📂 The right pricing model aligns value with expansion revenue

​

​

​

Today's newsletter is proudly supported by Conversion Factory 🎉

I started Conversion Factory to help startups go from a nice-to-have to a must-have. We're the only product marketing agency accessible on a subscription. That's right — no quotes, no scopes, no billable hours, no contracts. Pay us a flat fee (we have 100% transparent pricing on our site) and we'll fly through your backlog. Follow the link to check out our example work and learn more about how we can help.

Check out Conversion Factory →

​

📖 The following is an excerpt from my work-in-progress book, Founding Marketing. It's a (very) rough draft of thoughts, notes, and research... so feel free to reply with your feedback on what I should expand more on and what needs to be clarified. Enjoy!

The method by which user(s) pay to use your product and for how much is called the pricing model.

First, let’s go over the wrong ways to choose a pricing model.

Competitor-based pricing

It’s a pricing method that uses competitor prices as a benchmark, rather than setting a price based on company costs or customer value

Initially it seems smart that you should look at the other companies selling similar products to decide your own price point.

But the biggest downside of competitor-based pricing is that you don’t have YOUR pricing strategy, you have THEIR pricing strategy. Your company exists to offer customers something different to what is already on the market. You are offering more value and a better product, otherwise you shouldn’t be building it.

Plus, who’s to say their pricing is good or right?

Use competitors to inform your pricing, but not to determine it.

I think we can safely say that competitor-based is not a good strategy. We can do better than that.

Cost-based pricing

It’s a pricing method where the selling price is set by looking at all the costs associated with the product and then adding a markup over the cost.

It seems simple and smart, especially in the early days: Sell it for more than what it costs you… good business right?

Nope. Not for SaaS.

The funny thing is that it’s a bad strategy because SaaS is usually too cheap. It costs a lot to develop, but not much to maintain, and not much for each incremental customer.

But that doesn’t even matter because the customer doesn’t know, and doesn’t care, how much it costs you. They just care about what they get out of it.

Costs will change, they’ll fluctuate, and then what? You change your prices every time your costs change?

I think we can safely say, cost-based is also not a good strategy.

So, where do we go from here?

There are two strategic forces when choosing your pricing model:

1. Value
2. Differentiation

As mentioned before, choose the pricing model that aligns you the best with the value you deliver to customers.

Pair that with strong differentiation and you can use your pricing model as a competitive advantage. For example:

• Most project management apps charge per user, whereas Basecamp charges a flat rate
• Intercom’s pricing structure allows them to be modular and also provides many upsell opportunities

Let’s explore each one of these models in detail and then we’ll talk about how to know which one makes the most sense for your business.

Flat rate

e.g. $49/mo

The flat-rate model is the simplest way to sell a product. In flat-rate, there is only one package with one price. There may be a variance of price based on monthly or annual billing. In flat-rate, the user gets access to all features and has a set policy on how many users there are on the account. Many flat-rate plans are paired with a free trial.

The pros of using a flat-rate model are that it will be much easier to communicate, and in turn, much easier to sell. Marketing one plan is a lot more straightforward than marketing 3-4 plans. With one plan, you can focus everything you do on the one plan.

Using a flat-rate model will also make predicting revenue growth, churn, and lifetime value much easier. With every additional plan and rate, forecasting becomes exponentially more complex.

The cons of using a flat-rate model are that some customers may perceive your product as too expensive or too inexpensive to be a good fit for them. What I mean by this is simply that with a single rate and plan, it may be difficult to attract different types of users who have very different opinions about price. Customers may tell you that they really don’t need certain features or parts of the plan and that they would buy it if you stripped away certain parts and offered it at a lower price. The opposite is also possible: Customers want more features and services that the current plan can’t justify.

It’s also difficult to extract value from all the different kinds of customers on the plan. Some customers could generate a lot more revenue for you if you changed the pricing on certain seemingly insignificant variables. Flat-rate pricing essentially eliminates the opportunity for any expansion revenue. Getting that price right the first time can be tough. You have to test and iterate fast to nail down that magic number.

Example: Basecamp​

Part of Basecamp’s core value proposition is simplicity, which is exemplified in its pricing. A single plan with a flat-rate. It’s a statement.

