Pricing – Fuel, A McKinsey Company https://get.fuelbymckinsey.com Sun, 01 Dec 2019 18:15:45 +0000 en-US hourly 1 https://wordpress.org/?v=5.2.2 Software Pricing Pitfall #2: Settling For a Suboptimal Price Metric – Infographic https://get.fuelbymckinsey.com/article/pricing-pitfall-2-settling-for-a-suboptimal-price-metric-infographic/ https://get.fuelbymckinsey.com/article/pricing-pitfall-2-settling-for-a-suboptimal-price-metric-infographic/#respond Fri, 04 Oct 2019 19:09:23 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ Price metrics are not a new concept. Defined simply as a scalable quantity to which one ties the price of a sale, they have been around in one form or another for as long as products have been sold.

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So what works for your team? Choose a metric that works. There are 5 Broad categories of price metrics. 

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Software Pricing Pitfall #2: Settling For a Suboptimal Price Metric https://get.fuelbymckinsey.com/article/pricing-pitfall-2-settling-for-a-suboptimal-price-metric/ https://get.fuelbymckinsey.com/article/pricing-pitfall-2-settling-for-a-suboptimal-price-metric/#respond Wed, 04 Sep 2019 23:09:58 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ Price metrics are not a new concept. Defined simply as a scalable quantity to which one ties the price of a sale, they have been around in one form or another for as long as products have been sold.

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Boom Times for Pricing Metrics 

Price metrics are not a new concept. Defined simply as a scalable quantity to which one ties the price of a sale, they have been around in one form or another for as long as products have been sold. A price metric’s primary role is to allow a company to differentiate – to adjust prices to meet an individual customer’s (or group of customers’) willingness to pay. 

What is new is the breadth of price metrics that is now available for tech companies. 

In some cases, price metrics can almost transcend the field of pricing and become a key competitive differentiator. Several large markets have been disrupted by companies employing radical new price metrics. However, such creativity in price metrics is still more exception than the rule, and many companies succumb to the pitfall of not thinking beyond the status quo.

The options are so numerous we tend to think of five broad categories of price metrics rather than individual metrics:  

Seat based – metrics closely related to the number of people using the product
Usage-based – metrics related to how much or how frequently the product is used
Hardware-based – metrics based on the number of connected devices, or the amount of system resources required
Company business metrics – metrics based on the scale or performance of the customer (e.g., revenue, number of employees)
Success-based – metrics that align with the output or impact driven by the product (e.g., reduction in costs)

Startups Stuck in Their Seats

More than 20 years after the advent of the mainstream internet, pricing a product “per seat” – the metric closest to the license-based, legacy desktop software model – is still very common. In fact, the proportion of SaaS companies that use a variant of “number of seats” as their primary metric is 39%, making it the most common price metric category – according to a 2018 SaaS Survey by KeyBanc. 

While seat-based metrics can undoubtedly be the right choice for a subset of companies, it would be surprising if seats was the ideal metric for as many as 39% of SaaS companies. We frequently encounter startups that feel their seat-based models are not achieving their objectives. For many businesses, seats as metric fails to satisfy key price metric criteria:

  • Not linked to value – Consider an analytical product used by 100 users at an enterprise company, but with only 3 power users accounting for 95% of the usage. Beyond the initial 3 licenses, the value to the company would not increase consistently as more users are added.
  • Not scalable – Consider a tool aimed at a marketing team, which has remained the same size for 10 years, and shows no sign of changing. As the number of users is unlikely to increase, charging per user will likely never raise the revenue per customer, and so it is not a scalable metric for growth
  • Not auditable – How many times have people shared licenses (or credentials) with their colleagues for an online database? It can often be challenging to know how many users are truly using the product, and to set the price appropriately.

What seat-based models do have, however, is a higher degree of familiarity. This makes them easy to explain and implement, and therefore highly acceptable to the customer. So the very ubiquity of seats makes them the easy choice for companies without pricing expertise, which is often true of startups. In this way the selection is self-propagating. More seat models emerge, and seats beget seats.

Choose Value-Linked Metrics…

Still, does it really harm companies to price based on a metric that is not the best for their customers? The answer is yes. And in a number of ways. Most importantly, choosing the wrong price metric inhibits the ability to price differentiate. For example, if a company is selling some form of capacity when the buyer doesn’t value that metric, one of two things may happen:

  • Buyers will purchase fewer capacity units than intended, thereby pushing the purchase price down. 
  • Buyers will ask forthe needed amount of capacity for a lower purchase price, since they don’t want to pay the list price for the last few seats.

Either way, the buyer ultimately pays less than it is actually willing to pay. This was true of an online reference tool startup that priced its product based on concurrent user licenses (CULs) for their various content sets,  the expectation being that large Enterprises would purchase up to 8 CULs. Company research found that these enterprise clients were actually willing to pay the price levels that corresponded to eight CULs, and yet they purchased fewer than two CULs on average. Because the CUL metric was not value-based it did not work as a price differentiator, and customers were able to purchase a workable solution at a price significantly below their willingness-to-pay.  The vendor was missing out on signicant revenue it could have captured with a more value-based metric.

This can be avoided (or greatly mitigated) if pricing is based on a metric that is more strongly linked to the value that customers receive from the product. For example, a product that increases sales-win-rates might consider pricing on the customer’s baseline new business revenue, since the value realized will be a product of that revenue. A search engine might charge by the number of searches. An analytical tool might charge by the amount of analytical horsepower provided. Smart companies understand how they add value to the customers and align their commercial models.

