One critical decision for any software company is product pricing. For startups this is particularly the case as they are working with emerging technologies. One of the hardest decisions for a company can be pricing of the product. There are several models which follow (SaaS) or software-as-a-service. This article looks at how companies can use these pricing models and make the right pricing decisions. To put the information into real work practice interviews with real companies are provided for analysis.
The Key Pricing Models
There are four main pricing models which are Consumption, Freemium, Tiered, and Perpetual License. Each of these has strengths as well as weaknesses. Decisions makers have several decisions that they need to make before deciding upon a pricing model.
One popular pricing model is the consumption model. This allows users to tie the usage to the cost. This is also called “pay-as-you-go.” A customer is able to manage their use of a product or a service and the expenses related to it. This type of flexibility is valuable to a company are in the early stages of ramping up need for a particular product and have an anticipation for more usage in the future. A locked-in contract makes sense for the customer at a higher usage level, but pay-as-you-go might be preferred during the scale-up period.
Limited commitment into the future for customers is another important aspect of the consumption model. Traditional license models don’t allow customers to sever ties to a product immediately or allow them to scale back usage without some sort of negative penalty which can be significant. Customers must have an understanding of the value per use, but don’t have a clear view of the future use or how their usage patterns may change in the future. A pay-as-you-go model makes more sense for this sort of customer.
The vendor has a downside when working with the consumption model because they can’t predict revenues. The customer has more flexibility on their usage of a product or service which can vary month-to-month so this impacts the stability of the vendor’s income. As a company scales up and gets familiar with the value proposition of their product, the usage should go up. With a strong understanding of their user base and user needs for a product, it makes decisions about revenues easier. This revenue model has key metrics which include user growth rates, active users, and the average revenue per user.
The Freemium Model
The software-as-a-service companies soften use the freemium model. In the enterprise space and the consumer space, freemium if used. Freemium is a model that offers features or core services for free, but then changes a premium for components which are more sophisticated. The idea behind it is instead of expensive marketing and sales efforts, the company wants to create a low barrier for interested customers to get their product. The key is to get a lot of interest in the product and provide a minimum barrier such as a simple signup or a low cost (Free for a basic style offering) for users to try the product being offered. The intent of this is that the product will meet the needs of the users and entice them to pay for a premium offering. In 1983 Carl Shapirio released a paper and the freemium model comes from that paper. The paper was on the optimal pricing of experience goods and it argued that customers tend to underestimate the value of an experience good. He defined this as product value a customer learns after experiencing the product. The optimal price is one that is low as an introduction to the product which leads the customer to understand the true value of the product as they use it.
There are three freemium model methods which are commonly used to separate the premium offering from the free offering:
• Capacity Based Freemium -In this model a customer is given a free version up to usage, capacity, or threshold of number of users. This model is one of the most common in use today. One example of this is Dropbox. You get 2GB for free and then an additional 10GB of storage priced at $10 per month for the “pro” plan. For those that need 1TB or more there’s enterprise sales which are negotiated.
• Time Based Freemium – In this model there’s a free trail which will expire after a specified period. This allows the user to experience the product and learn the value of that product for free. There’s usually a higher conversion rate before and after the free trail if the engagement with the customer is there. There’s a 30-day free trial with Salesforce.com for its CRM platform. The trial gives a lot of the functionality of the product so that the user can see the value that the product provides for them.
• User-Case Freemium – This model is less common. Customers can use the offering for free if they fall under certain categories such as non-profit, educational, or non-commercial use. Example of this freemium model would be Adobe or Autodesk which address the student market.
Considerations for the Freemium Model:
• Customer Targeting – The freemium model is popular because you can quickly establish adoption and market share. A business that wants to scale up quickly will benefit from the freemium model, but it’s likely to attract Pro-sumers as well as SMB which might not be the ideal thing for your business.
• Value for free Users – The free aspect of it only makes sense if they get the “premium.” You have to be careful about the value the free customers are adding. This might be leveraging viral marketing, saving on marketing costs for some companies while others might be selling data or trying to save money through advertising.
