Pricing: A How-To Guide (Part 3)

This article is part 3 of a series; if you haven’t read them yet, here is part 1 and here is part 2.

Types of Products and Licenses

Armed with the discussion in the previous model, you now presumably have a handle on:

What type of product you intend to sell: is it a discrete thing, a consumable, a “product” or “service,” individual or sold by volume, and so on.
What your primary sales channel is likely to be: direct, multi-tier distribution, MSP/RMM, OEM, etc.
How you intend to package the product and related products: good/better/best tiered bundles, base product with add-ons or extensions, standalone or embedded/OEM, etc.
The basic sales model of purchase, license+maintenance, one-time use, or subscription.
For bulk products, how you intend to license and measure by some metric.

The variations are nearly infinite, so I’ll work through some examples here to demonstrate several options.

True Services

For custom-quoted services, there are four very typical models: Fixed Fee (Cost Plus, Value-Based), Time&Materials (T&M), Risk/Reward, and Retainer.

Fixed Fee: You come up with some estimate as to what it will cost you to deliver the service, then add a markup, and that’s what the client agrees to pay.
Time & Materials: You agree to a standard rate (typically hourly) with the client, and then as work is completed you bill them for the time spent plus any material resources consumed.
Risk/Reward: You agree to a base price with the client, but then get a bonus (or pay a penalty) due to over- (or under-)performance which could be based on any agreed-upon metrics such as time to completion, quality, etc.
Retainer: Client pays a regular fee for a bucket of hours per time period, with the actual work TBD. You are guaranteeing those hours if requested.

Productized Services

If there a specific type of service that you deliver regularly, you can often productize it into one or more fixed-fee options with constraints. Examples include things like different levels of penetration testing, or fixed-fee legal services like creating an estate plan. Once you have a very good sense for what it actually costs you to deliver a particular service and what variations and challenges you are likely to run into, you can create a formal product offering built around that service.

You will need to make sure that the price you set for the productized service is fair but likely a bit more than the same work done on say a T&M basis to absorb some risk. You’ll also need to craft terms for the purchase agreement that constrains your risk, for example you might cap the number of hours, or explicitly exclude certain activities. You should also consider creating entry level and premium level variants, if not three levels. Or, have a higher tier that includes the ability to add some custom work on top.

Discrete Products

For physical items or downloadable standalone software products, a discrete purchase model is often appropriate. You may need to think about ways to prevent people from copying your work, using software licensing or DRM schemes for example. Typical discrete products usually have a Manufacturer’s Suggested Retail Price (MSRP) but are often discounted for retail sale. You will also need to think about discounts and margin for your distribution channels.

Even with discrete products with a simple MSRP, you may need to consider volume discounting, reseller and distributor margin, and segment discounting, which we’ll get into below.

SaaS Products

Many B2B and B2C products these days are sold under a Software-as-a-Service model which usually means subscription plans: the customer pays a fee and thus has access to the software for the period of the subscription. There are a million variations, for example they might pay up front (like Netflix), or they may pay in arrears (like your water bill). There might be one price (Netflix), tiered pricing (typical home internet plans), volume-based pricing (some number of seats or gigabytes or whatever), or some combo. For volume-based plans, overages may be handled very differently: some with hard caps, some with in arrears catch-up billing, or some with soft limits that can be exceeded for a time before you get a call from Sales. There may be add-ons, extensions, and multi-product discounts.

Multi-channel Products

If you plan to sell your products across multiple channels (e.g. direct, resold, distribution, MSP, etc), you will have to take steps to avoid cross-channel conflict. This applies to both sales strategies (NEVER steal your resellers customers by taking them direct) as well as your pricing model:

Segment the market and assign specific segments to specific channels. You can do this by region, customer size, industry, etc.
Make sure you have a way for resellers to indicate that they are working with a given customer to avoid channel conflict―this is deal registration.
Make sure you align your pricing so that one channel does not undercut another. For example, don’t insist that your partners sell at $5.00, but then offer the same product direct off your website for $3.00 (at least, not for long).

Managed Service Providers

Because MSPs are really the customer you are selling to, and then they turn around and deploy your product as a service to their clients, MSPs often want a different pricing model for what you sell to them. In many cases, this means that you will end up defining monthly metered pricing (based on number of clients, seats, devices, gigs, or whatever) for your MSPs so that their product usage is closely aligned with the value they are delivering to their clients, and they don’t have to spend a lot of time negotiating or updated contracts with you.