Choosing the wrong price metric can also negatively affect the value proposition and sales confidence. A price metric, intentional or not, communicates to customers how a business adds value to them. As a result, choosing an inappropriate metric means misrepresenting the source of value creation, or at least not presenting it in the best possible light. This can complicate sales messaging and detract from the sales team’s confidence, ultimately leading to lower sales volumes and more frequent and dramatic discounting. 

… With Sufficient Predictability

One caution when choosing a highly value-based metric – ensure that it meets predictability requirements.  Usage-based metrics (e.g. API calls, # downloads, # site visits etc.), for example, are frequently seen as value-based, but they can be hard to estimate over time.  Even if the customer agrees that additional usage is value-linked and worth paying for in principle, tieing the price to an unpredictable metric results in unpredictable pricing. Budgeting is frequently important to customers, especially large enterprises, and uncertainty here can inhibit sales velocity. 

Predictability can be enhanced by either buffering against fluctuations – providing more usage for the same price, fixing price within a “band” of usage, and/or resetting price based on usage less frequently (e.g. annual price resets as opposed to charging on a monthly meter) – but all of these methods share the downside of reduced future upsell potential.  An unpredictable metric can still be the right choice overall, but should be chosen with visibility of these potential consequences, and with an execution strategy to mitigate them.

Unlock Significant Value

The impact of changing to value-aligned pricing metric is frequently immediate and dramatic. Consider the following examples from the public eye, as well as our own experience.

  • A cloud-based content management provider with rapidly declining growth implemented a new pricing metric which improved correlation with willingness-to-pay by over 10X, and resulted in an almost immediate 10% revenue increase.  
  • Through switching from seats to “active users,” an analytics provider managed to reduce churn by 3 percentage points and saw a large improvement in sales rep satisfaction.  
  • Mention, a social media monitoring tool, raised their average revenue per account by 269% by switching from seats to the number of “alerts” that an organization configures.  
  • An appliance-based network software vendor realized an 8 percentage point  YoY revenue  growth rate increase through switching from a traditional hardware-linked metric to a measure of network connection speed
  • Even Google is an example here, since a big part of its success came from changing the standard price metric for online advertising from cost-per-impression to cost-per-click.

How to Pick the Right Metrics 

The way to find a price metric that could deliver the kinds of results mentioned above is through a combination of brainstorming and evaluation:

Brainstorm possible metrics
Use the categories defined within this article and attempt to think of several metric options that would fit in each. Look to companies in adjacent industries for inspiration. Consider how the company creates value for customers (i.e., does value increase per user?  Per session? Per gigabyte?) and look for metrics that align with the amount of value created.

Evaluate the shortlist
Teams should evaluate the shortlist of metrics against the 5 key criteria for a price metric:

  1. Link to Value – A great price metric aligns with the amount of perceived value that customers receive from the product. If customers agree that as the metric increases, they get more value from the product, they will not question that the metric is a sensible basis for pricing.
  2. Scalability – Ideally, a price metric provides a pathway to future growth.  If a metric is scalable, it is expected to grow following the initial sale, and so tying it to growth will help increase revenue per customer over time.
  3. Predictability – Being able to budget is important to customers, so a metric that does not allow them to predict what their prices will be in the short- and long-terms can be a barrier to adoption.
  4. Auditability – To prevent abuse of the system and/or ambiguity around prices, a metric should be able to be objectively measured, without relying primarily on the customer to provide the relevant information.  
  5. Acceptability – Finally, for the metric to be successful it must be acceptable to the customer. Even if the metric satisfies the above four criteria, if customers don’t feel it is fair to tie this metric to price, the customers may reject the pricing model, hampering initial sales velocity.

Rigor and confidence can be added to this step by launching customer research to achieve an ‘outside-in’ perspective of the metrics.

Select the best overall metric(s)
Given a business’ objectives and strategies, some of the criteria defined above will be more important than others. Startups should agree on which criteria are most important and create a weighted performance score for each metric.  The metrics with the top overall scores will be your best candidates.

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It is worth mentioning that, having picked your preferred metric, you still have work to do in (a) deciding how price scales with that metric, and (b) verifying through careful revenue modeling that converting to the new metric will be revenue positive. But aligning on an optimal metric is undoubtedly a hugely important step that is trodden too infrequently.

Choosing a price metric doesn’t have to be difficult or complicated. But for the reasons we have discussed, startups shouldn’t just make the easy or default choice. By being thoughtful and taking these few simple steps, startups can choose a price metric that can be a critical lever to accelerate growth.

In our next article in this series, we will be exploring the startup Pricing Pitfall #3: off-target value communication.

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Pricing Pitfalls: The Four Most Common Packaging Mistakes https://get.fuelbymckinsey.com/article/pricing-pitfalls-the-four-most-common-packaging-mistakes/ https://get.fuelbymckinsey.com/article/pricing-pitfalls-the-four-most-common-packaging-mistakes/#respond Mon, 03 Dec 2018 20:00:51 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ The Rise of Tiered Packaging Several years ago, much of the guidance with packaging was just “make sure you create packages!” This sounds almost redundant, but it spoke to the fact that we frequently observed companies using the monolithic “one size fits all” approach. The implicit message to the customer is: This is our product. Take […]

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The Rise of Tiered Packaging

Several years ago, much of the guidance with packaging was just “make sure you create packages!” This sounds almost redundant, but it spoke to the fact that we frequently observed companies using the monolithic “one size fits all” approach. The implicit message to the customer is: This is our product. Take it or leave it.

