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Theory of SaaS Pricing

What is SaaS Pricing?

Software as a service (SaaS) is a model of creating companies that aim to have a recurring membership model in exchange for hosting the service on behalf of customers. A lot of companies are based on SaaS, such as in the fields of email marketing, customer relationship management, authentication, and more. You don’t make your own email sending, customer tracking, or authentication software usually, you let another company or service do it for you. Some of these can be self-hosted software, such as using an authentication library rather than a SaaS, but it doesn’t necessarily need to be, and if you're at scale, you probably will be using a SaaS rather than rolling your own.

Each price point you can set for your product acts as a signal to your customers. Signaling is where others have an impression of you based on something that you own or do, whether it be positive or negative. In short, you signal some quality. For example, if you owned an expensive watch, people would think that you're rich and therefore have the qualities of being rich along with it, such as classiness, regality, sophistication, or other such quality. In the same way, your pricing model represents the value of your product. If it is high, then your customer will feel that your product is premium and luxurious, and if it's low, it could be seen as affordable but good.

Note that the quality of the product must be commensurate with the price you choose to set. If the price is high but the product is bad, customers will feel ripped off. There are four categories here:

  1. High price / high quality
  2. High price / low quality
  3. Low price / high quality
  4. Low price / low quality

When the price and quality match, it is generally fine, but if there is discord between them, then you start seeing trouble. With a high price and low quality, what happens is what you'd expect, customers feel like they've been ripped off and you won't have a good reputation for future products.

In contrast, if the price is low but the quality is high, customers might be confused as to why it's so cheap and might be a little suspicious. You actually see this a lot for business to business sales (B2B), or also known as enterprise sales, where companies who are buying actually feel that you won't put in the work and won't be around in a few years since you aren't charging enough to cover your costs and grow your company. Therefore, they actually won't buy because the price is too low! You'd think that customers always want the lowest price, but this is actually not true! Companies are motivated here more by avoiding risk if your solution stops working when you shut down rather than getting the best price, because switching to another solution can get more expensive than even the price of your product.

In general, remember this about pricing theory if nothing else:

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Customers are not only motivated by price, but by many other factors such as quality, risk avoidance, social signaling, and so on.

Even in the quality versus price matrix, there is some nuance. Early adopter customers actually will tolerate a bad quality product at a high price because they want to believe in the mission of the company and founders, and they trust that the product will eventually reach the quality commensurate with the price it is set at, so if you are targeting these types of customers, you can set your price with where you eventually want it to be.

Pricing models

Free

You sometimes see free products out in the marketplace. This is not to say that they are freemium (which we will discuss soon) but that they are entirely free. These are somewhat rare as usually the creator wants to make money off of their creation, but it's possible. We do not necessarily recommend making your product free, even in the beginning, because of the fundamental reason of signaling, as discussed above. Users won't value your product because they're not paying anything!

One of the few times we'd recommend offering a free product is if you use it as a lead magnet. This means that you are using this product to pull in customers to your other products. For example, if you are making a personal finance tool, you might want to provide a free calculator app that figures out when you can retire based on your asset appreciation. The important thing is that your lead magnet app is not too complex so that you don't spend more time on it than necessary, and definitely not more time than the main app you're trying to get paying customers for! Think about what products you can offer of this scale. Make sure to get some way to contact them later, such as with an email list form in order to access the smaller app. This way, once you know they'd want to use it, you can upsell them on your actual product. More information about lead magnets and general marketing strategies are discussed in the Marketing guide.

Freemium

Freemium is very common in the SaaS world. It is the practice of offering a free version of the product and having one or more paid tiers. Generally, freemium consists of a perpetually free tier gated by features, usage limits, or other such restriction. A related but distinct concept is the free trial. A free trial is limited by time usually, in contrast to freemium's feature or usage restrictions, and it gives all of the functionality of the paid tier for that limited period of time.

Freemium and a free trial is very useful as a lead magnet, as we talked about earlier. You can get some users to try your product at their own discretion, without having them use up all of your resources as they're restricted in features or time.

A word of caution about offering freemium is that your support burdens might go up substantially as many new users will enter the system and might overload your company. This is especially true both of freemium users and also of companies who do not yet offer a paid product. In the first case, as we had shown about signaling, people who use free products often don't value the product substantially enough to pay but want to extract the most value out of it, so they often inundate support staff with requests. In contrast, those who do pay often have lower support needs because they value the product enough to learn it well. Be wary of this dichotomy in the customer base.

This problem is largely solved with a free trial as customers can try the entire range of the product and yet they're limited by time, so after the time is up, they have to turn into paying customers or they risk losing their access to the product. This ensures that they must place their money where their mouth is and pay up.