Usage-based

e.g. $9 per 1,000 API calls

The usage-based model is essentially a “pay as you go” model where a customer will be charged more the more they use the product. Some common ways SaaS businesses use usage-based pricing is by charging per action (like per post, email, API call, etc), charging a percentage of revenue made, charging a percentage of a transaction processed, or charging for storage used.

The pros of the usage-based model are that the pricing scales with the customer. As the customer grows or uses the product more, the price increases. This is also a good way to attract multiple types of customers who may greatly vary in their price sensitivity. A user who doesn’t want to use the product much only gets charged for what they use and a superuser generates a lot of revenue for you.

The cons of the usage-based model are that it may disconnect the value from the product. Maybe a small customer makes a large number of API calls and a large customer makes a small number of API calls.

It may also be difficult for prospective customers to calculate how much they will be paying. It might be too granular to do a quick calculation in your head or keep track of how much is actually being used.

Another possibility is that customers will be discouraged from using the product since they will be charged for using it more. Customers may adopt a frugal mindset and not use the product as much as they would with a different pricing model. It also makes it much harder to predict revenue in the future since you have no control over your customers’ usage of the product. You may experience slumps or erratic spikes in revenue that make managing your cash flow difficult.

Example: Stripe​

Stripe charges a percentage of charges processed plus a fixed amount per charge. More charges processed through Stripe results in more revenue for Stripe.

Example: Postmark​

Even though it could technically be considered more a hybrid model, notice how it’s still based on how many emails are sent, including a fee for every additional thousand emails.

Example: ConvertKit​

ConvertKit takes a different approach by only charging for how many subscribers an account has.

Tier-based

e.g. Starter - $9/mo, Pro - $49/mo, Enterprise, $499/mo

The tier-based model essentially creates different versions of the product to use at different price points. This is the most common pricing model used in SaaS today. Usually, companies will create 2-4 tiers for customers to choose from.

If you do use a tier-based model, it’s very important to get the names for each tier right. It needs to be in alignment with how the tiers are created. If the tiers are largely separated by the number of users, you’ll want to name the tiers according to user size, and so on.

Anchoring, a strategy we’ll cover later, is also critical with tier-based pricing. The differences between each tier all serve as anchors, and it’s important to structure each tier appropriately.

The pros of the tier-based model are that you can appeal to multiple types of customers without basing the price on usage. Multiple tiers allow you to appeal to multiple types of customers, thus expanding your market and increasing revenue potential. Each tier can tailor to a different kind of buyer.

Tiers also have a unique advantage to be able to upsell to customers. A company could attract many customers with the lowest tier, and then work to graduate them and upsell them to a higher tier.

The cons of the tier-based model are that the tiers could potentially be confusing to customers. Tiers have to be very carefully constructed and communicated to avoid as much confusion as possible. Every tier increases the complexity of the decision for the customer, so more tiers mean more complexity for the customer, which creates a harder decision for the customer.

Example: Fomo​

Fomo splits out tiers first by upgraded support and then second by advanced service and features.

Example: Kinsta​

Kinsta offers several different tiers based on a variety of factors like WordPress installs, monthly website traffic, storage, and more.

User-based

e.g. $9 per user

The user-based model is also a very popular choice for SaaS companies as it’s simple to understand and provides huge potential for expansion. In a user-based model, companies charge “per seat.” In other words, if you want to add a colleague to your account, the price increases. Every extra user on the account is charged.

A lot of SaaS companies choose a user-based pricing model simply because it seems attractive. But a user-based model should only be used for products in which each user sees or experiences something different. Otherwise, users will probably just share a login.

The pros of the user-based model are that it’s easy to understand. Similar to the flat-rate model, the user-based model usually gives customers full access to the product. It’s very easy for customers to calculate what they would pay depending on how many people they want to add to the account.

It’s also advantageous because the revenue will scale along with the adoption of the product in the company. As the company grows or the use of the product increases across the company, revenue grows with it.

The cons of the user based model are that it may limit the adoption of the product. Similar to the usage-based model, customers may be discouraged to further use and adopt the product because it will cost them more.