Thankfully, we see this far less frequently today, particularly with SaaS companies. Most startups we encounter have adopted a “Good, Better, Best” (GBB) approach. This means creating several tiers of packages which vary in terms the price level and the amount or quality of items included (features, services, usage levels, etc.).

The Many Benefits of Good, Better, Best

Adopting the GBB approach has many benefits. Since customers typically dislike “take it or leave it” offers for anything other than very simple products, providing choices can make a customer more likely to buy. If nothing else, moving from a single offering to a GBB approach will likely increase velocity of sales.

However, GBB can also offer a highly-effective method of price differentiation. In swapping one price level for three (usually), you can accomplish two things. First, you make your product viable for customers at the lower end, who would not have purchased it previously (therefore adding sales volume). Second, you create a higher price point to monetize customers who would value a premium offering. All of this equates to more value capture at the initial sale. These packages can then even be used to grow your base business through upselling customers from basic to premium packages. It’s encouraging that we’re seeing more innovative GBB models in the startup community.

There are many other approaches to packaging. Use-case and buying center-based strategies can be effective for more mature companies selling to enterprises. But GBB is simple and readily accepted by customers. A GBB model – when well designed – is a highly-effective packaging strategy.

The Four Frequent Flaws in GBB Design

The key words in the above sentence are “when well designed.” The reality is that while many startups now realize the benefits of GBB, few have taken steps to create a robust approach. We commonly hear “we didn’t put a lot of thought into our packages.” We estimate that this oversight translates to a loss of 5-15% percentage points of revenue growth a year.

In order for a GBB system to work effectively for both price differentiation and sales velocity, GBB packages must be designed with well-defined customer segments. Each package should provide the target segment with a product it will be satisfied with, at a price it is willing to pay.

Customers vote with their wallets. The clearest indicators your packaging strategy is flawed will be the buying choices your customers make. If the distribution of package purchases does not match your expectations or desires (e.g. 75% of customers purchasing “good,” when you forecasted 40%) or your sales reps are consistently unable to upsell customers to higher-level tiers, you can be confident your issues lie within your packaging strategy.

The specific packaging issues we see most frequently are outlined below:

(P Axis = Price; V Axis = Value)
  • Too Much in the Base – The base package is just too good. The vast majority of customers are happy with what is included in the base package, and they don’t value the extra offerings in the higher-level packages enough to justify an upgrade. The majority of the business then shifts to the entry price point, which drops revenues unnecessarily.
  • Decoy Choices – A company has followed the conventional wisdom that the goal of GBB is to draw customers to the middle version. Now the good version is too light. And the best version is so incremental in value to the better version, that the middle option is the only realistic choice. In this situation, the other packages serve only to make the middle option look better. You will get the sales velocity benefit of packaging, but nothing more.
  • Unrealistic Comparisons – The difference in price of the packages so large that any differences in value between packages are immaterial. It’s easy to imagine a customer choosing between packages costing $200, $500, or $750 a month. But can you imagine them truly considering options that cost $200, $2,000, and $20,000? When this is the case, the customer doesn’t really have a genuine choice anymore. They will feel forced into the one option designed for them. Now the benefits of having a choice-based packaging system erode.
  • Too Many Sources of Difference – Tiers do not work when the packages differ across too many attributes, particularly attributes that cut across different and unrelated use cases. It is likely that a customer will attach value to some of the sources of package differentiation, but not to all of them. This can result in the customer objecting to paying the premium for the higher-level package, since they feel that much of that premium is for items they don’t need (this effect is particularly marked when the price difference between packages is also high).

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Best Practices for Designing the Good, Better and Best Tiers

The solutions to poorly-tiered packaging are not complicated, but require a solid understanding of your customer segments, needs, and willingness-to-pay. All of this can be obtained through robust customer and prospect research.

  • Align on a suitable base – Developing a base (“good”) package, with the necessary minimumfeatures, is a critical step in the design journey. Price differentiation is about giving your customers something that they are satisfied with at a price they are willing to pay. The segment of your customers with the lowest willingness-to-pay should be satisfied with the base package. Thus, the base package should be the lowest spec package you can produce while preserving this satisfaction. All items which are “table stakes” should be included, along with any low-value items that would be a distraction while selling.
  • Tier by only the key value drivers – The next step is to determine what are the few key value drivers that truly drive value perception to the segments with higher willingness-to-pay. These value differentiators can be comprised of multiple features, but the breadth of overall functionalities or capabilities that they enable should be limited. Less is more in this case, since this will allow sales and marketing to build a clear value story around the higher tier packages and will make the upsell case more compelling.
  • Build in up-sell triggers – You can further strengthen the upsell pathway by incorporating thresholds into your package design. Placing caps on capacity or usage by tiers can drive upsell to the next tier when the customer’s needs outgrow the current tier. This is a particularly effective strategy when the threshold is the customer’s amount of usage of a highly valuable feature or function, since the up-sell trigger will then be self-selected and a natural reflection of increased value consumption from the product.
  • Consider scaling prices separately – Large price differences across packages are often primarily driven by companies trying to address large differences in customer scale and willingness-to-pay through the packages alone. For example, “we will make our ‘best’ version focused on Enterprises, and so will put capacity constraints on the ‘better’ version.” As mentioned above, this creates unrealistic choices. A better approach can be to remove ‘scale’ factors from the packages (make packages vary by quality components alone) and use a price metric to scale the price of each package to the customer (for example, package A may cost $500 to a customer with 500 employees, but $5,000 to a company with 100,000 employees).
  • Break out niche functionality – Sometimes certain features or functionality will be valued very highly by a small portion of customers. However, unless this group happens to be the highest willingness-to-pay segment that you’re targeting your “best” package towards, these features do not belong in a GBB framework. Similarly, if these features address very different use cases to the core product functionality, their inclusion in the GBB framework could cloud the value stories. The best practice is to monetize these niche features separately as add-ons instead.
  • Price the tiers to value delivered – For most buyers (especially B2B), low-priced offerings signal poor product quality. This can create a perception of risk, and so bring doubt into the purchase process. Therefore, for sales velocity as much as value capture, it is important to price each tier at an appropriate level for the amount of value delivered.

