This is a blog post about some of the most basic elements of pricing a product or service. Since the longest a post like this should be is about 3,500 words, the scope of what is covered here must be significantly narrowed. This discussion therefore focuses mostly on the sale of a single product or service and on the right price point. Decisions get more complex when there are multiple offerings with different price points for different features and you are thinking about upsell, cross sell, negative churn etc.
As context, I have written many other blog posts already about topics related this post including:
- Product/market fit: https://25iq.com/2017/02/17/a-dozen-lessons-about-productmarket-fit/
- Steve Blank on business models https://25iq.com/2014/10/18/a-dozen-things-ive-learned-from-steve-blank-about-startups/
- Eric Ries on Lean Startups https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/
- Growth: https://25iq.com/2017/02/10/a-dozen-lessons-on-growth/
- Customer Acquisition Cost (CAC) https://25iq.com/2016/12/09/why-is-customer-acquisition-cost-cac-like-a-belly-button/
- Churn https://25iq.com/2017/01/27/everyone-poops-and-has-customer-churn-and-a-dozen-notes/
- Freemium: https://25iq.com/2017/04/22/the-rise-of-the-freemium-business-model/
- Multi-sided markets: https://25iq.com/2016/10/22/a-dozen-things-ive-learned-about-multi-sided-markets-platforms/
- Network effects: https://25iq.com/2016/03/24/two-powerful-mental-models-network-effects-and-critical-mass/
- Subscriptions: https://25iq.com/2017/07/15/amazon-prime-and-other-subscription-businesses-how-do-you-value-a-subscriber/
This post will be number 11 in this series and a post next weekend on scalability will be number 12. That will result in the series of 25IQ blog post fitting the usual dozen lessons template.
The first focus of any startup founder should be to prove the validity of a value hypothesis. If a business does not make a product or service that customers are willing to pay money for, nothing else matters. Anu Hariharan, who is a Partner with the YC Continuity Fund writes:
“A great way to waste money, resources, and jeopardize the future of your company is to invest in a growth program before you’ve proven you can retain customers. In other words, it’s best not to hire a full-fledged growth team to put major ad dollars into growth until you’ve ensured you don’t have a ‘leaky bucket’ problem.’”
The amount of unique value delivered by a new business should be significantly more than the established competition if a startup wants to be successful. If the value delivered by the business is “me too” relative to existing competitors the competitive environment will be is more than hard for a startup.
Only after the value hypothesis has been proven should the startup focus on a growth hypothesis. A key part of the growth hypothesis is the business model and a key part of that is pricing. The question of pricing raise many issues, one of which Marc Andreessen addressed recently:
“At the growth stage, when a startup is fully in market and building out sales and marketing efforts to expand, the decision [to invest] becomes far more about the financial characteristics of the business—particularly unit economics: can the startup profitably sell its product to each customer?… we see far more SAAS startups underpricing their product than overpricing.
The problem with overpricing seems obvious—we in our daily lives as consumers are more likely to buy products if they are cheaper, and so pricing higher is presumed to reduce sales.
But that’s not how business markets tend to work—in business markets, where customers make what’s called a considered purchase, the result of a reasonably objective and rigorous analysis of options, startups that underprice tend to have the problem I call “too hungry to eat”—by pricing too low, they can’t generate enough revenue per deal to justify the sales and marketing investment required to get the deal at all. In contrast, by pricing higher, the startup can afford to invest in a serious sales and marketing effort that will tend to win a lot more details than a competitor selling a cut-rate product on a shoestring go-to-market budget.”
There are many types of businesses and each has unique attributes that are in a constant state of change. There are an endless number of permutations of the relevant variables and the systems involved in the business. Nothing remains the same and everything is always in flux. That is no small part of what makes business so interesting to me.
This post can’t possibly discuss pricing optimization for every type of business since there is so much variation. For example, gross margins can vary greatly depending on the sector involved (DM means developed markets). But general principles and best practices can be discussed. Gross margins are a very important part of creating an optimal pricing strategy:
I don’t want to insult anyone reading this but I don’t want to leave anyone behind either (this tension between expert readers and novices is always a challenge in writing these posts). What’s a gross margin? Lighter Capital provides an example:
“ABC Company buys Widgets for $1 and can sell each Widget for $10. On each sale, they make $9. The gross margin for this company is 90%. On the other hand, XYZ Company buys Thingies for $5, and sells each Thingy for $10.
|
ABC Company |
XYZ Company |
|
|
Sale (One Unit) |
$10 |
$10 |
|
Cost of Goods Sold |
$1 |
$5 |
|
Gross Profit |
$9 |
$5 |
|
Gross Margin |
90% |
50% |
Assuming all else is equal, ABC Company has a higher margin on their sale (90% vs 50%)..”
To further make the discussion in this blog post more manageable by limiting its scope I will mostly focus the text that follows on a “software as a service” business (SaaS). Gross Margins in public SaaS companies look like this according to data compiled by venture capitalist Tomas Tunguz:
“…investors prize SaaS companies because providing SaaS service costs very little, and consequently these startups record very high gross margins. The median gross margin for publicly traded SaaS companies expands from 50% in year four to just under 75% in year five, as the chart above shows.”
