What’s Your Pricing Strategy, Part 2

by Tien Tzuo

In a recent blog entry, we talked about how subscription businesses can use pricing models as a powerful tool for achieving their business objectives. We discussed six common business objectives, including upsell, adoption, and cash flow, and provided examples of companies that use pricing to achieve those objectives.

Now let’s bring our attention to some of the most common pricing models we see out there. As you can imagine, there are many, many ways you can price for your subscription services. What follows is not intended as a comprehensive list, but just 5 common models that we see. Creative companies will even combine two or more models for a hybrid pricing strategy.

1. Module-based pricing: This is one of the most basic models. It allows customers to pick and choose which modules or features of your service they pay for. Many of the classic enterprise software companies like Siebel or Oracle use this. For example, you might charge $3000/month for an analytics feature. Module-based pricing is effective when you’re trying to upsell more services or increase adoption within your customer base.

2. Resource-based pricing: in this model, you charge a flat rate for a given amount of service. For example, your accountant bills you for the number of hours he works. Storage is another example: your price depends on the number of GB or cubic meters used. Resource-based pricing is useful if you’re trying to increase adoption of your service—the flat fee typically encourages more consumption. Especially if you combine it with an upsell model where you can sell more services priced on a usage basis (see #3).

User-based pricing is actually a very common type of resource-based pricing. Most businesses that adopt user-based pricing sell licenses that are assigned to users. Thus, customers are purchasing capacity, and not actual users. If your goal is to reduce barriers to entry and get customers on board quickly, user-based pricing is a great strategy. For example, Salesforce.com recently ran a promotion offering its Group Edition at $99/user/year.

3. Usage-based pricing: this model charges for service by consumption, for example $0.45/minute for your cell phone service. While you might be attracted to the simplicity of usage-based pricing, note that it’s not a great strategy for collecting cash upfront. With usage-based pricing, you can’t ask for a year’s worth of services (and cash) upfront.

4. Tiered + overage pricing: in this model, customers pay a given price for a specified amount of service, plus an additional fee when they exceed that amount. For example $39/month for 450 minutes, plus $.45 for overage. Offering a tiered usage pricing system is effective for bumping customers up to the next level, especially if they get charged for going over their limit.

5. Promotional pricing: we’re all familiar with this one—the special sale. In this model, you might discount by contract or calendar period, or by season to entice customers wary of spending a lot of money upfront. For example, you may charge an introductory rate of $19.95/month for the first three months, and then $39.95/month. Promotional pricing helps reduce barriers to entry and encourages adoption of your service.

These five pricing models act as levers to help you achieve important business objectives. And as you can imagine, your business is at a real disadvantage if your infrastructure can’t support these pricing models.

Pricing Model	Business Objective
Module-Based Pricing	Adoption
Resource-Based Pricing	Target different segments and/or verticals, adoption, reduce barriers to entry
Usage Pricing	Linear revenue growth: might hinder adoption
Tiered + Overage Pricing	Upfront cash, upsell
Promotional Pricing	Reduce barriers to entry, adoption

Give away the razor and sell the blades – or rather, mobile phones?

by K. V. Rao

After posting this blog, we thought we owed AT&T some props. So here you go:

Who doesn’t have Olympic fever? I do, and during my hours of watching Phelps break record after record, I notice the commercials. One commercial in particular has caught my attention and that’s Apple’s ads for the new iPhone 3G being priced at just $199 – half the price it was before. Why would they do this? They certainly don’t need to. The answer: AT&T. The phone service giant is actually subsidizing Apple $200 per iPhone.

So what’s going on here? The answer: subscriptions. AT&T is actually going to make more money in the long run as they now have monthly rates with more pricing and plan options on the service. In other words, customers will actually pay anywhere from $10 to $20 more a month, depending on the options they choose.

This really highlights the power of subscription plans -- the ability to use pricing to attract a wider number of customers, and make more money per customer in the long run. AT&T’s customers now have more options to choose from when picking a plan, something that wasn’t an option with the first iPhone release, so the price increase isn’t unexpected or ill-recieved. Every customer has different needs, even iPhone customers, and AT&T is addressing that, and making a higher profit while they’re at it. Check out this engadget article that discusses the new pricing plan in more detail.