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Although more detailed decisions will need to be made, following these simple guidelines around pricing will help startups avoid falling into the common pitfalls of ineffective good, better, best packaging.

In our next article in Pricing Pitfalls, we will be exploring the next startup pricing challenge – selecting an undifferentiating price metric. You can email the authors at Fuel@McKinsey.com for more information. And please follow Fuel on LinkedIn and Twitter for more pricing insights.

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Startup Pricing Pitfalls: A how-to series on avoiding common pricing mistakes https://get.fuelbymckinsey.com/article/some-common-pricing-mistakes/ https://get.fuelbymckinsey.com/article/some-common-pricing-mistakes/#respond Wed, 05 Sep 2018 19:05:37 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ A couple of weeks ago, we met with the CEO of a startup (let’s call him Barry) who was looking to transform his pricing strategy. At Fuel, we are big believers in the idea that to produce a great solution you must have a holistic understanding of the problem. So, we ran Fuel’s Pricing Quick Diagnostic in […]

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A couple of weeks ago, we met with the CEO of a startup (let’s call him Barry) who was looking to transform his pricing strategy. At Fuel, we are big believers in the idea that to produce a great solution you must have a holistic understanding of the problem. So, we ran Fuel’s Pricing Quick Diagnostic in advance of the meeting, and informed Barry that we would take him through the results in the session. This is familiar territory for us – nothing new here. But what did stick out for us was what Barry said immediately after sitting down.

“So, tell me. How bad is it?  Is this the worst pricing you’ve ever seen?”

Besides being a curious intro to a problem-solving session, Barry’s line nicely illustrates the way executives often think about pricing problems. They tend to assume they have unique and insurmountable problems. That they have dug themselves into an inescapable ditch through flawed pricing practices. Nobody could possibly be doing this as badly!“Regardless of the specific industry or situation, startup executives continuously fall into the same traps.”

Regardless of the specific industry or situation, startup executives continuously fall into the same traps.

The reality is quite different. Having run the Pricing Quick Diagnostic for countless startups at various stages of growth, what strikes us is how frequently the same pricing problems pop up in markedly different companies. Regardless of the specific industry or situation, startup executives continuously fall into the same traps.

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The good news here is that for pervasive problems there are tried-and-true solutions. Our hope is that by shedding light on these all-too-common pitfalls, executives will have the strategies they need to take steps to diagnose their problems, craft a solution, and begin harnessing the growth acceleration that strategic pricing will bring.

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In a series of upcoming posts for Fuel, we will unpack the four most frequently encountered pitfalls and how to address them. These are:

  • Value-agnostic Packaging – without careful design, packages will likely not address customer needs and willingness-to-pay — leading to unexpected customer choices
  • Undifferentiated price metrics – the metric accepted by your industry and peers is not always the right metric for you
  • Off-target value communication – startups frequently talk about what customers should care about, not what they do care about
  • “Wild West” discounting – in order to be effective, sales reps need some degree of flexibility, but too much can result in indiscipline and prevalent value leakage

For each pitfall we explain what the problem is, how to know when you have the problem, and practical advice on what you can do about it. In the meantime, if you have any questions on pricing and packaging, please feel free to contact James Wilton, Fuel’s Pricing Lead, directly at james_wilton@mckinsey.com and follow Fuel on LinkedIn and Twitter for more pricing insights.

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The Hidden Competitive Advantage of Pricing https://get.fuelbymckinsey.com/article/the-hidden-competitive-advantage-of-pricing/ https://get.fuelbymckinsey.com/article/the-hidden-competitive-advantage-of-pricing/#respond Tue, 29 May 2018 19:16:13 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ Running a growth-stage company is hard. Founders and CEOs face constant demands from their investors and pressure to grow fast or die slow. In the midst of building and managing a sales force, figuring out marketing channels, and scaling up product and operations, pricing is often relegated to the list of to-dos with an indefinite […]

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Running a growth-stage company is hard. Founders and CEOs face constant demands from their investors and pressure to grow fast or die slow. In the midst of building and managing a sales force, figuring out marketing channels, and scaling up product and operations, pricing is often relegated to the list of to-dos with an indefinite deadline.

So, how do companies establish their pricing strategies?  In our experience, it goes something like this: early in the business the CEO needs to set a price. She has little or no data from which to extrapolate, so she takes an educated guess. The product begins to sell! The price is tweaked a little bit if the product evolves significantly, or if the product offerings are expanded.  For the most part, however, it stays the same.  More fundamental changes are considered briefly, but are dismissed due to concerns for messing up and seeing revenue decline or churn increase.  In short, that initial guess becomes an unmovable anchor point.  Does this sound like the way you set your pricing?

