How do you choose the right pricing strategy for your SaaS business?
Some will tell you freemium is the best path to broad adoption and massive growth. Others will warn you that paying customers are the only customers that matter. even if there are fewer of them. Either way, there is never a simple answer to the question.
This gets to the heart of why pricing strategy is so difficult. You are forced to choose between lots of users or more revenue per user. If you try to do both at the same time, you will struggle. And no matter which option you choose, you will face customer retention challenges.
To help your pricing journey, let’s dive into the two common strategies used by SaaS companies. The first is maximizing the total number of customers. The second is maximizing revenue per customer. We’ll show you how each strategy works and show how each impacts customer retention. And we’ll conclude with lessons you can use for your own pricing/retention strategy.
Strategy 1: Pricing to Maximize Total Number of Customers
Many people assume maximizing the total number of customers is the ONLY SaaS strategy. That’s only sort-of wrong.
Most of the household names in SaaS followed a simple playbook: get users now, monetize later. Dropbox is a great example of this. Check out their business stats when they filed for IPO earlier this year:
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The company now has more than 500 million registered users, up from 25 million in 2011 and 400 million in 2015. This is the kind of growth that VCs drool over. And they rewarded Dropbox with more than $600 million of venture investment.
Those VCs were then rewarded with an IPO earlier this year, which valued Dropbox at more than $9 billion. Not too shabby, right?
The key to Dropbox’s crazy fast growth was two-fold:
1. Offering a freemium product
Offering a no-cost version of the product made it easy for anyone and everyone to give Dropbox a spin. When it comes to winning tons of users, cheap is good but free is better.
Even if you don’t want to give away your product, a limited free trial period is compelling in some cases. Direct experience with a product can develop into long-standing loyalty. I still use the Dropbox account I activated in college back in 2010. That leads to my second point…
2. Creating product virality
Dropbox’s growth piggybacked on an ingenious referral program. The initial program was dead simple, rewarding both the referrer and referee. Here’s how it worked: if you invited a new user to Dropbox and she accepted the invite, both of you get extra free storage.
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This dual incentive scheme helped Dropbox spread like wildfire.
How Customer Maximization Pricing Affects Retention
Customer maximization helps companies make big land grabs and capture tons of customers. But pricing low to get users has its downsides. Dropbox is a great example of this.
Despite the crazy growth numbers and millions of users, Dropbox has a revenue issue. At the time of IPO, it only had 11 million paying users. That’s less than 3% of all users on the platform. That implies the consumer viral growth only created a pool of ~490 million non-paying users (*cough*, freeloaders).
For a company of Dropbox’s scale, all these non-paying users turn into a significant cost. To cut these costs, Dropbox moved off of Amazon Web Services and onto their own custom infrastructure. That saved them $75 million over two years.
What’s more, in 2016 Dropbox started force customer churn by deleting inactive Basic accounts. This encapsulates the customer maximization paradox:
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Giving away product for free allows you to get tons of users fast
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Users who don’t pay for a service value it less than those who do pay
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Users who undervalue your free service are unlikely to ever pay for your service
Dropbox is a victim of its own success, stuck with hundreds of millions of users who will never pay. It is telling that Dropbox for Business represents 30% of paying users despite being launched only five years ago.
Despite Dropbox’s success, retention of low-value users remains a burden they must address. It is a lesson for other companies that want to follow the same growth strategy.
Strategy 2: Pricing to Maximize Total Revenue Per Customer
Low prices and rapid user adoption fueled Dropbox’s growth. But that isn’t the only strategy available.
Many SaaS businesses choose to focus on monetizing users from Day 1. This strategy is particularly common for B2B SaaS companies. In B2B software, customers are used to paying for services received & value created. Whereas in consumer SaaS, users often expect a free version of the product to be available.
The tradeoff here is that a revenue-first strategy requires you go out and find paying customers. B2B companies often invest a lot of money into sales and marketing teams to find and win new customers. In fact, VC-backed companies often run without generating a profit for years. Instead of capturing profit, they choose to hire lots of staff that can increase growth.
There are tons of ways to approach SaaS pricing to maximize revenue per customer. Here are two common approaches you should consider:
1. Usage-based Pricing
In a usage-based pricing scheme, you charge the customer for some fixed unit of value. Many SaaS companies will do this as a per-seat charge or price on the number of active users. Simple and straightforward.
2. Feature-based Pricing
Feature-based pricing schemes increase the price as the customer uses more advanced features. These features generate more value for the customer, so they command a premium price. Tiered SaaS offerings use features as the main source of price differentiation.
Choosing between usage & feature pricing is not an either/or proposition. Companies often combine the two approaches into a single strategy. Here’s an example. Video conferencing provider Zoom charges increasing subscription fees based on two factors. First is the number of conference hosts (usage), and the second is admin control + customization (features). They add one more wrinkle too – using their Business & Enterprise plans requires you bring on 10 or 100 hosts. That means certain features are “usage-locked” to large teams only.
How Revenue Maximization Pricing Strategy Affects Retention
It increases churn – simple as that.
You give away value for free, and it is easy to win lots of “customers” who never pay you. Once you introduce a price, users must determine if the solution value is more than the cost. In the ideal world, you increase the price until it matches the value users receive. In reality, companies must give users a lot more value than they charge so the solution feels like a bargain. And when consumers get used to a service, the perception of what is a bargain changes.
The perfect example of this? Netflix & its failed Qwikster product.
Back in September 2011, Netflix made a major announcement. It was separating its video streaming service from the DVD-by-mail business that started it all. The DVD service was rebranded “Qwikster”. Users would need to have two separate accounts to get both services. And with the new name came new pricing. Before Qwikster, the combined DVD + streaming offering cost $9.99 / month. Afterward, each service cost $7.99 / month.
The rationale was simple. As streaming grew more popular, the company had to spend more money on content licensing. To offset those costs, they wanted to start growing revenue.
A new name for an old service wasn’t an issue. The changed pricing was a massive problem. In only one month, the company found itself down 800,000 customers from the prior quarter. Customers hated managing two accounts for the different services. And they weren’t stupid – Netflix wanted them to pay $6 / month more for the exact same service (DVDs + streaming).
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Netflix CEO Reed Hastings ended up apologizing for how he announced the decision. But the company still stood by its decision to separate the pricing of streaming from DVDs.
On the flipside, Netflix is also a great example of how customers will accept small price changes (if they are getting a lot of value).
In October 2017, Netflix increased the monthly price of its most popular streaming product by $1 (from $9.99 to $10.99). This was different from the Qwikster experiment in a few ways. First, there was no real change to the product experience. Netflix was charging more for the same thing. Second, the price change itself was only +10% (versus 60% increase for Qwikster).
The results were… surprising. In a good way.
During Q4 2017, the company’s subscriber growth beat Wall Street estimates by 33%. That translated to 2 million new streamers in the US & 6.4 million overseas in the period. And the company’s revenue growth was greater than the subscriber growth. This meant customers were tolerating the higher prices without much complaint.
What’s the takeaway? Increasing price is risky – it can cause big churn if you aren’t careful. But if the product value is clear and price changes moderate, your business can weather the storm.
Conclusion
Pricing strategy has a huge impact on customer retention.
Companies that choose to underprice their service will struggle to monetize later. That struggle to make money can lead to forced churn to get rid of inactive customers to cut costs.
Companies that try to maximize revenue per customer must be careful too. Sensitivity to price & product changes can result in massive churn if not careful.
Pricing is one weapon in the fight to reduce customer churn. But it is a double-edged sword: be careful not to get hurt.
This article was originally featured on the StatusQuota blog.