One Time Purchase

A one time purchase is a pricing model where the customer pays only once and gets to receive the product forever afterwards. This is typically not seen in SaaS but more seen in information products such as books, courses, and the like, as customers in that segment do not expect to continuously buy access to a book each month in order to continue reading it.

One place you do see one time purchases is in early access models. These are where the company will offer a perpetual license to the SaaS for a substantial discount over the regular price, often calculated as the lifetime value (LTV) of the customer. If your annual plan for example was $100, and you expect your customer to stick around for 3 years, you'd set your one time purchase license at somewhat less than $300, such as $250, depending on your preference. This allows early adopters to support you while you build your company and in return they get to use the SaaS perpetually (or at least until you shut down). You may not want to run this model forever though, as eventually you want to keep up the recurring nature of the SaaS, because, like in the freemium section, customers who paid some time ago might forget the value you provided them and start increasing their support request load, which is undesirable for you.

Subscription

We come to the last model, subscription, which is a recurring model of payment in return for access to your SaaS. This is the most widely used model and is somewhat broader than the others. For example, subscription pricing can include freemium options as well as be paid only, without any free version of the product.

Typically, subscriptions come in a few models as well as tiers which separate the different variations within these models. Such models include feature-based or usage-based pricing. In a feature-based model, features are gated from each tier. For example, you could have features A, B, C, D, and E only for the highest tier, and for the lowest tier, only have feature A, with the tiers in between having some combination of those features. In this way, those who buy the higher tier will get more features. This is especially useful for enterprises as they have more thorough feature requirements.

Enterprise

Enterprise pricing models are quite complex and won't be covered fully here. However, for the basics, enterprises usually have much higher needs than your regular customers, such as having custom security measures and dedicated support contracts.

The propensity to pay for enterprises are much higher as well, which is why you won't see many companies advertise their precise enterprise related prices; rather, you'll see a vague "Contact Us" decree. This is because enterprises buy more through a direct sales model. You will be expected to show up at their offices and literally sell them the product, with lead times taking anywhere from 6 months to multiple years, depending on the level of bureaucracy. Because of this, your pricing must reflect the time and money investment into these companies. You'll be looking at 5-figure and up (even to 8 or 9 figures in certain cases) contracts.

However, don't fall into the trap of seeing big money and thinking that this is the exclusive way to go for your SaaS, as there are many pitfalls with enterprise sales. One is the lead time, as mentioned, where you might go years without any income from your SaaS, and not even any product-market fit. Because the iteration times are so long, you might not even be building what they want to buy, which you might not know until later. As well, enterprise sales require lots of industry connections in order to even get meetings with your prospective customers, connections which you may not have. Even if you do get the sale, you may not desire it being such a large part of your revenues, as if it's over a certain limit, you start to become a consulting company of the enterprise customer rather than becoming a SaaS, always having to modify your product not for the good of your many other customers but for your largest customers instead. This can cause the product to break product-market fit and you may be left in a sticky situation, having to either cut off your big customers or having to mollify their requests. Jason Fried of Basecamp explicitly doesn't want large customers due to this fact, so they keep prices at $99 per month for any size of customer, without even a tiered pricing model. This is just something to think about as you continue your pricing journey.

Choosing a Pricing Model

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Choosing a Price

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Billing providers

You've determined the price you want the product to be at, now you have to choose a billing provider to actually allow you to charge your customers.

Stripe

Pros: Widely used, great API and documentation

Cons: Doesn't handle SaaS specific things like taxes

The great thing about Stripe is that is is very easy to get started with, as it has stellar documentation and a great API. You only need to add a few lines of code to incorporate it. However, the biggest problem (which its competitors solve) is that it is not necessarily focused on SaaS but on anyone trying to sell anything online. It only handles things like charging a customer, but it doesn't handle other things like subscriptions, recurring payments and most importantly, taxes. That's right, you have to manage your own taxes for every jurisdiction you sell in, which, being SaaS, can be any country in the world.

However, for getting started with your SaaS journey, there is no better company than Stripe, which we wrote a guide for. We also wrote a more advanced guide for setting up recurring subscriptions in Stripe, because Stripe doesn't manage this by itself, you as the developer have to add this functionality. You could use Paddle or Chargebee but you'd be paying an extra 2.1% per transaction (2.9% for Stripe vs 5% for Paddle or Chargebee).

Paddle

Pros: Handles SaaS specific things that Stripe doesn't

Cons: Higher fee (5% here vs 2.9% for Stripe)

Paddle is a great billing provider because they take care of things like taxes that Stripe doesn't, as mentioned in the Stripe section. However, along with this, they have a higher fee to compensate, at 2.1% higher for handling this. We think it's well worth it, as handling taxes on your own is annoying to say the least.

Braintree

ChargeBee

PayPal