Companies worry too much that changing their strategic pricing architecture and tactical policies risk leaving significant value on the table. Getting pricing right should be a key part of any startup’s strategy, and should be considered early in the growth trajectory.“For those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage.”

For those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage.

Growth through pricing

Our research and experience shows that startups that tackle pricing issues strategically and tactically see a 10-15 percentage point increase in their revenue growth rate within 12 months of implementation. Those pricing changes can result in higher average customer value (ACV), decreased churn, and the ability to reach new customer segments with better-tailored offerings. And this result holds across a range of industries and business models.

So, why are the potential gains so great for startups in particular?  Startups are exceptional at creating new sources of value for their customers, but they are far less effective at capturing that value. Pricing optimization allows them to reverse that “value leakage,” and they can do so across each of three key levers:

Increase ‘perceived value:’ Customers pay for the value that they perceive in a product, not for the value that is actually there. The relationship between the two is determined by how well a company communicates to its customers the value it delivers. Startups always know they are adding value, but often don’t understand which parts of their value proposition resonate with different customer segments – often resulting in an undifferentiated offering to the middle of the market. Startups can increase customers’ willingness to pay by tailoring their price and product positioning to the specific segments they serve.

Set price to willingness-to-pay: What customers are willing to pay for the value they receive is highly variable across any customer base. This is especially true for startups, which frequently serve customers across industries and sizes. But when startups pursue diverse customers with the same go-to-market motion, they often have little understanding of what different customer segments need and might be willing to pay. Even if they did possess this understanding, pricing to willingness-to-pay requires a system to effectively differentiate pricing based on that willingness-to-pay. Common challenges include:

  • Linking packages to value: How can you package features in a way that leaves customers with low willingness-to-pay satisfied with a truncated offering, but ensures that those with high willingness-to-pay will always upgrade?
  • Linking pricing architecture to value: How can you charge different prices to different customers for the same product in a way that will be perceived as fair? This is about linking your pricing units to customer value. Companies frequently default to metrics like seats and licenses. These metrics are fine so long as the value of the product truly increases with the number of users. But where it doesn’t, usage-based metrics like GB of storage or hours of usage may work better. Some companies are also experimenting with success-based pricing.  Here, they price with metrics based on customers’ revenue or profit so that the price scales in lockstep with the value delivered.
  • Setting price levels to willingness to pay: How do you know what a customer is willing to pay? And if you do know, how can you use that information to optimize market share, revenue or profit? Figuring out the answers to these questions requires not only customer interviews and surveys but a working knowledge of the sophisticated quantitative methodologies used to get customers to reveal their true preferences.

Get the price you deserve: Even if startups have a good system for determining the list price, that system can be undermined during the course of the sales cycle. Companies often willingly bend on price in order to meet logo or volume targets, or they grow so fast that a rigorous approach to discounting is discarded. In either circumstance, there is value to systematizing and rationalizing discounts. For example, you should determine up front what levels of discounting are justified by the value derived from new customers justifies discounting, and you should align reps’ incentives with price to discourage excessive discounting.

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Overcoming barriers to pricing success

Given the demonstrated potential impact of pricing optimization, why don’t more startups proactively take the necessary steps?  Several common internal barriers often prevent companies from pricing effectively.

First, there is usually a significant knowledge gap that must be overcome. In contrast to sales, marketing or product development, startups usually don’t have personnel with expertise or experience in changing pricing models, and therefore don’t have the robust quantitative approaches that give real insight into value perception, customer preferences or willingness to pay. Bringing in pricing expertise, from outside the company if necessary, is critical to establishing a more robust pricing function and making sure that pricing changes increase revenue rather than cause churn or declines in ACV.

Risk aversion is another understandable barrier to price optimization. Changing the price, particularly for existing customers, is perceived to be a dramatic and risky move that many companies are afraid to make. That fear arises less from any risk inherent to changing price and more from the same lack of understanding described above. Targeted market research using proven approaches can mitigate the perceived risk of price changes.

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Finally, growth-stage companies have limited management bandwidth, and often see pricing changes as a secondary priority. This arises in part because of the common misconception that revenue growth is more easily driven by volume than by price, leading management to focus on customer acquisition over pricing optimization. It is amplified by a perception that pricing is always a long-term profitability play rather than a short-term revenue accelerator. But as we’ve shown in this article, there are significant gains to be made from getting pricing right.

Pricing optimization is not an overnight growth lever for startups. But for those companies with the foresight to undertake pricing transformations early in their growth trajectory, it will be a consistent source of competitive advantage, and an undeniable growth accelerator.

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Pricing: The Secret Weapon You Haven’t Thought About https://get.fuelbymckinsey.com/article/pricing-the-secret-weapon-you-havent-thought-about/ https://get.fuelbymckinsey.com/article/pricing-the-secret-weapon-you-havent-thought-about/#respond Fri, 27 Apr 2018 19:17:50 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ In our experience, there are several barriers to pre-IPO companies optimizing their pricing, and one of the most prevalent is the lack of firm evidence that pricing is not already optimized.  The reason?  Successful startups typically exhibit huge growth rates, and nothing hides opportunity better than success.  Even if you suspect your pricing isn’t perfect, […]

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In our experience, there are several barriers to pre-IPO companies optimizing their pricing, and one of the most prevalent is the lack of firm evidence that pricing is not already optimized.  The reason?  Successful startups typically exhibit huge growth rates, and nothing hides opportunity better than success.  Even if you suspect your pricing isn’t perfect, how would you know? And if your results are great anyway, why should you even care?

