SaaS Pricing Models & How They Affect Valuation
Even if people haven’t heard of software as a service (SaaS), chances are they have used one.
That’s what makes SaaS such a powerhouse in the world of digital assets.
The SaaS business model relies on recurring subscriptions for its income. Subscribers pay to essentially lease software that is hosted in the cloud. This means there are no physical copies or license agreements, making it incredibly easy for customers to access your service.
If done correctly, investors love the SaaS business model. The recurring revenue stream makes the business model one that is full of gold, and is the main reason why SaaS companies tend to fetch a higher valuation than most other online businesses.
A SaaS company is more difficult to value as there are more moving parts. Our SaaS valuation guide provides a comprehensive overview of the valuation method that should be used.
In this article, we’re going to narrow down the focus to pricing models, and discuss why this deserves special attention.
Why is a SaaS Pricing Model So Important?
Having a product that people need to use creates the opportunity for endless potential. Whether that’s business to business (B2B) or business to customer (B2C), the SaaS business model can do it all.
Whatever your customer base is, there’s always one thing at the forefront of their thoughts…
Justifying the price of the software is often the main pinch point preventing customers from subscribing. This is particularly true if your service is new to the market and you haven’t fully established yourself yet.
This is actually something that a good SaaS pricing model can help with.
Making it as easy as possible for customers to see value in the service you’re providing is a powerful persuasion tactic. Some SaaS companies provide a “freemium” level to their pricing which allows a restricted level of free use.
Everyone likes something for free. Getting these customers in through the door then makes it easier to upsell them. This is just one of the many strategies that companies will implement.
See how a pricing model starts to become very important?
Combining good software with good marketing will naturally start to boost your profits. Higher net profit is the number one way to increase a SaaS valuation.
But there’s also more to choosing the correct pricing model, as buyers like to see that SaaS companies are operating sustainably.
The pricing structure is a direct contributor to the customer acquisition cost (CAC) and the customer lifetime value (LTV). Both of these metrics are hugely important in deciding whether your business is successful.
While it is possible to change a model after a business begins trading, it’s a lot easier to get it right the first time. Completely changing the pricing structure risks alienating the customers you already have. The ideal scenario is a low CAC and a high LTV. This is not only what’s needed to be successful, but is also what values your SaaS company at a higher price. These two things often come hand in hand.
Even if you’re not thinking about selling your SaaS business just yet, getting operating procedures implemented as if you were will help you to succeed.
Getting through the start-up and into the hyper-growth phase requires people to sign up to become paid customers. To ensure as many people do that as possible, it’s important to get the correct pricing model in place early. With a fair few choices, we’re aiming to look at which one will work best for you.
Why Are There So Many Different SaaS Pricing Models?
Software by definition is highly customizable. This opens up endless possibilities regarding design, function, and features.
When you combine this with an arsenal of marketing tricks, it makes for a mind-boggling number of possibilities.
It’s also pertinent to mention that due to both of these factors, what works for someone else might not work for you. A pricing structure should find the balance between maximizing profit and being easy for customers to understand.
Pricing in itself is a key component of conversion rate optimization (CRO).
With a sound model in place, slightly tweaking prices will allow you to see how that affects net profit, CAC, LTV, and churn. The idea of increasing the price is a daunting one for many startups.
The inevitable question is… “what if people leave?”
The mission objective of a SaaS company should be to make tasks easier for people. Whether that’s automating a company’s marketing funnel or making bookkeeping easier for accounting services. Proving your worth to a user is what turns them into loyal customers.
If your software helps a company grow, it might be beneficial to have a pricing model that also grows. If a bigger company needs to use more features then it makes sense to charge them more. Chances are if they’re making more money, then they’re willing to pay more for quality.
At some point, it’s likely that your company will outgrow its price.
Owning a SaaS company is a constant cycle of listening to user feedback and implementing updates. These updates improve your software so that value can increase.
Take a look at the streaming giant Netflix.
When they made the move to online streaming in 2014, they offered a single tier of pricing known as “standard” for $7.99. As their user base grew they invested in more content and felt this justified a price increase.
Fast forward five years to 2019 and they now offer three tiers of pricing, the standard of which is now available for $12.99.
How did this affect their company?
Put simply, their subscriber base is higher than it’s ever been.
There are examples like this throughout the SaaS business world. Although, there are of course cases where this hasn’t worked so well. But by listening to your customers and implementing a pricing model that allows both yourself and your customers to get more out of it counts as a win-win.
What are the Best SaaS Pricing Models?
Without further ado, we’re going to get into the different kinds of pricing models and discuss how they affect a SaaS business model and in turn the valuation.
As mentioned before, setting up a company as if you’re working towards an exit often leads to things running smoother. Getting into this way of thinking early is a lot more beneficial than when you become more established. Customers who start in the early stages are usually a lot more understanding. Things become more difficult to change as you get more users.
While not strictly a pricing model of its own, we feel it’s important to include this as part of the discussion.