Other MSPs just act as resellers, at least some of the time, or you may end up creating custom OEM-style arrangements with them. Expectations can also be somewhat different depending on region in terms of pricing structure and who the actual purchaser of your product is.

Original Equipement Manufacturer (OEM)

OEM price structures are all over the map and depend heavily on what the OEM component is and how it will be embedded within the vendor’s product. A simple whitelabel might be treated like a resold product with just some added margin, whereas a more complex OEM integration might trigger a per-unit fixed OEM payment, or the OEM might get a percentage of each unit sold. There may be a bulk up-front payment, guaranteed minimums, volume tiering, and so on―you will see a lot of variations. In general, however, if you are offering OEM components for other vendors to include in their products, try to align what you charge them with your costs and the value that will be delivered to the end customer.

Custom Pricing

Many companies like to hide their pricing, or custom-quote every deal. This is OK if you are only selling direct, but as soon as you start to leverage resellers or especially distributors it gets complicated. Custom quoting every deal also inhibits the scale and speed at which you can sell your product, although this may not be an issue at first. Distributors in particular would prefer a fixed price list with clear discounting rules, as they’d prefer not to keep coming back to you for quotes. And if you intend to sell to the government, they often insist on you having clear public pricing so that they can ensure that they are receiving appropriate government discounting. And speaking of discounting…

Product Discounting

There are many types of discounts that are applied to base product pricing:

Pre-pay discounting: For some product types you allow the customer to use the product for a period of time and then charge them for its use. If there’s a volume metric, the customer may pre-select the quantity or you may measure their usage after the fact: this is metered billing. If you can get the customer to pay up front, you are likely to give them a discount (as it reduces your risk slightly), and the customer is likely to pay for more quantity than they actually use.
Volume discounting: Many products apply discounts if a customer buys more than one unit, with discounts kicking in at specific volume tiers. For example, say a customer buys 25 units or more, they get 10% off; 50 or more they get 15%, etc. Note that volume discounting introduces discontinuity in the pricing (i.e. 500 units may be CHEAPER than 499 units) so it’s best not to have huge discount jumps.
Term discounting: For subscription products, it’s very common to apply discounts if the customer agrees to purchase the product for some longer term. If your core pricing is based on a month of usage, for example, you might give a customer 10% off if they buy for a year, 15% for 2 years, etc. This might vary slightly if they are actually pre-paying, or of they are just committing (via a contract) for the full term. You’ll see this especially in B2C SaaS sales where getting someone to commit to a 3 year subscription may get them 80% or more off.
Channel discounting: If you sell through resellers and distribution, you will have to offer them a cut of the profits in order for it to be worthwhile. You’ll likely bake this into the reseller agreement you have them sign, and their discount may depend on exactly what type of reseller they are and how much added value they provide. Or you may offer a higher discount to more invested resellers―if they take your training, for example, and if they sell a high volume. If you are using distribution, the distributor discount will typically be stacked on top of the resellers’ discount.
Segment discounting: it is very common for companies to offer discounts based on specific market segments, typically for segments such as the government, educational institutions, and non-profits. The level of discounting can vary widely, although 8-15% seems to be typical. Note that the government (in the US at least) does regulate how discounts are applied; this is to ensure that the government isn’t cheated (you have to discount at least as well as your largest commercial customer) but also that you aren’t cheating to win government business (discounts have to be consistent across agencies).
Regional discounting: You may have to sell your product under different currencies and in different regions, and each currency and region may receive different discounts due to exchange rates and regional cost-of-living adjustments. For example, we often added significant discounts for B2B SaaS products sold in Latin America due to regional differences in how those products are sold.
Discretionary discounting: In many cases you may apply discretionary discounting for a variety of reasons. If you’re effectively doing custom pricing for each deal, this really is your default! But even if you have a defined MSRP and discounting rules, it’s common to allow your salespeople to apply a small discount to help win specific deals. If you have sales managers, sometimes the discount can be higher with their approval. Usually it’s a good idea to get some concessions in return for those discounts, for example a case study, referral, or some other marketing goodie.

Sample Pricing Model

In this section I’ll walk through a complete pricing workup for a single, multi-channel, B2B SaaS subscription product that is sold at volume, like say an endpoint security priced by the number of devices.

Let’s start with a price that offers zero discounting for anything, which means that we’re selling this at low volume to a non-priority commercial customer with basically no contract or guaranteed term, and we’re allowing the customer to pay in arrears after the service has been delivered. So basically, “here customer, use 1 seat of my product for a month and then I’ll charge you.” We’ll call this our starting price.