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The truth is that a detailed look at customer level sales data can often expose not only whether you have a pricing issue, but also what kind of pricing issue you have.  The trick is knowing what to look for – what analyses to run and how to interpret the results.  And you should care, because we have shown that improving your strategic and tactical pricing execution typically adds an extra 10-15 percentage points of revenue growth to even rapidly growing pre-IPO companies.  Capturing this opportunity requires you to first know there is an opportunity to capture, but many startups do not have the time or experience necessary to run the necessary diagnostics.

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To help the startup community capture value through pricing, we at Fuel by McKinsey are offering pre-IPO companies an opportunity to get a Pricing Quick Diagnostic for free for a limited time period.  If you provide us with 2 years of monthly sanitized customer-level revenue data1, we will provide you with 3 key charts that will help identify opportunities for you to inflect your business with pricing improvements.  You’ll also receive a guide to interpreting your results.

As an example, we recently conducted a similar analysis for a SaaS company growing at >130% per year.  We determined that the company’s packaging scheme was preventing upsells, and that the company was ineffectively monetizing different customer segments.  Having realized these shortcomings, the company has pledged to address these issues and capture the value they are missing.

Learn more about our Pricing Quick Diagnostic here or Register Now.

Questions? Email us at fuelpricingqd@mckinsey.com.  We look forward to meeting you and identifying your pricing opportunity.

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Is Your Pricing Page Slowing or Accelerating Growth? https://get.fuelbymckinsey.com/article/is-your-pricing-page-slowing-or-accelerating-growth/ https://get.fuelbymckinsey.com/article/is-your-pricing-page-slowing-or-accelerating-growth/#respond Fri, 28 Oct 2016 20:36:19 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ Savvy SaaS players think carefully about what pricing information they publish, when, and how. We’ve identified three pricing communication practices that set winners apart from the rest. Consider ditching your pricing page once you pass $10,000 in ACV More than 90% of the SaaS companies in our database stop displaying a transparent pricing page on […]

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Savvy SaaS players think carefully about what pricing information they publish, when, and how. We’ve identified three pricing communication practices that set winners apart from the rest.

Consider ditching your pricing page once you pass $10,000 in ACV

More than 90% of the SaaS companies in our database stop displaying a transparent pricing page on their website once their average annual contract value (ACV) exceeds $10,000. Furthermore, those that ditch their pricing page are often able to tilt up-market with annual ACV increases of 24% by adding larger customers. Compare that with just 14% for their peers who still have a transparent pricing page.

Why would removing your pricing page help you attract bigger customers? One reason may be that when customers see prices on your site, the phenomenon known as “anchoring” kicks in. Larger customers pigeonhole your solution as “too cheap to be good,” or they may start negotiations at a lower point instead of finding the right price for the value they will likely capture.

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You may also want to stop advertising free trials

Equally interesting, our data show that taking free trials off the website also correlates with healthier ARR growth. Of the SaaS companies in our database who ditched their pricing page, 50% continued advertising free trials of their product on their site. On average, their ARR growth was 40% lower than that of our member companies that don’t advertise free trials. The reason? One possibility is that customers who like to “try before they buy” may take longer to make a purchasing decision. They spend more time shopping around and may eventually get distracted and settle for the “do nothing” solution. If you can close a deal without having to wait for the customer to play with your product first, you close it faster.

As another intriguing point, the companies we examined that offer free trials have higher average sales costs—66% of ARR, compared with just 21% for companies that don’t advertise their trials. Hence, we see that free trials can be more expensive if the wrong leads are signing up. This can also distract salespeople, if those prospects need frequent “touches” throughout the trial.

Are there any downsides to taking the free trial off the website? Companies that don’t advertise trials spend significantly more to onboard new customers: $32,000 versus only $13,000 for companies that advertise their trial. Hence it may make sense to keep advertising your free trial despite the higher cost of sales if you are adding lots of customers. It’s also worth noting that just because you don’t advertise free trials doesn’t mean you can’t offer them if you need to.

If you keep your pricing page, shoot for more tiers

If ACVs are below $10,000 or you have decided to keep your pricing page anyway, think carefully about what’s on it. The number of tiers you define can make a big difference in your revenue growth.

Of the SaaS companies in our database that offer transparent pricing information, about 60% have defined three or fewer pricing tiers. Those that have defined more than three tiers boast 25% higher ARR growth and significantly lower discounting rates than the others. These differences in ARR growth and discounting rates suggest that companies with more tiers may be able to align their pricing more tightly with customers’ willingness to pay.

Another phenomenon we often see on pricing pages is tiers with nonsense names. Potential customers have a much harder time understanding what names like “standard” and “premium” mean versus more descriptive names like “freelancer,” “small business,” and “enterprise.” Descriptive names help customers sort themselves into the right category rather than looking for the cheapest category that meets their needs.

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Our analysis shows that when it comes to conveying pricing information, less can be more in some cases—while in other cases, more is more. With that in mind, ask yourself:

  • How is your ACV and ARR growth?
  • What changes could you make today in your pricing communication strategies to get those growth numbers up?

