving examples, as well.

    To your point, I’ve put together a “pitch” for the service over on the Sixteen Ventures blog. I didn’t think this was the right outlet for that. Hopefully it answers your concerns and even more, puts to rest your belief that it isn’t useful because its too cheap (or that we don’t know what we’re doing because of the low price point). You can see that post here: http://sixteenventures.com/blog/introducing-the-pricing-page-tune-up-service.html

    By the way, thank you for calling me out on the lack of information on our landing page and the services’ pricing. It certainly made me sit down and write the post that I linked to which should answer your questions. But your blind criticism of our service and its pricing is as unfounded as me taking a cursory look at Skritter and saying that since its only $9.99 a month it must be worthless. I don’t know your market. I don’t know how your customers buy, what they’ll pay, how they’ll pay; that is your job. A statement like the one you made just doesn’t seem fair, does it?

    Thanks again for reading.

    - Lincoln

  7. Lincoln,

    First, when I took another look at my pricing comment about your business it was unfairly harsh and I apologize for that; I was looking at it as a potential customer who has to set pricing and who might want help and you are correct, my criticism was rather blind. I was trying to say that it could appear that way to some not that it is. The post you referred to had some higher price points and I’m glad. A report with an analysis based on checklists and low-hanging fruit for $100-200 could be very valuable but it is clear from reading your post that this is only the start of the range of services you offer.

    I appreciate your follow-up comment and look forward to your future posts on this topic.

    Thanks – Doug

  8. Anne Gunn says:

    I actually just finished reading a rather nice, short eBook on this subject by Neil Davidson over at redgate (www.red-gate.com). The book can be read online for free or can be purchased:
    http://www.neildavidson.com/dontjustrollthedice.html

    Neil’s point of view is similar to the original post’s: pricing is important but just one part of your overall marketing strategy and you need to coordinate your price message with all your other messages. But he has time, in that format, to do some nice review of the basic principles (Pricing 101) and I particularly appreciated his many concrete examples of companies, including his own, who Got it Wrong in some particularly easy to recognize (in hindsight) way.

    The book’s a quick read, maybe 65 sparse pages of content, a two page summary checklist, a bibliography, and some advertising content at the end.

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