One of the other major cons is that it may not reflect the value of the product. If you are just granting access to the product, users will probably just use a shared login. The amount of users needs to be tightly aligned with the value and actual use of the product. Some customers may be off-put by charging per user because they don’t want to have to worry about how many seats to buy the team.

Example: Notion​

Notion offers a few tiers with various options for storage, features, and service, but all are centered around the number of users.

Example: SavvyCal​

Similarly, SavvyCal bases pricing on the number of users, but offers different tiers for the level of features and branding needed.

Example: Close​

Close creates three tiers all priced per user based on the level of sophistication of each type of user.

Feature-based

e.g. Feature Set A - $9/mo, Feature Set B - $19/mo, Feature Set C - $29/mo

Many confuse feature-based pricing with tier-based pricing, but they’re actually very different. With tier-based pricing, different features could be available in different tiers, whereas with feature-based pricing, certain features are an additional price altogether.

This could also be described as “add-on” or “modular” pricing. The lines between feature-based pricing and an entirely different product are often blurry, but the concept remains the same: charge an additional amount for an additional set of features that are separate from the core product subscription.

Feature-based pricing provides a nice path to expansion revenue as these upgrades can offset or even exceed churned revenue from canceled customers. It can also be easier to communicate and market to your customer base than including it in a higher tier.

The disadvantage comes in the form of perception. Customers may be reluctant to pay more or simply don’t understand the additional value. Add-on features can seem less necessary.

Example: Intercom​

Intercom might be the ultimate example of the hybrid model. Notice how products and features are bundled and unbundled, with an upsell path for any combination that a user chooses.

Credit-based

e.g. $9/mo for 4 audiobooks per month

Credit-based pricing offers a unique model for products that don’t require continuous use. Credits can be purchased either through a subscription or through a one-time transaction and then redeemed in the app for some sort of use.

Lorenzo Frattini of Clayton explained how they decided to try this model since they perform vulnerability/security scanning of codebases, which by nature are rather discrete and don’t require continuous use. They started offering subscriptions with credits and the response with users has been very positive so far.

The pros of credit-based pricing are that you can provide users a way to pay for your service without having to worry about when they’ll actually use it. A subscription purchase of credits supplies you with recurring revenue without users having to worry about which tier or feature is best for them. The main difference between usage-based pricing and credit-based pricing is that the user is charged before they use your app, whereas they’d be charged afterward in a usage-based model.

The cons are that the likelihood a customer cancels or asks for a refund because they have a surplus of credits is high if they’re not using the product regularly.

Audible

Audible offers different tiers, monthly or annual, to get a certain amount of books per month. Each additional book is then an additional, one-time transaction.

Hybrid

e.g. Core - $99/mo, $9/mo each additional user, Add-on - +$49/mo

There are different dimensions to a product’s price.

The pros of the hybrid approach are that you can differentiate your pricing and plans from your competitors and offer a new package that may serve your customers better. There are also multiple expansion opportunities as you give customers more than one reason to upgrade.

The cons of the hybrid approach are that it can very easily get too complicated. Mixing features, users, usage, tiers, freemium, and enterprise models will make it too complex for customers to understand how to pick the right package for themselves. It can be too much for too many… jack of all trades, master of none type of situation.

Example: Drift​

Drift mixes tier-based with user-based with feature-based with basically every other type of pricing model.

Example: Appcues​

Appcues shows a variety of both pricing models and activation models, along with a hybrid of tier-based, user-based, and feature-based plans.

There you have it:

• Flat-rate pricing (e.g. Basecamp)
• Usage-based pricing (e.g. Stripe)
• Tier-based pricing (e.g. Kinsta)
• User-based pricing (e.g. Calendly)
• Feature-based pricing (e.g. Intercom)
• Credit-based pricing (e.g. Audible)
• Hybrid pricing (e.g. Drift)

A lot of times, pricing can’t be determined by a single value metric like an API call, a user, an email, or a feature. So you have to mix in a secondary value metric or even a third value metric in order to best align yourself with the value your customers are getting from the product.

Each of these models can be mixed and matched for a custom combination.

—Corey

​