The findings we’ve shared here are the latest from McKinsey’s SaasRadar database—a proprietary benchmark of private and public B2B SaaS companies with annual revenues ranging from $10 million to $500 million. Participants receive a report comparing their performance and metrics to those of a hand-picked cohort of peers. The report’s findings help management teams to gain actionable insight into the drivers of growth and customer lifetime value.

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Time to Rethink Per-User Pricing for Your Enterprise Saas? https://get.fuelbymckinsey.com/article/time-to-rethink-per-user-pricing-for-your-enterprise-saas/ https://get.fuelbymckinsey.com/article/time-to-rethink-per-user-pricing-for-your-enterprise-saas/#respond Sat, 01 Oct 2016 20:40:37 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ The message is loud and clear: In a McKinsey survey of enterprise software customers, more than 75% said they want pricing metrics that are… Easy to understand. Think “number of employees” versus “rate-adjusted user equivalents.” Legacy on-premise software customers have long complained about the complexity of pricing metrics, and SaaS companies are now rethinking those metrics. […]

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The message is loud and clear: In a McKinsey survey of enterprise software customers, more than 75% said they want pricing metrics that are…

  • Easy to understand. Think “number of employees” versus “rate-adjusted user equivalents.” Legacy on-premise software customers have long complained about the complexity of pricing metrics, and SaaS companies are now rethinking those metrics.
  • Aligned with how customers perceive value. Price goes up only when the customer captures more value—such as greater revenue or lower costs. For example, Zuora, a subscription revenue management company, charges based on a customer’s total amount of recurring revenue.
  • Easy to track and predict. Customers can predict the amount they have to pay as they use the software. For instance, Salesforce.com charges based on customers’ number of salespeople, not number of CRM contacts. Number of salespeople is easy to track and control, but number of CRM contacts may shoot up unexpectedly

The most classic software pricing metric is “users.” Sometimes, user-based pricing metrics make perfect sense. At Salesforce.com, the number of users (i.e., sales reps) aligns with Salesforce customers’ perceptions of value, because each additional salesperson will likely bring in new revenue. Other times, non-user metrics (such as “revenue,” “employees,” or “beds in a hospital”) can be easier to understand and can align more tightly with what customers value. (See Exhibit 1.)

Most sales reps still prefer user-based metrics. When we interviewed enterprise sales reps, over 80% said they viewed user-based metrics as easy to understand and sell, while less than 50% expressed enthusiasm about more novel metrics.

A missed opportunity

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Companies that don’t broaden their view of pricing metrics may be missing out: When we analyzed participants in our SaaSRadar database, we found that companies with non-user based metrics tend to grow about 40% faster than those that don’t. (See Exhibit 2.)

That said, there are still plenty of user-based metrics in the SaaS world: about 50% of our database participants are sticking to per-user as their pricing metric (for instance, $10 per user per month). As much as 27% base their pricing on usage (for example, $10 per gigabyte of data stored), and only about 10% use customer revenue as their pricing metric. (See Exhibit 3.)

What’s going on? Despite customers’ interest in more creative pricing metrics, most legacy sales reps have difficulty understanding and communicating pricing metrics that are based on something other than number of users. That’s especially true when they’re selling to legacy software buyers, such as old-guard procurement professionals vs. newer line-of-business buyers.

Mix it up to grow your ARR

To capture greater ARR growth, companies have to do more than just sprinkle a few novel pricing metrics into their mix. Instead, they need to think strategically about their metrics—and tailor them to the unique circumstances and nature of their business.

Zuora, for instance, links pricing to the amount of subscription revenue the customer has on the Zuora platform. That creates an efficient and optimized billing cycle. Each customer’s value scales with overall amounts billed. For Zuora, pricing by customer revenue aligns tightly with customers’ perceptions of value. The more a customer’s revenue grows, the more it needs a service like the one Zuora provides. And that creates automatic upsell as subscription revenue rises.

At times, using a hybrid pricing model—one comprising both user and non-user metrics—may be the best move. As we noted earlier, Salesforce.com’s pricing per sales rep aligns well with its customers’ perceptions of value since each additional sales rep will probably generate new revenue. But pricing pegged to a salesperson’s productivity would link even more directly to their revenue, making it easier for certain customers to say, “yes.” So Salesforce.com might further grow its ARR by augmenting its per-user pricing with metrics like seller productivity.

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In all of these examples, the non-user metrics are easy for customers to understand, align with what customers value most, and are easy for sales reps to negotiate and sell. Result? Everyone wins.

The upshot

You don’t—and you shouldn’t—have to give up per-user pricing if it aligns best with your customers’ perceptions of value and is easiest for them to understand and track. But to sweeten the odds of growing your ARR, you can—and you should—consider experimenting with metrics that align even better with what matters most to your customers.

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The 6 Rules of Setting Price for SaaS Offerings https://get.fuelbymckinsey.com/article/the-6-rules-of-setting-price-for-saas-offerings/ https://get.fuelbymckinsey.com/article/the-6-rules-of-setting-price-for-saas-offerings/#respond Sat, 01 Oct 2016 20:39:17 +0000 https://get.fuelbymckinsey.com/article/auto-draft/ In many cases, SaaS companies underprice their offerings because they lack the right processes for updating pricing as quickly as they’re increasing value for their customers. A 2013 survey of 270 SaaS companies by PriceIntellegently provides some blunt findings: at 41 percent of those companies, the founder sets the prices—a statistic which exposes an alarming lack […]

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In many cases, SaaS companies underprice their offerings because they lack the right processes for updating pricing as quickly as they’re increasing value for their customers. A 2013 survey of 270 SaaS companies by PriceIntellegently provides some blunt findings: at 41 percent of those companies, the founder sets the prices—a statistic which exposes an alarming lack of progress since the ‘90s when Jim Barksdale, then CEO of Netscape, famously declared: “If we have data, let’s look at data. If all we have are opinions, let’s go with mine.”

