You’re pricing your SaaS product all wrong

Over the past couple of years, I’ve polled dozens of startup executives about how they approach pricing and monetization for their SaaS products. One of the questions I ask is, “How did you come up with your pricing?” Given how data-driven the executives tend to be about other aspects of their businesses, I initially expected their answers would be thoughtful and backed by evidence. Here’s what I heard instead.

The first response: gut-based pricing. The founders got in a room, brainstormed for a couple of hours, and made a gut decision on pricing. While that’s not an ideal process, I could certainly sympathize with how busy the founders were and how they probably had never gone through a pricing exercise previously.

The second response: competitor-based pricing. The founders looked at what other companies were doing, copied the model, and charged slightly less. They figured competitor-driven pricing would help them get initial traction and then they could always optimize pricing later. That came off as short-sighted to me. It would naturally draw the business into unwanted comparisons against said competitor and could push the (larger, better-funded) competitor to fight back on price, escalating into a profit-draining price war.

The third response: cost-plus pricing. The finance guy calculated what the costs would likely be (acquisition and ongoing costs), added room for an attractive margin, and left things at that. While I liked that approach a bit more and certainly appreciated the thorough documentation of costs that went into the decision, it seemed to me like the cart was leading the horse.

These anecdotes aren’t one-off aberrations. They reflect how the majority of startups come up with their pricing, and I have new evidence to back that up. In a survey my firm conducted of 1,000 SaaS companies, we found that most companies procrastinate on pricing and make decisions without the right data or the proper grasp of customer value. The result is a systematic failure to fully monetize SaaS products and capture the value of new innovations.

Only 14 percent of SaaS companies considered pricing before building their products, with the rest incorporating pricing later in the development process or only once the product was ready to go live. Building products without considering pricing wastes precious engineering time and resources on features that buyers don’t care about. It results in having a product that a company then has to find a market for, rather than launching already knowing there’s product-market fit.

A measly 7 percent of SaaS companies have conducted in-depth pricing research. This type of research helps quantify the value, willingness-to-pay, and price sensitivity of target buyers. Without that information on hand, a company is flying blind with its pricing.

The consequence of procrastination and gut-based decisions: Pricing doesn’t work for customers. A miniscule 6 percent of SaaS companies say their pricing model aligns perfectly with the value their product delivers. The majority say their pricing model either doesn’t correspond at all or only somewhat corresponds with value. When pricing doesn’t correspond to value, it becomes excruciatingly difficult to retain customers and grow the value of cohorts over time. Having net negative churn becomes a pipe dream since a company has no way to monetize customers when it delivers additional value.

How to get pricing on the right track

SaaS companies have tremendous flexibility to monetize their products, unlike many other industries. They aren’t bound to the costs of delivering their products, since once a product is built the main costs come from acquiring new customers rather than continuing to service existing ones. SaaS businesses can (relatively) easily test and experiment with new packages, value metrics and price levels. This monetization flexibility is going to waste.

The only things stopping companies from deploying pricing as a strategic weapon are a lack of information and lack of resources devoted to pricing. Both can be fixed, and the ROI of doing so is a no-brainer. After optimizing its pricing at the end of last year, for example, one company saw a 71 percent increase in its average selling price. What’s more, its pricing changes didn’t slow down deal velocity as new prospects were less price sensitive and the sales team has done a better job at ROI selling.

Like any other strategic initiative, the first step to correcting pricing is owning up to the problem. A company should list out the weak spots in its business that may be the result of suboptimal pricing. Some common examples: net dollar retention is too low; it takes too long to pay back customer acquisition costs; too many deals get escalated to management for deep discounts; too few deals get escalated because the price is a drop in the bucket.

Next, teams should list out hypotheses for how pricing could evolve and map those hypotheses back to the most pressing challenges for the business. This requires creativity and benchmarking across different companies to get all the pricing ideas on the table. Evaluate the pros and cons of these hypotheses and what conditions need to be true in order to actually help solve the challenges. This helps companies focus in on a handful of realistic, high-potential options (although there will be some disagreement internally about what will work best).

The next step is research and testing. Companies should get feedback from target buyers in their market on value, willingness to pay, and the reaction to new pricing. This could come in the form of pilots with specific sales reps, A/B tests to the pricing page, or – more often – surveys with customers and prospects. When surveying buyers about pricing, I recommend using indirect research techniques such as choice-based conjoint, van Westendorp, or Gabor-Granger to get the best possible feedback. This research and testing gives companies realistic insights on how the market would react to pricing changes and what the potential upside would be. Best-in-class companies then leverage the research to model out the financial impacts to their business across a range of scenarios (downside, expected, upside) and set KPIs they want to see to deem the pricing change a success.

It’s then time to go live with the new pricing, monitor results, and continue to evolve. Pricing is a muscle, and it gets stronger over time as companies innovate, test, and learn from their customers. The returns from focusing on monetization aren’t so bad either and can set a company up to become a large and enduring business.

Kyle Poyar is Director of Market Strategy at OpenView, an expansion stage VC.