This is another great example of the power of subscriptions, and how with a subscription model, you have more dials and levers to best monetize your overall value proposition. At&t has harnessed this by recognizing that their iPhone market is wide and different customers will use this fantastic gadget for different things. The price of the product went down, but in the long term A&T will have a wider customer base and higher recurring revenues.

What’s Your Pricing Strategy, Part I

by Tien Tzuo

We’ve talked a lot about how running a subscription business is different, and how flexibility in pricing and packaging is important for building and scaling a subscription business.

Often, people will approach us and ask, “That’s all great, but how do I know what type of pricing and packaging is best for me? Can you help us think that through?”

At Salesforce.com, we started with a simple per-user pricing model, and evolved it over time to include multiple editions ranging from Group Edition to Unlimited Edition, each with a different price point. Over the years, I’ve often been asked why we went with this price structure, and whether we considered other pricing models, such as per module pricing or usage-based pricing. You can follow some of that thinking in the talk I gave at Stanford University.

But to help people think through their own pricing, we typically bring it back to a discussion of their business objectives. These business objectives can vary based on a number of dynamic factors, such as current competition, capital needs, growth requirements, etc. Below I’ve listed the six most common business objectives we see, and how they shape pricing and packaging.

1. Target different segments: In 2000, we decided at salesforce.com that pricing would be simple: $65/user/month. We quickly found that this price was too high for the smallest of customers (e.g. the SOHO market), and that the large companies actually wanted to pay more for increased service and functionality. Sometimes, a fixed pricing model can alienate everyone. It’s important to offer each segment the right package at the right price.

2. Target different verticals: are you looking to get into a new vertical, or expand your footprint into a new geography? You could create a special service bundle for the public sector vertical, for example, or a new pricing structure for European customers. We recently talked to a company looking to get into the transportation vertical. The problem was, the new competitors in this space price differently, and had taught the buyer to expect a low monthly fee s for service, so a new pricing plan was in order.

3. Increase adoption: customer adoption usually spells more business—both new and repeat. Charging a flat fee typically encourages consumption (and adoption) of the service. A flat fee works well if you can combine it with an upsell model where you can sell additional services into the installed base, possibly priced on a consumption/usage basis. Netflix charges a flat rate of $8.99 for unlimited movie rentals per month. But if the renter wishes to hold onto more than one DVD at a time, he’ll have to upgrade to a more expensive plan. Another adoption strategy is to allow customers to build their own package to suit their own needs, making them much more likely to use your service. Once salesforce.com customers choose an edition, they can pick and choose add-on features that match their business needs, like a customer service portal, partner relationship management, or marketing campaign management.

4. Upsell: existing customers often represent low-hanging fruit for new revenues. SaaS company WebEx bills customers on usage of its Web conferencing service. Offering a tiered pricing system makes it easier to bump customers up to the next level, especially if they get charged for going over their limit. Another upsell strategy is to have a pricing model that scales as a company grows or gets more value from the system. So at Salesforce, a company can start with just 10 users, for example, but the sales rep can then monitor usage and encourage the company to add more users over time. We’ve spoken with companies that chose to have a simple pricing, say $1000/month, and our immediate reaction is, “Where’s the upsell?”

5. Collect cash upfront: if collecting cash upfront is your objective, then your pricing needs to support this. For example, a pure usage-based pricing model may seem attractive at first. The problem is, you don’t know how much to charge until after the fact, and so can only support billing in arrears. That makes it impossible to ask for a year worth of service up front. As another example, if you look closely at your cell phone bill, you’ll see that monthly service fees (say, for the 450 minute plan) are billed in advance, and overage prices (e.g. when you go over 450 minutes) are billed in arrears.

