Back in 2014, McKinsey published a report titled “Grow Fast or Die Slow” that studied the life-cycles of over 3000 software and online service businesses; including SaaS startups. The report made an interesting observation – a software company that grows at 20% annually had a 92% chance of shutting down within a few years.
There are several reasons why this happens – product-market fit is a big contributor. But when it comes to SaaS products, pricing is perhaps an equal, if not larger, contributor to startups failure.
Thanks to pioneering startups like Slack, Trello and Evernote – a large number of SaaS startups have a free tier in their pricing model. The conversion rate from free to paid version of the product in most cases is in the low single digits (around 5%). This means that for every 100 users, only 5 of them pay to use your service. In other words, your pricing model should account for the resource expended in getting free users to keep using your product.
This is a problem because it places undue stress on the paying customer. A product that could have been profitable at $1/month/user would need to be priced several dollars more simply to sustain your free users. The higher price of your paid plans disincentivizes conversion and pushes conversion rate down even further.
The alternative to freemium in most cases is a free trial. This is relatively better because you at least know that the freeloading customer won’t stay on your platform forever – they either convert to a paying customer or stop using your service. According to a study published by Totango, the conversion rate on the free trial model is as high as 15%.
But this does not automatically make free trial a better alternative. Free versions of most SaaS products are severely limited in their functionality. To be able to scale your usage in any sustainable way, most businesses will need to upgrade to a paid plan. To look at this another way – free users of a product do not truly consume a lot of resources.
On the other hand, free trial is typically offered on the most premium plan. At a per-user level, the resource consumption of free trial users is thus significantly higher. Regardless of which pricing model you pick, it is thus important to take a look at the resource consumption pattern of users that are not contributing to your top line and account for this cost while devising a price plan.
Resource utilization by non-paying users is just one of the many factors to consider while building your pricing plan. Your customer acquisition strategy is important too.
A lot of popular SaaS startups today have invested in online marketing strategies like content marketing, SEO and social media. Startups that are loaded with VC money also use PPC networks like Google Ads to quickly scale their business up.
But if you are a SaaS provider in a legacy industry like construction or heavy machinery, you are also to have a bigger focus on your sales functions. The marketing ROI and cash flow cycles of your business is very different when you are marketing-heavy as compared to when you are sales-heavy.
For instance, with traditional sales, the turnaround time for a prospect to become a paying customer can be anywhere between a few weeks to several months. Cash flow from your paying customers have to sustain the cost of your sales operations during this sales cycle. This is not the case with new-age marketing strategies where your resource utilization in nurturing your prospect (through newsletters, emails, etc.) are dramatically lower.
On the other hand, a good chunk of SaaS sales expense is through commissions. That is, your business only expends money upon successful conversion. Online advertising, on the other hand, consumes your budget before you can even bring your target buyer on to your website.
A growing number of startups today invest in what is called “Smarketing” – that is an aligned approach towards marketing and sales. This is shown to increase ROI by as much as 208%. Your pricing model needs to adapt to the sales and marketing strategies you have picked for your business – SaaS businesses targeting legacy businesses invest heavily in outbound sales and are thus naturally priced higher than tech startups targeting ‘modern’ industries like social media and SEO. These businesses can afford to price their products low and still be profitable.
Besides all these operational expenses, one thing that a lot of SaaS businesses struggle with is in maintaining sustainability with scale. SaaS continues to be one of the most popular industry segments for venture capital funding. And as it is with any VC-funded startup, there is tremendous pressure on these businesses to scale up quickly without focus on unit economics.
This forces these SaaS startups to push free plans and lower prices unsustainably. Not only does this impact the viability of these startups, the single-minded focus on scale against economics is also damaging to the industry as a whole since competitors who seek sustainable growth are forced to compete against such predatory pricing models.
While VC funded startups may manage to sustain over the long term through equity dilution and consolidation, this accelerates the closure of bootstrapped competitors who may not be able to keep up against unsustainable business models. Such businesses may sustain with a couple of strategies.
First, suchstartups tools may look at niche specialization. VC-funded startups seeking hockey stick growth may seek to build a generic product that appeals to all of their target group. Bootstrapped competitors may look at specializing in a specific industry. This makes them more appealing among a small audience thus helping them justify a higher price, but to a smaller audience pool.
Another way to sustain is by reworking their pricing strategy. A startup competing against VC funded businesses offering subscription pricing may pick a consumption-based pricing model. They may also replace a recurring fee model with a credits-based model where users buy lifetime credits that are consumed based on usage. This delivers a value proposition that is different from what competitors offer and is thus sustainable.
As this article shows, SaaS pricing is influenced by several factors and can thus be tricky. Understanding your industry, your buyers’ expectations and competitor strategy is thus critical to ensuring long-term survivability of your startup.