Freemium is offering your service for free but with a limited set of features.
It is often used in conjunction with other pricing structures. For example, Basecamp, a project management and communication software for remote teams, offers a “personal” level.
This free version has limits on the number of projects, users, and storage. This allows customers, particularly those from small businesses, to use the software for free. If you believe the software will prove its worth to people, then persuading them to buy becomes easier.
Pros of the freemium pricing model:
- Great functionalities (free of charge)
- Tailored upgrade packages
- Encourages customers to want more
Cons of the freemium pricing model:
- Some customers aren’t looking for upgrades
- You may end up with a lot of free users
Flat Rate Pricing
The most basic of the popular models is flat rate pricing. Pretty self-explanatory, companies will charge a single fee to use their service.
This means that everyone who pays the subscription cost gets to use all the services that the software provides. It’s a one size fits all method that puts all customers on the same plan.
The simplicity of this model means it is the easiest to implement. It’s a format that every customer will be familiar with. The only difference between this and an eCommerce store is that customers of your SaaS product are not paying to own the product outright. Instead, they pay a monthly or annual subscription to use the product for as long as they desire.
Basecamp makes use of flat rate pricing. For $99 a month you get full access to their software.
The beauty of this method is its simplicity. It’s easy for people to see exactly what they’re paying for. They don’t have to worry about what features they do or don’t need because it comes as one package.
Because of this, a lot of startups use this model when they first begin. When you first put your software out into the market it’s probably not going to be the finished article. There will be many more ideas in the pipeline. A lot can be said for having something that gets you up and running.
However, the benefits of this model are also its limitations.
Will a large company need the same features as a small local business? It’s only natural that the price increases as more features are added, but keeping customers happy becomes more difficult.
Continuing to use flat rate pricing means that you’ll be missing out on profit. The ability to charge customers more who not only make more profit but will be using more of the software becomes a challenge.
Pros of the flat-rate pricing model:
- Easy to create
- Easy to sell
- All customers understand it
Cons of the flat-rate pricing model:
- Difficult to draw out value from different users
- One change might scare your customers
Tiered pricing aims to offer something for everyone. One of the most popular models, it’s something most people will be familiar with.
This is where companies offer different pricing based on the number of features you require. It might even begin with a freemium level before scaling up in price through different plans.
A company that implements this pricing model is the search engine optimization tool Ahrefs. They offer four plans that start with a “lite” version for $99 a month, all the way up to an agency version for $999 a month.
Although the lower tier of pricing may seem expensive, Ahrefs built themselves up to be one of the market leaders, and as such they can use their brand to charge more.
The benefit of this system is obvious. Tiered pricing can maximize your profit by creating packages based on the customer’s needs.
It also leaves room for the customer to grow.
It’s common to see three levels of pricing, low, medium, and high, but this doesn’t have to be the case. Tiers can be created based on what relates to your software. The pricing model only becomes a problem when the tiers are not clearly defined by easy to understand features.
People will want to know what they’re getting for their money before they sign up. If they can’t categorize themselves in one of the payment plans then you risk losing them before they even had the chance to become a customer.
Pros of the tiered pricing model:
- Suitable for multiple personas
- Brings more revenue
- Clear upselling strategy
Cons of the tiered pricing model:
- Choices can become overwhelming
- Impossible to satisfy everyone’s needs
Per User Pricing
Another hugely popular SaaS pricing model is per user pricing. If more people want to be added to the plan then it’s going to cost more.
The project management tool Monday.com uses this pricing strategy. For five users the basic package costs $39 a month, for ten users this increases to $79, and this scales all the way up to 200 plus users.
The pricing doesn’t have to be linear, doubling the users doesn’t always mean doubling the price.
This system tends to work best if your software is marketed in the B2B space, as packages can be tailored to the size of a team. It’s also easy for customers to work out what payment plan they should be on as well as when they need to scale up.
This is another model that offers something for everyone.
The downsides of this model can encourage people to “cheat” the system more than the other models. Multiple people using a single log-in to get around paying a higher fee might be something to watch out for.
Pros of the per-user pricing model:
- Predictable revenue
- Revenue grows with the subscription
Cons of the per-user pricing model:
- Limited adoption
- Easy for customers to abandon your service
- Hides the real value
The Usage-Based Pricing Model
The type of pricing model directly impacts the cost of your SaaS product.
If customers use more of your service, the cost increases, and if less, the cost goes down. The usage-based pricing model is based on this straightforward philosophy.
It is a pricing model that doesn’t appear often in SaaS businesses. It is mostly used for platforms charging for API, bandwidth, processed transactions, or used data.
Amazon Web Services is one example of a company using the usage-based pricing model.
Increasing in popularity, more businesses are finding ways to adapt this model into their strategy. Social media tools, for example, are charging for scheduled posts, accounting solutions charge per invoice, and other related services.