Why are gross margins so high in SaaS? The answer is explained well by Andreessen Horowitz in a blog post:
“Paraphrasing Jim Barksdale (the celebrated COO of Fedex, CEO of McCaw Cellular, and CEO of Netscape), ‘Here’s the magical thing about software: software is something I have, I can sell it to you, and after that, I still have it.’ Because of this magical property, software companies should have very high gross margins, in the 80%-90% range. Smaller software companies might start with lower gross margins as they provision more capacity than they need, but these days with pay-as-you-go public cloud services, the need for small companies to buy and operate expensive gear has vanished, so even early stage companies can start out of the gate with relatively high gross margins”
Bill Gurley lays out the value of high gross margins for a business here:
“There is a huge difference between companies with high gross margins and those with lower gross margins. Using the DCF framework, you cannot generate much cash from a revenue stream that is saddled with large, variable costs. …Selling more copies of the same piece of software (with zero incremental costs) is a business that scales nicely. Companies that are increasing their profit percentage while they grow are capable of carrying very high valuation multiples, as future periods will have much higher earnings and free cash flow due to the cumulative effect of growth and increased profitability.”
Bill Gates in 1993 described what Bill Gurley is talking about in this way:
“It’s all about scale economics and market share. When you’re shipping a million units of Windows software a month, you can afford to spend $300 million a year improving it and still sell it at a low price.”
One useful way to better understand the context and implications of what Andreessen, Gurley and Gates are saying is to follow the Charlie Munger approach and “invert” the analysis. If a SaaS business has 60-90% gross margins it has headroom “below the gross margin line” to spend on these three expensive and unavoidable aspects of their business:
- Research and Development (R&D)
- General and Administrative (G&A)
- Sales and Marketing. (S&M).
What I typically do when considering the economics of a business is perform a “reverse math” analysis of business financials using well-known benchmarks. Like almost every other business, the SaaS company will have familiar categories of expense. To illustrate, I will use an example of a specific software as a service (SaaS) business serving enterprise markets which recently went public so we have access to an IPO that is not too dated. MuleSoft’s financials in that document include this chart:
You can see that MuleSoft’s gross margin was 74% in 2027. Tomas Tunguz notes that MuleSoft’s gross margin:
“is better than the public software average of 71%. Professional services margins used to be -25%, but the company has brought that figure up to breakeven in the last year. This may also be a contributing factor to the increase in average contract value.
Mulesoft is rapidly approaching cash flow from operations breakeven and net income profitability. Cash flow from operations breakeven means the business generates as much cash as it consumes setting aside financing and investing activities. Mulesoft operated with an estimated sales efficiency of 0.57 in 2015 and a estimated sales efficiency of 0.63, which implies a payback period of 19 months, right on the average.”
MuleSoft’s R&D and G&A alone are 35% of revenue, which leaves less room for spending on sales and marketing needed to grow the company. Every business has general and administrative costs. To illustrate:
Every SaaS business also has R&D costs (this cost can range between 10 and 30%nd should drops as the company matures and is operated more effectively).
“In general, R&D expenses (as measured as a percent of revenue) for public SaaS co’s are lower than traditional licensed software companies. Unlike licensed software vendors, SaaS companies are not required to support multiple technology stacks (i.e., operating systems, Web servers, databases, etc.) or a variety of hardware platforms. Additionally, SaaS solutions are typically version-less (all customers are on the same version) thereby enabling critical R&D dollars of the organization to focus on the next version and innovation.”
The next item on the list of below the gross margin line expenses is sales and marketing. This is an expense that can easily kill a business or make it a winner. The very best companies have products that sell organically. Bill Gurley writes:
“All things being equal, a heavy reliance on marketing spend will hurt your valuation multiple. …You will be hard pressed to find a company with a heavy marketing spend with a high price/revenue multiple. This should not be read as a blanket condemnation of all marketing programs, but rather a simple point that if there are two businesses that are otherwise identical, if one requires substantial marketing and one does not, Wall Street will pay a higher valuation of the one with organic customers.” Organic users typically have a higher NPV, a higher conversion rate, a lower churn, and more satisfied than customers acquired through marketing spend.”
As an example of how complex pricing issues can be, another important pricing issue is how a price will impact customer acquisition costs (CAC) and churn. I’ve been involved in setting services prices since there were zero portable mobile phones in service. That is a long time ago. One thing I have learned over the decades is that the higher the price and the longer the contractual commitment, the higher customer acquisition cost (CAC) and churn will be. If this were not the case all customers would be signing up for >10-year binding contractual commitments. People do not like to give up optionality by signing long terms contractual commitments, so sales incentives (e.g., price discounts) and higher sales and marketing costs are often required in order to get a longer customer commitment.