6. Reduce barriers to purchase: let’s face it—people are worried about the economy these days. They’re not comfortable shelling out a lot of money right upfront. Variable pricing can make it easier for them to get started. For example, variable pricing by contract period or calendar date feels less risky and provides value: $19.95/month for the first three months, and then $39.95/month. As another example, we recently spoke with a CEO who reported that where he used to be able to do multi-year contracts, now he’s seeing customers demand quarterly commitment and billing periods.

The hallmark of the subscription business is its flexibility. And as you can see, this flexibility allows you to achieve several business objectives with different pricing models. Next week, I’ll elaborate on the five common pricing plans that we see in recurring revenue businesses.

Textbooks-as-a-service?

by K. V. Rao

Regular readers of the Z-Blog will know we’re always on the look out for new examples of businesses that are transforming from selling products to offering subscriptions – cars, movies, farm produce -- here’s one that recently caught our attention, as well as the New York Times, around textbooks.

Get this -- Publishers are starting to offer subscriptions to electronic versions of textbooks, allowing college students to “rent” the book for a period of time. The cost is quite a bit less than the printed version, but it allows publishers to compete with the used textbook market while saving some trees.

Here’s how it works: In the old way, publishers would sell a printed textbook, for say $209.95. Students balk at these outrageous prices (Hey, that is a lot of beer money,) look for used copies, and publishers end up losing revenue. The only chance for new revenue is to release an updated version, which could take several years.

Innovative publishing companies are finding a way out of this bind by offering subscriptions to textbooks online. The publishing company sells a one-year, or two semesters as it were, subscription to the textbook. Students download it online, for say $109.99, quite a bit less. After a year, the ebook expires, cutting back the used textbook market. Not only does this cut out the middleman for the publisher, they also get to make that same $109.99 year in and year out. Sell your product cheaper, make more money, and join the green movement, all in one fell swoop – what CEO wouldn’t like that?

The savvy publishing company named in this article is Cengage Learning. All textbook publishers should take a cue and start offering textbooks-as-a-service. They would stay competitive with used booksellers and make poor college students everywhere very happy.

RedHat spending $20 Million to Manage Subscription Billing

by Tien Tzuo

I recently attended the Pacific Crest 10th Annual Technology Leadership Forum in Vail, Colorado, a fantastic event where you can hear the CEO and CFO’s of so many companies discuss the state of the technology industry.

One session stuck with me – the one with Charlie Peters, the CFO of RedHat, a subscription-based open source technology provider. Charlie Peters is a pretty impressive guy. When asked about his operating expense, Charlie revealed the following interesting fact (highlights are mine):

You should keep in mind that we have one major project that we're working on this -- we're spending about
$2 million a quarter on some systems work. And it's all the systems on the customer facing side of the business that go from the time you take a lead, to develop a quote, to entitle an invoice and then collect customer data around in all those entitlements and all the way through renewals. We have 10-20 systems there that need to be integrated, that were designed for a [much smaller] company … and we're heading to a billion and beyond.

(You can find the full transcript of Charlie’s Q&A session online).

Basically, RedHat is spending $2 Million per quarter on their quote-to-cash systems. Charlie further says:

[this is] going to take us two years, two-and-a-half years on a systems -- internally we're calling it transformation, but you could call it system refresh, system scaling, whatever you want to call it, which is involving a lot of time and effort, but I think it's going to have a good payback.

At $2 million a quarter for 8-10 quarters, this means that RedHat will spend approximately $16 to $20 million to create the operational systems that they need to scale to a billion dollar company. Not their SFA or accounting system, but the operational system in between that today is spread across 10 individual applications.

This may seem shocking to some, but this is very, very similar to what we found from our Salesforce and WebEx days, and what we wrote about in our July 22nd post, “Oh the Pain.” Charlie, we feel your pain. Subscriptions businesses are hard; the quote-to-cash process in a subscription business is very different, and the fact is that there aren’t a lot of systems out there that are designed just for their needs. Hence the $20 million price tag.

I think we’re going to go ahead and call Charlie. The train may have left the station there, but it can’t hurt. And if you’re looking to become the next RedHat, or the next Salesforce, or the next Netflix, give us a call. Hopefully we can save you millions of dollars (and a lot of pain).