4 Common Mistakes with SaaS Pricing: How to Avoid These Costly Errors
Source: Pexels
Introduction - Why is choosing the right SaaS pricing strategy important?
Many SaaS companies make common pricing mistakes that can be costly. In this article, we will discuss four of the most common SaaS pricing mistakes and how to avoid them. These mistakes can have a significant impact on your bottom line, so it is important to understand them and take corrective action. Let's get started!
SaaS Pricing Mistake #1 - Arbitrary or Gut Instinct Pricing
SaaS Pricing Strategy Mistake Summary
The first common SaaS pricing mistake SaaS companies make is setting their SaaS pricing arbitrarily, based on their gut instinct. This can be a tempting SaaS pricing strategy, with pros and cons as it's relatively quick and easy to do, relying on information perspectives that they already have, rather than actual data they've worked to collect and analyze. However, as SaaS and subscription metrics company ProfitWell notes, basing your SaaS pricing on the "sounds about right" approach leaves potential revenue on the table. By leveraging actual data and metrics, you can focus your time and resources on the customers most likely to pay for your SaaS product or service (aka your ideal customer), and set your SaaS pricing closer to what your ideal customer is willing to pay for your SaaS product or service.
Also, according to one Harvard Business Review (HBR) article on When It's Safe to Rely on Intuition (and When It's Not), "the types of problems that do not benefit from intuition are ones that have clear decision rules, objective criteria, and abundant data with which to perform an analysis," such as how to price your SaaS offering.
Additionally, by factoring in your target financial metrics, such as desired gross margin, operating margin, EBITDA margin, net margin, and cash available for owner distributions in your pricing model decisions for your SaaS company, you can ensure that you're pricing your SaaS product or service at a level that is sustainable for you and your SaaS company in the long run.
Further, by ensuring that your price point isn't set too low for your SaaS company, you can provide a better customer experience for your customers. Customers may be resistant to price increases if you need to increase your price point to achieve the right pricing in the future, so setting a price point that is sustainable for you and your SaaS company from the start will prevent the likelihood that you will need to increase your price in the future just to sustain your business.
Source: Pexels
SaaS Pricing Mistake #2 - Pricing Solely Based on Your Costs and Desired Margins - AKA Cost-Plus Pricing
SaaS Pricing Strategy Mistake Summary
The second common mistake SaaS companies make is pricing their offering with cost-plus pricing. Cost-plus pricing, or pricing your SaaS product or service solely based on your costs and desired margins. While it's important to factor in your costs and desired margins when setting the pricing structure for your SaaS product or service, this pricing strategy ignores the customer willingness to pay for different buyer personas.
As a result, you may be leaving money on the table with cost-plus pricing by setting your price too high or too low for your SaaS offering.
SaaS Pricing Mistake #3 - Using Competitor Based Pricing to Set Your Price
SaaS Pricing Strategy Mistake Summary
The third common mistake SaaS companies make is using competitor based SaaS pricing. This may initially seem like a reasonable approach, and it's important to have a sense of what other SaaS companies are charging in your industry, as it can give you a sense of what the market might bear for your SaaS offering, based on an external sense of what customers pay your competitors.
However, relying solely on this pricing strategy prevents you from pricing your SaaS offering based on the unique value of your SaaS offering to your potential customers.
It can also make your SaaS company a copycat price taker and preclude you from having the opportunity to truly differentiate yourself relative to your competitors. Besides how do you know for sure that other SaaS companies in your industry have the right SaaS pricing model?
SaaS Pricing Mistake #4 - Setting your SaaS Price Based on the Perceived Monetary Value to Your Customers
SaaS Pricing Strategy Mistake Summary
The fourth common mistake that many SaaS companies make is pricing their SaaS offering based on the amount of monetary value they believe their SaaS offering could earn their customers (via increased sales) or save their customers (via decreased costs). This may seem like a reasonable pricing strategy, because it ties your pricing to a tangible benefit your customers may receive. However, it can be challenging to determine the exact monetary value your customers will gain from your SaaS offering.
Further, even if you are able to determine the monetary value of your SaaS offering for different customers, for example that you save them $100,000 per year, how much of that value can you reasonably expect to capture from your customers via pricing? Whether your SaaS business charges 10% or 30% of the value provided to your customers is arbitrary. This approach also does not take into account the budget constraints of your customers. Say you decide charge your customers 20% of the $100,000 of value your SaaS offering saves them each year, or $20,000. If your customer has only budgeted $10,000 to spend on cost saving solutions during the year, your offering will be excluded from consideration by being outside of their budget.
Source: Pexels
SaaS Pricing Solution - Set your SaaS Pricing Based on the Willingess to Pay of Your Customers
Our suggested approach to pricing your SaaS offering is to price it based on the willingness to pay (WTP) of your customers. This means that you'll want to research what different buyer personas are willing to pay for your SaaS offering, and price it accordingly.
As one HBR article notes, "by estimating WTP and working backward to determine price, [SaaS companies] can confidently maximize profit margin while capturing as much value as possible from [their customers]."
Below are four methods the HBR article presents that SaaS companies can use to determine the WTP of their customers when developing their pricing plans. Where applicable, we've also included examples of companies offering these various methods as services, or commentary on these methods based on our experiences working with business customers.
