Shaping the Pricing Strategy for a SaaS Product

Startups can fund growth either by spending VC money or by the money they earn from their customers. A business can use a variety of pricing strategies when selling a product or service—and, according to Price Intelligently’s SaaS Pricing Strategy ebook, a good pricing strategy is twice as efficient than improving retention and four times as efficient as acquisition. Even though, out of every 10 blog posts on growth, 70% are focused on acquisition, 20% are centered on retention, and only 10% is about pricing.

With this article, you will become familiar with the basic unit economics of SaaS products and how those metrics shape a pricing strategy. You will also learn how to create quantifiable buyer personas based on the metrics—and how buyers can influence the positioning and packaging of your product.

Learning the Unit Economics of Pricing

Every price is a number—and it can be derived from other numbers. First of all, we need to understand the basic unit economics of good pricing. Doing so will help us understand whether we can calculate a proper price or we should follow a gut feeling.

While some companies prefer not to stress over pricing too much in the beginning—like Google when they decided to offer one price of $50 per employee per year in half an hour—I’m going to advocate a data-based approach.

Measuring Customer Acquisition Cost

Customer Acquisition Cost (CAC) is the cost associated in convincing a customer to buy a product or a service.

CAC = total cost of marketing and sales / # of customers acquired

In some cases, calculating CAC may not be straightforward as it depends on your definition of the “total cost” of marketing and sales. For example, measuring advertising spend is relatively simple—but should you also include the cost of the engineering team building the latest batch of new viral features? How do you track that on regular basis?

It’s always better to look at product and marketing as a whole and include that cost. Calculating the real cost of marketing-oriented engineering may be difficult, but I had some success with training engineering teams to estimate projects in terms of budgets instead of hours or story points.

If your estimate is that a project will take $10,000 instead of 10 story points, it’s much easier to include engineering projects in your CAC. (As a sidenote: budgeting estimates are also easier to prioritize. Making a choice is easy if you know that project A will cost $5,000 in order to bring a projected value of $6,000—and that project B will cost $7,000 but bring $10,000 in value.)

Measuring Lifetime Value

Lifetime Value (LTV) is a prediction of all the value a business will derive from its entire relationship with a customer. Long story short:

LTV = ARPU / churn rate

ARPU is Average Revenue Per User. Churn rate, when applied to a customer base, refers to the proportion of customers or subscribers who leave a supplier during a given time period—for example, in a single year.

The appropriate time period depends on the stability of your business. Older companies can safely track long-term churn. Startups will want to focus on short-term time periods like quarters or, sometimes, even weeks, depending on pace of execution and changes in strategy.

Measuring the LTV:CAC Ratio

To run a successful business, you need an LTV:CAC ratio of at least 3:1. That’s because sales and marketing aren’t the only expenses LTV has to cover in order for a company to function, and a LTV:CAC ratio of ~1:1 leaves no room to grow. And growth requires investments.

Ideally, we’d all aim for the highest possible ratios. But in the real world value is in the eye of the beholder—the customer. Products with great brands, like Apple or Nike, can force higher margins without reducing demand for their products. They can act like they have inelastic products. (Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.) Thanks to their brands, these companies aren’t selling bare items such as shoes or phones. Apple sells status; Nike sells you a better, healthier image of yourself. Self-confidence is worth much more than electronics or clothes alone.

Every company must figure out the right margins on its own based on its products, customers, and brand. In fact, branding is often touted as the new great startup competency and a predictor of future success. As VC capital becomes increasingly abundant, brand stories, which take more time and skill to develop than brute force acquisition methods, are getting more and more important. If you want to be like Apple or Nike, start with asking yourself: who do you want your customers to become? Here’s Nike’s answer, for example: “if you have a body, you’re an athlete.” The rest of their brand story reinforces their answer—you, too, can build on top of yours.

Qualifying Variances Across the Metrics

Metrics bring science to the art of marketing. Unfortunately, many early-stage companies only measure their average CAC and LTV. A macroscopic view may help in making high-level decisions, surely, but a low-level view on CAC and LTV will let you understand the overall picture, just as qualitative research aids quantitative research.

Let’s talk qualifying variances across the metrics. We’ll discuss two ways to do so:

1. tracking variances in metrics across channels
2. tracking variances in buyer personas

Tracking Variances Across Channels

In business, a channel is the pathway through which goods flow from producers to consumers. Since there can be many different paths for a customer to learn about a product, and each path can be more or less difficult to go through, it stands to reason that each channel can have its own CAC.

Channels dry out over time. Given two channels with comparable bandwidth of potential customers, a fresh channel can yield more new customers than the older channel simply because the marketing department might have already acquired most of the customers through the older channel.

When channels dry out and the average CAC goes up, companies can look for new sources of growth either by releasing new products or by finding new channels to sell their existing products. Early-stage startups usually have to do the latter as they’re simply not old or popular enough to run out of potential customers. Small companies often start with small and cheap channels which dry out quickly.

As a startup gets more traction, it can move up to bigger and more expensive channels thanks to first sales or VC funding. Traction, a book by by Gabriel Weinberg and Justin Mares, describes 19 different channels early-stage entrepreneurs can use, as well as a framework to help you replace underperforming channels with fresher ones in a lean, experimental manner.

But as new opportunities arise, big companies sometimes find new channels, too. In 1998, for example, Apple introduced an online store for their computers—a direct channel for customers all over the world. They’d sold more than a million dollars’ worth of computers in just six hours. “That’s great,” said Steve Jobs according to one of his biographies. “Imagine what we could do if we had real stores.” The first physical stores opened in Tysons Corner, Virginia, and Glendale, California, in May 2001. Back then, opening real stores wasn’t an obvious move—but in the end they turned out to be a great source of new revenue, persuading unconvinced customers to buy themselves a Mac.