Pros of the usage-based pricing model:
- Price increases parallel to the usage
- Reasonable upfront costs
Cons of the usage-based pricing model:
- Difficult to predict revenue
- Difficult to predict customer costs
The Per-Storage Pricing Model
Cloud-based SaaS businesses often use tiered pricing based on the customers’ need to use storage.
Google, for example, allows its users to access 15GB of storage. If a user wants more storage, they will need to pay extra.
Dropbox is another example of a company using the per-storage pricing model. The company allows you 2GB of free storage, after which users who want extra storage pay a certain fee.
It is a smart business model and is suitable for all software or service companies that want to encourage customers to upgrade on the storage limit.
Pros of the per-storage pricing model:
- Clear selling strategy
- Increased revenue
- Encourages customers to sign up for more
Cons of the per-storage pricing model:
- Some customers may find this model unfair (to pay extra for the same service)
Free and Discounted Trials
It’s possible for all of the aforementioned pricing models to offer a free or discounted trial of your SaaS product.
These act as an enticer, welcoming potential customers into trying your software with little or no upfront risk. Trials can vary in length, some lasting a few days while others up to a month.
The hope is that people recognize the quality of your software and see value in paying the asking price.
Some companies will employ a tactic where a trial automatically runs into a full paying subscription if not canceled by the user before the end of the trial date. If this is something you implement, make sure you adhere to the regulations of the local government and the payment processor you decide to use.
Before deciding on whether free or discounted trials are a viable option, tracking should be set up so the success can be monitored.
What’s the conversion rate? How many people become full paying subscribers?
Tracking all of this will reveal if it’s a worthwhile strategy.
With a pricing model established, how you receive the money is just as important.
Monthly recurring revenue (MRR) and annual recurring revenue (ARR) are the two options but one is largely preferred.
Annual Recurring Revenue
Exactly as it sounds, ARR means offering the customer one payment that covers subscription for a year.
It’s rare to see a SaaS company only offer an annual subscription. If it does it’s usually in the B2B marketplace where contracts are more widely used.
This is because you are potentially missing out on a large amount of revenue. Most new customers will be unwilling to commit to a year-long subscription. This is especially true as it requires a higher entry price.
It’s commonplace to see ARR combined with MRR. A monthly subscription will be marketed more but an annual subscription is sometimes also offered. To make this more appealing it will often be offered at a discounted price, twelve months for the price of eleven for example.
Once you start building up a loyal customer base this offer might become more appealing to people. If they’re a regular user then why not get the discount?
Getting one payment upfront does make things easier when it comes to tracking metrics. However, ease shouldn’t be prioritized over revenue.
Monthly Recurring Revenue
MRR is the preferred choice of billing for not just most SaaS companies but also the investors that purchase SaaS companies.
This is because MRR is a more accurate representation of how your company is doing. It is easier to chart success. While metrics from ARR can be broken down into months, having monthly revenue makes it easier to track the results of any tweaks you make to the system.
It’s more appealing to the customers too. They aren’t tied down to a one year plan, they can commit for as long as they need. While this may increase churn it also increases the subscriber count.
Let’s talk about transfer-ability real quick, and the worst enemy of transferring your business to a buyer…Paypal.
How a Pricing Model Affects Valuation
The profit your SaaS company earns is a direct factor in the valuation it receives. Implementing a pricing model that fits your customer’s needs and maximize your profit will lead to a higher valuation.
The fact that higher profit receives a higher valuation shouldn’t come as news to anyone. What is often overlooked is how a reevaluation of your pricing structure is one of the best ways to improve this.
If you are not using MRR then you should consider developing an option to include it as a billing type. You want to encourage as many active customers as possible and a large upfront cost is likely to put some people off. The number of active customers is a factor in generating the valuation.
As if there wasn’t enough on your plate, the payment processing platform you use is something to be wary about.
How are you going to take payments from customers?
It might seem like a good idea to put all your trust in a company as big as PayPal, but it can cause problems when selling your company.
Remember, when you sell your company you will be transferring everything over to the new owner. This might include source code, employees, and any domains. However, what’s not always thought about is the transfer of the paying subscribers.
PayPal makes it very difficult to transfer over a payment portal from one person to another. The last thing you want is to cause any issues that derail a takeover. Other payment processors should be considered when running a SaaS company, or at least you should diversify your ability to process payments.
Looking to Sell Your SaaS Business?
If you read this article and it got you thinking about how much your SaaS business was worth then this will be for you.
We have a free valuation tool that has been designed with SaaS businesses in mind. Feed it some of your metrics and it will chew over everything before spitting out a valuation derived from years of industry experience.
Or, maybe you want to have an actual conversation about what kind of exit you could make? We have a team of business analysts that you can schedule a call with that has helped millions of dollars worth of businesses plan life-changing exits.
They understand that valuing a SaaS business is not black and white. They can talk you through their thinking and can even guide you in the right direction if you’re not quite ready for a sale.
If you are ready to move towards an exit then submit your business through our sales page.
There just might be an investor waiting to make you an offer you can’t refuse.