The first discount we’ll offer is a pre-pay discount. We like this because we get the money earlier, there’s no risk of the customer defaulting, and usually customers will buy more than they really need because handling overages can be a pain. At my prior company, many customers would sometimes purchase as many as twice as many seats as they actually used in any given month. So let’s say we offer 20% off if a customer is willing to pay up front.

Next, we’ll offer a term discount i.e. if the customer pre-pays for a full year or more, they get a discount. This is good for us because we get the money up front and can put it to use. It also reduces customer churn and payment processing costs. So let’s say 10% off if they pre-pay for a year. Note that this specific license—a 1-year pre-paid subscription license—is likely what we’d actually let standard distributors and resellers offer to the market, so we might call this our base MSRP. In addition to the 1-year term, we’ll also offer a stacked multi-year discount for 2- and 3-years, say 10% and 15% additional off the base MSRP. Again, this helps reduce customer churn and gets us the money earlier. Note that we could also optionally offer a contractual long term subscription but ask for annual payments (so the customer commits to three years but pays in three installments). Think about this like a payment plan and you’d probably want to charge something like a 5% financing fee per year, which would end up reducing the multi-year discounting the customer gets.

On top of our base MSRP we’ll also offer volume discounting. We’ll have to come up with a tiering structure, something like 50 seats @ 10%, 100 seats @ 15%, 250 seats @ 18%, and so on. The tier breakpoints and discount-per-tier will depend on the product and how it is measured, plus what our primary target customer size is. For a typical endpoint security product which can be sold based on the number of protected devices, we might end up with 25, 50, 100, 250, 500, 1000, 2500, 5000, and 10,000 device tiers and discounts up to 50% at the top tier. Maybe our vendor targets mid-size companies, so we’ll be a little more aggressive with the discounting in the 250-1000 tiers. Note that under standard volume tiering, a customer can purchase any quantity, so for example a customer might buy 152 seats and they’ll end up in the 100-249 seat tier with the applicable discount. The list of all volume tiers plus 1-, 2-, and 3-year terms will be our full MSRP price list.

On top of MSRP, resellers and distributors will get additional discounting to cover their margin. We’ll have new resellers get 20%, resellers that do more than $100k of business/year get 25%, and resellers that do more than $500k get 30%. To implement this we won’t create a separate price list; when a reseller places an order their discount will be applied to the purchase price. Of course they can re-sell our product at whatever price they want, but any price they set above their own purchase price they’ll get as margin. For distributors, we will give them an additional 5% on top of the reseller’s discount, whoever they are selling to. We will assume that in general resellers will handle their own marketing and sales costs, although we’ll offer our own Sales Engineers if available to assist with demos and we will also offer some Marketing Development Funds (MDF) for joint marketing activities.

For federal and state government, we will offer a 12% discount stacked on the volume-tiered MSRP. Government generally wants a better discount than a vendor’s largest commercial customer, so stacking it on top of the existing volume tiering makes sense. Similarly, we’ll offer 10% to educational and non-profit institutions, because we’re nice guys who don’t suck. Many government agencies and schools are quite large, so they’ll end up with a fairly high volume tier, additional discounting, and probably some extra discounts because they often don’t have much money. Plus, many government agencies and public schools have to purchase off of special contract vehicles, which may mean we end up creating custom pricing for those contracts anyway.

We also want to service the Managed Service Provider market, so we’ll go all the way back to our starting price (monthly metered) on top of which we’ll offer the MSP a 40% discount, but then we’ll stack our volume tiering on top of that as well. We will use our standard volume tiering, although typically MSPs are expected to have higher volumes since they bundle multiple customers. As a result, they might end up with as much as a 70% total discount if they have over 5000 total seats. This will allow MSPs to flexibly package our product into their offerings, regardless of whether they sell it monthly or annually or whatever, and still compete with our direct offerings.

We may also sell to RMMs who will in turn sell to MSPs, and we might sell as an OEM to other vendors. For these we will use custom contracts and whatever deal we can negotiate, but for RMMs we will need to keep in mind that the RMM should pay a little bit less than an MSP so that they can mark it up before they sell to the MSP. But we’d expect volume to by much higher as they’ll sell to (hopefully) many MSPs. OEMs may be completely custom, depending on how much of our product the vendor will consume, their target market, etc―could be a single fixed fee per unit sold, a percentage of each sale, or whatever.