Method #1 - Surveys and Focus Groups
One way to determine the WTP of your customers is by conducting customer surveys or interviews with potential customers in your target market, to gauge their willingness to pay. Surveys tend to be more affordable than focus groups and generally provide more quantifiable data, while focus groups generally provide more qualitative information unique to the individual participants.
As with much in life and business, what you get out of customer surveys and focus groups depends on what you put into them. It's important to ensure that you're asking questions that encourage customers to respond truthfully. It's also important to survey a statistically significant number of users. Following both these guidelines will increase your likelihood of obtaining useful customer data that you can use when setting your pricing.
One service offering customer surveys that could help companies get the customer data you need to optimize your pricing is qualtrics. You can learn more about their pricing research software solution here.
Method #2 - Conjoint Analysis
Conjoint analysis is a specific type of customer survey where customer respondents are asked to rank different groups of features. The customer responses are then used to assign numerical values to each feature, revealing customer preferences. Using this customer preference data can help you determine which features to prioritize and include in your offering and then set pricing for a given set of features.
One service that specializes in conjoint analysis for companies is Conjointly. You can learn more about their conjoint analysis capabilities here.
Method #3 - Auctions
Auctions can be an effective technique for determining the WTP of potential buyers or investors in your SaaS business, because they link the act of disclosing customer preferences for a given offering with the likelihood of obtaining it by creating a sense of competition. However, there are inherent challenges we'll discuss below that may prohibit this approach as being an effective method to determine the WTP of your customers.
There are several different auction types that can help you determine the WTP of your customers. The HBR article presents some of the most common:
Open outcry auction (English auction)
In an open-outcry auction, a pool of prospective buyers makes progressively higher bids. The consumer who bids the most typically wins by bidding (and therefore paying) an amount that is just above what the consumer who offers the second-highest willingness to pay spends.
Sealed-bid second-price auction (Vickrey auction)
In a sealed-bid second-price auction (Vickrey auction), a group of prospective purchasers submits sealed bids. The individual who offers the highest bid wins the bidding, but he or she must pay the second-highest bid. Bidders are encouraged to submit an exact willingness to pay in order to optimize their chances of winning while minimizing the risk of overpaying.
Sealed first-price auction
Bidding is similar to Vickrey auctions, with the exception that the highest bidder pays the price they bid (as opposed to the second-highest bid). Bidders frequently submit lower bids than their exact willingness to pay in this sort of auction in order to acquire value if they win.
Real-World example - Investment Banker M&A Sale of Business Process
Source: Masha Ray
Our Founder and CEO, Brian Zapf, spent the better part of a decade working as an investment banker and corporate development professional, advising and executing on the buying and selling of companies.
As part of this work, he led and participated in auction processes designed to determine the maximum price that a buyer would be willing to pay to own a given business. These auctions were confidential, meaning that the bidders did not know who the other bidders were or how much the other bidders had offered, but they were aware that other companies were bidding and they structured the pricing and terms of their offer accordingly.
After completing several of these auctions with several different companies, both SaaS and not SaaS, the effectiveness of the auction strategy at maximizing pricing and optimizing terms was proven. It was common to see purchase pricing increases of 20-50% above the initial bids over the course of the auction process.
Some challenges with using auctions to set your SaaS pricing for customers is that in a SaaS business, where recurring revenue is a key driver of your value, you want to have a steady stream of new customers signing up at consistent pricing as this makes it easier to forecast and also derive usable information from key SaaS metrics like ARR and MRR. The uncertainty of the auction process for customers can delay new customer sign-ups. The auction process also adds uncertainty around average revenue per user (ARPU) / average user pricing, making forecasting more challenging. As such, unless you are able to batch your customers into cohorts of limited sizes and they have strong incentive to compete with other potential customers to sign up for your service in that cohort, rather than find an alternative SaaS provider, auctions likely are not the best method to determine the WTP of your customers.
Method #4 - Experiments and Revealed Preference
It's becoming easier to gauge the genuine willingness of customers to pay based on their prior choices. This is known as revealed preference because the information is derived from what the customer does, rather than what they claim. The difficulty with this technique is that missing variables might muddy the interpretation of data.
Running studies to determine the willingness to pay of SaaS customers is one approach to avoid this problem. For example, you could change your pricing to see how sales are affected. You may minimize the danger of confounding variables by randomizing which customer groups are offered which pricing (A/B testing) and using control groups (such as existing customers for whom pricing remains constant over the duration of the experiment).
Conclusion
Now that you are familiar with these 4 common pricing mistakes that SaaS companies make (arbitrary pricing, cost plus pricing, competitor based pricing, and monetary value based pricing), hopefully you can avoid them.
Pricing is one of the most important aspects of success for any business, and one that many SaaS companies often overlook. By understanding these common mistakes and taking corrective action, you can ensure that you are setting the right pricing for your service. After all, the best SaaS pricing is pricing that optimizes your revenue and profitability relative to the value and set of features you are delivering to your customers.
If you would like to potentially improve your pricing approach, Flight Financial can help! Schedule a free 25-minute call with a SaaS financial expert here.