As another example of the complexity of pricing issues, when founders talk about SaaS they often assume the revenue is recurring. Many founders who think that they have recurring revenue really have 12-month deals. While this normal early on, especially for a pilot, it isn’t annual recurring revenue (ARR) if it is just payment spread over a year. This is especially true if there is no per-time period and per-user price. Until there have been renewals what is “recurring” in ARR is unknown.
Yet another issue is the topic of freemium or selling religious icons to the already converted. This can be a useful strategy to reduce CAC. But you need to be careful since freemium results in higher COGs, which is hidden CAC. If you give away storage to get sales leads that isn’t really COGs now is it. It is just a different sort of sales and marketing spending.
What are most SaaS companies spending of sales and marketing? Tomas Tunguz writes:
“…In the first 3 years, these public SaaS companies spend between 80 to 120% of their revenue in sales and marketing (using venture dollars or other forms of capital to finance the business). By year 5, that ratio has fallen to about 50%….”
How should a SaaS company find the right price points for its services? They are best discovered through actual interaction with customers and a series of pricing experiments. The right price is discovered through a carefully constructed but inevitably slightly trial and error process. For example, a startup might start with its first paying customer and set a price. As the startup reels in new paying customers the business can gradually raise prices as it grows its customer base but only until it meets significant resistance on price.
This gets us to the related issue of setting price for a new category of SaaS. What I tell founders is that the best way to price of a new service that customers have not seen before is to set price so it produces sufficient gross margins so that the business has a margin of safety. I like to see a business set a target of at least 70% gross margins on SaaS. It can be lower at the start of the effort but there must be a plan to get it higher. An 80% gross margin would be better obviously. If a business can’t eventually get to a point where the business generates a 70% gross margin in a SaaS business it really needs to think hard about whether it has achieved sufficient product/market fit. A gross margin of 60% is living more dangerously obviously. Of course, most business have far lower gross margins than a SaaS business as was noted in the Median Gross Margins by industry chart above. But the more general point remains true for any business: if a startup is not able to generate better than industry standard gross margins it very likely does not have sufficient product/market fit.
Reid Hoffman believes:
“People underestimate how much of an edge you need. It really should be a compounding competitive edge. If your technology is a little better or you execute a little better, you’re screwed. Marginal improvements are rarely decisive.” “The question comes down to…not to think of it just as a question of ‘Oh, I have a better product, and with a better product, my thing will work, as opposed to other things.’ Because unless your product is like 100x better, usually your average consumer…they use what they encounter. If other[s] are much more successful at distribution and they have much better viral spread, they have better index and SEO…it doesn’t matter if your product is 10x better, the folks don’t encounter it.”
If you deliver this sort of value, you can set your price on a value basis. Lincoln Murphy of Sixteen Ventures writes:
“The definition of Value Pricing is: Applying a price to a service that is congruent with the value derived from the service rather than the underlying cost to create and deliver the SaaS, market prices, specific margins, etc. Which makes Value Pricing the most effective method of pricing for SaaS and Web Apps… something like cost+margin just doesn’t make sense. The key to Value Pricing is knowing the, well, value of your service as perceived by your target market AND/OR market segments (not all are alike) … If I sell something for $100, I want to provide at least $1,000 in value to them… at least.”
As an example from another industry, let’s look at the New York Times which has gross margins that are typically about 62%. The New York Times has a yearly average revenue per user (ARPU) of ~$140 which is ~ $11.66 a month.
Churn and CAC are known only to the management of the New York Times which means investors must guess at what they are to calculate unit economics. My post on unit economics is here.
The New York Times, like other businesses, periodically conducts pricing experiments to see what it pricing power is. What is tested in these experiments is what Warren Buffett calls is “pricing power” of the business. Buffett’s famous quote on this topic is:
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
What determines pricing power? Whether the business has a sustainable competitive advantage, a topic that I wrote about in my blog post on Michael Porter. https://25iq.com/2013/08/26/a-dozen-things-ive-learned-about-strategy-business-and-investing-from-michael-porter-2/ and this post I wrote about Charlie Munger. https://25iq.com/2015/10/10/a-dozen-things-ive-learned-from-charlie-munger-about-moats/
Setting and managing prices is both an art and a science. Having a top rate data science team and some people who have real world experience are both invaluable. Many interacting variables are involved even before you start calculating and managing the business against metrics like lifetime value (LTV). The best way to learn the art and prefect the science is to actually create pricing plans for a business it in a real business setting. In setting and managing prices there are best practices, but there are no precise formulas. The more you do it, the more skill you will acquire.
Notes:
http://blog.ycombinator.com/growth-guide2017/#checkretention
https://stripe.com/blog/marc-andreessen-ama
https://a16z.com/2015/09/23/16-more-metrics/
https://leadedgecapital.com/why-we-like-saas-businesses/
http://sixteenventures.com/saas-pricing-strategy
http://tomtunguz.com/mulesoft-s-1/
https://www.opexengine.com/are-ga-expenses-increasing-for-saas/
https://www.lightercapital.com/blog/calculating-gross-margin-for-your-saas-business/
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