Pricing (For Fun and Profit)

For the past several months, I have been working for a startup that sells software-as-a-service to consumers and businesses. This experience, when combined with reading several interesting blog posts, has led me to think a lot about how to properly price your products. Pricing can be extremely difficult - in fact, most startups get pricing wrong the first time. And it isn't easy to change pricing after fact. If you read popular tech blogs, you have probably seen several examples of startups who pissed off their users by changing pricing (even if what they were doing was actually the most logical move).

So I can't say that I have developed a formula for optimal pricing, but I have come up with two general (and slightly hazy) guidelines for maximizing your profits. They are as follows:

  • Get as many engaged users as possible
  • Maximize the profitability of your paying users

Engage Your Users

So this one may seem logical, but there are actually some unforeseen consequences. There are actually two ways to increase the number of paying customers. The first is to get more users. This one is actually the easier of the two, since it is directly actionable (or at least more actionable than the second). Spend more money on marketing, or on business development with your channel partners. By increasing the number of users, you will get more paying customers. This definitely works, although it isn't a trivial process. The problems of this are two-fold: user acquisition costs tend to get exponentially higher after a point, and increasing users will often increase incremental costs. There are a lot of startups that are actually unprofitable based on marginal costs - their TCO for a user is higher than the lifetime value. A lot of these companies believe that they can attain profitability by acquiring more customers - unfortunately, the math does not bear this out.

So, what can they do to escape this trap? Well, the easiest way is to engage a higher percentage of their users. For every hundred users that sign up for a service, a relatively small number will continue to use it past the first few days or weeks. Although the overall free-to-paid conversion rate is pretty small, the free-to-paid conversion rate of active users is significantly higher (possibly by an order of magnitude). This makes the assumption that your free product is sufficiently limited such that users will actually want to upgrade - if you give away too much for free, people will not upgrade out of the goodness of their hearts. So, the best way to increase the number of paid users is to increase the number of actively engaged users. If you increase your engaged users by 1%, your paid users will likely increase by a similar amount. For simplicity's sake, let's assume that you have 100 users. Of those, 20 are engaged, and four pay for your product. If you can get another 10 engaged, you will have six paying customers. If you had attempted to do the same thing with user growth, you would have needed to gain an additional 50 customers. At the same time, you would have had to support those 50 customers, only two of whom would actually pay you anything. So, if possible, it makes sense to go for user engagement over sheer user acquisition.

Maximize the Profitability of Your Paying Users

The second point also seems obvious, but has some hidden subtleties. Notice that I didn't say "maximize the number of paying users." Instead, you need to maximize the overall profitability. Sometimes this involves charging more. Most startups charge too little for their products. A lot of them could probably be profitable if only they charged more. "But we offer a number of different pricing options," you may say. The problem is that most users won't upgrade out of the goodness of their own hearts. They will choose the least expensive plan that meets their needs.

One of the things that you learn about in business school is price elasticity. As you increase the cost, fewer people will buy. My theory is that once people actually pull out their credit card to pay, they are somewhat price insensitive. You assume that if you increase your price by $1, you will lose a fixed percentage of your customers. The truth is that people think in terms of thresholds (which is why most prices end in $9s). So, for example, most people may perceive all prices from $3 - $10 as being roughly the same, and then all prices from $10 - $50 may be roughly the same, and then $50 - $200, and so on and so forth (these numbers are all invented). You will experience some drop-off as you increase the price within a range (since all customers are not equal), but the change in demand will be relatively small within a range (sort of like a step function).

If you increase pricing from $3 to $9, and you see a drop-off of 50%, you have still increased your revenues by 50%. And it's possible that you have even increased your profits more because you have to support half as many paying users. You can make those paying users super-happy, which should hopefully decrease churn. Even if you see a drop-off of 66%, the move may still make sense since you have reduced the user support load. Plus, the users are probably higher quality, since they are paying more.

One interesting strategy I have seen is converting low-paying users to ambassadors. Many companies do this with referral bonuses. So let's assume that you get X capacity for free, and the low-cost plan costs $3 a month and includes 5X the capacity. The high-cost plan costs $9 a month, and includes 20X the capacity. Let's say that you have 9 customers paying for the low-cost plan (since the low-cost plan actually provides plenty of capacity). You are making $27 a month. So now let us assume that you increase the cost to $9 by eliminating the low-cost plan. For simplicity's sake, let's assume that 2/3 of the customers don't sign up for the more expensive plan. Your revenue is identical. But let's also assume that you allow users to increase their capacity to 5X by referring 20 friends. Not everyone will want to refer friends. Some will continue to pay, and others will use the free option or go to a competitor. But let's assume for this contrived example that the 6 customers refer an average of 10 friends, or 60 customers in total (the non-paying users will refer friends, but we will lump those into this pot). From those 60 customers, you can expect at least 12 engaged users, and 2 paying customers. So your revenue has actually increased to $45. Overall, this can provide a significant win.

All of the numbers in this post are contrived, but you can see that there can be significant increases in paying customers without actually increasing total users. It seems like the number of users has become the most important statistic (eg. Facebook has 500 million users), but engaged users seems to be far more correlated with profitability. And it is even possible that correctly pricing (and incentivizing) your product can help to maximize engagement.