• Learning from the Free Users – Companies need to keep tangible numbers related to their free users. They may also want to use cohort analysis to understand their conversion rates and to track viral referrals so they understand the return on investment for the free users.
• Cost to Serve the Free Users – It’s important to understand the continued cost of serving free users and the acquisition costs of the free users. A good comprehension of this cost and the estimated conversion rate will help to make quick determinations as to the market required to make viable business decisions as well as the premium members required which support the free members. These costs can include storage, bandwidth, as well as service and customer support.
• The Size of the Market ¬– Freemium adds and other step, so a large market is critical for this model to succeed.
• Does the Product have Network Effects – Does a user benefit more if there are more users of the service or product? This relates to switching costs as well as referral rates. An example would be GitHub or WebEx which are more valuable when more people are using it.
Optimizing Conversion Rates
When a freemium model is constructed there has to be a balance between offering too much (little incentive for a customer to upgrade) or too little (not enough interest for the customer to update to premium). There are several questions to ask in regards to what freemium model to use and what metrics the version should be based upon:
• Get Customer Insights by Giving Enough Away – You want to offer the free version as a means to attract customers to the top of the funnel and for understanding more about customer behavior. Before a paid option is offered, you have to have a good sense of how often the customers are using the free offering and how they are using it. This allows you to offer opportunities for payment and to drive further usage of the product.
• Conversions Are Aligned Around Product Features that Drive Repeat Usage – With a strong understanding of what’s driving repeat usage will create more understanding of both the customer needs and use case that the offering is currently meeting. You want to build your revenue model around the repeat usage and customer needs which is harder for the free customer to avoid.
• Conversion Takes Time – Phil Libin, CEO discussed a strategy for his company which in the first 30 days the initial conversion rate was 0.5%. There was a focus on getting as many users as possible and then after two years, the conversion rate was 5.5%. This was done by adding more features over time. Some users drop off at a pay/don’t pay point when the freemium no longer meets their needs.
The Tiered Model
The most common model of SaaS is the tiered model. This has a long history and is effective means of price discrimination which dates back to the software created in the 1980s. The idea is to tie pricing to a driver of usage and value which may be modules, seats, servers, and other scale factors. This is similar to cellphone packages which offer minutes. The tiered bundles encourage a customer to upgrade to the next highest level.
This is used to create a long relationship with the customer. As the customers needs grow so does the model. The future needs and the current needs of the customer can be met with a tiered model. A customer can “graduate” into the higher tiers over time when it’s warranted.
A tiered model finds success when it’s segmented appropriately using metrics and intangibles such as the customer’s expectation of service level. They are not changed more for “a service they barely need”, they are charged more when they need more services from a company. They may upgrade when they see that the higher level offers more “value,” even before they reach a required need for the new level.
A tiered model offers advantage for a company that includes lower average cost of acquisition which is relative to lifetime value since they have more upsells and renewals, predictable recurring revenues, and an average selling price that is more stable. In addition, they don’t need as many sales or discount to keep their customers. The company strikes a balance between providing for a customer’s needs over a long-term relationship, and a steady revenue stream, versus a longer difficult sales process as the customer is asked to make a longer commitment.
The key metrics that are used this model include customer churn and rate, net new growth in subscribers, and the conversion rate between the tiers.
The Perpetual License Model
The subscription model has largely replaced the perpetual model, but it’s still worth discussing this model. In some cases, this model may be ideal. The traditional perpetual license models are structured with an upfront payment with about 18-25% for support and maintenance as well as professional services. The long-term buy-in and high upfront cost made it difficult for CFOs to adopted subscription packages as they had already committed to other software packages and had paid the perpetual fees. The rule of thumb was that annual subscriptions were priced with a 3-5 year payback on fees for a perpetual license in most cases.
In some cases, it’s more sense for a customer to consider a perpetual license and not a subscription. When there’s an investment of greater than 3 years or when the capital costs are very low, it’s prudent for a customer to use a cost analysis to see if perpetual licensing makes more sense financially. There’s also tax implications for capitalizing this type of license and not using an annual expense.