Worse: the study finds that nearly one in five SaaS companies set their pricing by guessing what the right price might be.

It’s not an exaggeration to say that many SaaS firms don’t price as scientifically as they could. The most common mistake is that companies price for their initial markets and don’t change their pricing as their products’ roadmaps change.

Price points that worked well in the early days often underprice the product over time, for two good reasons. First, as young SaaS companies begin to serve larger clients, moving into the enterprise space, they typically don’t adjust the pricing plans that were originally structured to serve small and mid-sized businesses. Second, as their products’ capabilities expand, most startups don’t increase their prices to match the greater value that the more capable solutions now generate for their customers.

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To set pricing correctly, SaaS companies should take these six steps, at least annually, and maybe more often than that:

1. Determine relevant customer segments

It’s essential to tailor pricing to each customer segment. That presupposes that SaaS firms understand how their customer base is segmented. (Many of our clients in this space lack good data on this, so if you have some catching up to do, you’re not alone.)

A good first step is basing customer segments on potential spend (that is, by potential budget available), the nature of the solutions (which may vary by industry or customer size), and by type of buyer (line of business, engineering, IT, etc.) With that groundwork in place, it’s possible to use analytics and interviews to dive deeper into each segment.

2. Interview customers in each segment

There are three main objectives for the interviews: first, to identify why customers value the service; second, to understand the best mechanism to charge for that value creation; and third, to determine which products and processes customers use that can be augmented or replaced by your product.

 There are many ways of getting at this data, ranging from in-person interviews to Web-based surveys. Web analytics specialist Qualaroo has a useful survey tool that asks this key question: “How would you feel if you could no longer use this product?”

When probing into pricing, it’s much easier to ask relative pricing questions—not absolute ones. Is this product more or less valuable than another product? That will elicit more candid and useful responses than a question that sounds like it’s fishing for praise. For more on this topic, check out this presentation from KissMetrics:

You should also focus questions on how customers will pay. Because SaaS solutions are connected by definition, it’s easy to measure and bill based on value-aligned metrics that may be able to extract more value than the old on-prem metric of “seats.”

3. Construct business cases to determine what the right price should be

The best pricing models match a customer’s “time to value” with its “time to expense.” Let’s compare a couple of examples: Twilio, a SaaS offering that saves developers time to get products to market, and a PBX solution that slowly reduces datacenter costs year over year. In the first example, savings in developer time are an easily quantifiable value driver that customers get almost right away. Hence, customers are happy to use pay-as-you-go pricing to get the ease of use that Twilio offers. In the second example, customers may need to be educated to see how and when they’ll save by using the PBX solution. They may also be more comfortable paying a higher price if payments are pushed into the future and aligned more closely with the timing of value capture.

4. Build bundles that match customer needs and encourage up-sell 

Best practice bundling calls for each bundle to meet a particular set of customer needs while balancing two important concepts. The first is to ensure that every customer has a great experience. The second is not to put so much into the low-tier bundle that customers have no reason to upgrade to higher tiers and more valuable packages!

Hence, SaaS companies need to put critical features for usability in all bundles but identify features that allow top-tier certain customers to extract top-tier value and restrict those to more expensive packages. Often simplicity is key here as it helps potential customer self-sort into the right package rather than giving a long, complex feature list, which can be incomprehensible to potential customers unfamiliar with the product.

One relevant example was a client that had included unlimited use of a valuable feature across all of their bundles. The feature was also quite expensive to provide as it relied on a human to be in the loop. They noticed that many customers who should have been in the top tier were instead buying at a low-tier price and using this feature like crazy! By limiting use at the low tier and moving “unlimited” to the higher tier they were able to properly align value created with the price point their customers paid allowing them to capture more revenue and rescue profitability.

5. Double-check all cost-plus considerations

While we always recommend pricing to value, unit economics are terrifically important in SaaS. A common rule of thumb is that [Annual Contract Value] / [Customer Acquisition Cost] > 1. However, looking at McKinsey’s SaaSRadar database, only about 45 percent of companies manage to hit that ratio!

When setting pricing, it’s important to understand the costs of acquiring and supporting a customer. After all, the business must ensure that prices are high enough to enable the company to achieve certain margins. Otherwise, it won’t be much of a business!

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6. Test frequently by tweaking pricing to see the effect on sales

As noted earlier, pricing has to be handled dynamically—as an ongoing business process that reflects continual changes in the marketplace, the competitive landscape, the value and range of offerings, and the size and sophistication of customers.

Hence, it’s crucial to have a process for regularly testing new prices. Some of this can be done the “old school” way: pushing proposed prices to the point at which customers cry out. It can also happen on the web site, using A/B testing or other feedback tools to quickly gauge how possible price tweaks are affecting the numbers and types of inquiries, leads, and lead conversions.

The bottom line: once you’ve set your pricing, you’re not done. Pricing should be an essential and frequently used tool in the toolbox of every SaaS company.

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