Pricing Model Output

Putting all of the above together, we will come up with several documents:

An MSRP price list. This will have a Stock Control Unit (SKU), basically a product ID, for each individual price we offer whether sold direct or through resellers and distribution. For our example above, this is 1 product X 10 volume tiers X 3 contract terms = 30 individual SKUs. Since we also sell to government and education/non-profit customers, we’ll have to then replicate the commercial price list for each of those markets: this means we’ll be creating 90 new SKUs for each new product on this price list. Note that we won’t include and won’t actually sell the product direct to customers at the monthly metered starting price we talked about above, or the monthly pre-pay; those were just defined as a way to start thinking about the model.
MSP Pricing. We will also come up with pricing for MSPs based on their 40%+volume discounting. This might not be a formal price list with actual SKUs (unless our billing system requires them) but we’ll publish the list for them to see so there are no surprises when the end of the month arrives and we send them the metered billing.
Standard Partner Agreements. For resellers, distributors, and RMMs we won’t have separate price lists but our billing system will have to implement the terms of the relevant agreements, applying whatever discount is defined as part of the agreement with that specific partner. For most parties, this will just be standard percentage discounts applied on top of MSRP that we can store in the CRM and pull into billing. We might have a few RMM and OEM contracts however that define custom pricing, so those will likely have to be manually billed.
Note that individual internal salespeople will be allowed to offer an additional 10% discount as needed for both direct and reseller deals. Sales managers are allowed to go up to 20% discount, and the CEO can override that and set whatever price she wants.

So there you have it―a complete distribution-ready pricing model with at least 100 individual SKUs defined for each product, plus standard channel, market segment, and discretionary discounting. This may be more complex than you will need at your organization, at least for a while, but you should be able to extract the bits you need as a starting point. Note however that for other product types (consumer, services, etc) the story will be different―this example only applies to B2B SaaS!

How to Set Pricing

We are now deep into three articles about pricing, and are finally at the point where we can talk about setting the actual price you want to sell your product for. It should be clear however that the price you set will depend on what you are selling, who you are selling it to, and the channel(s) you intend to use and all the other factors mentioned above. A B2B SaaS subscription model will point you towards one price, but if you wanted to sell under a license+maintenance model the calculation would be very different.

Let’s continue with the subscription model for now, and talk about how you actually settle on a price. There are several main factors that will influence your pricing:

What the market will pay: this is the most important factor, since if customers won’t buy at the price you set then you will go out of business. Note however that you may choose to set MSRP fairly high, and then relax your discounting rules for individual deals, or you might run frequent discount sales―these are strategies to create urgency which may work in some market segments.
Your COGS: Cost-of-Goods-Sold, this basically means what it costs you to create and/or deliver each unit of what you are selling. This could be materials cost, hosting costs, packaging and delivery costs, and so on. You should also include development costs, licensing and royalty fees for any included components, infrastructure costs, and so on. You can optionally try to include marketing and sales costs, but those are often hard to define―you might just want to figure out some percentage overhead margin that you want to include.
What message you want to send to the market. If you price a bit higher than the competition, you are suggesting your product has more value; if lower, that you might have a product with fewer features. But if your competitors are considered to be bloated, or legacy older products, you can use your pricing to affect your market positioning.

What the Market Will Pay

There are any number of ways to arrive at the price the market will pay, including some formal market analysis that usually involves interviewing customers and asking questions in just the right way. For most markets, you can also just look at the competition and see what they are doing; your pricing can choose to fall in line, or deviate based on your strategic goals. Again, lower pricing might send a signal that you have a more streamlined, less bloated offering that is priced to move; higher pricing might suggest that you have some unique solution that no one else has yet. Your marketing (and your product) will have to back up those claims!

On the formal market analysis side, there are several different techniques that you could try to do yourself, or hire an outside firm to do for you. These include Van Westendorp’s Price Sensitivity Meter, the Gabor-Granger Method, and Conjoint Analysis. To be honest, I’ve never actually used one of these market analysis techniques: most of the products that I’ve managed thus far either had enough competition that our pricing was primarily driven by competitive considerations, or were early stage unique products such that we defined custom pricing for each new deal. Your mileage may vary.

Another key consideration is the set of features included in your product. If you have bundled several features together, you might not be compared to a single competitive product, but instead to several products. For example, if your endpoint security product protects against malware but also includes endpoint software patch management, any customer looking at your product versus the competition should be comparing pricing for your product against the pricing of your competitor’s endpoint product plus a separate software patch management product (assuming the customer wants both!). And this is where packaging comes into play: do you bundle stuff together assuming the customer will want all of it, or offer separate add-ons to give the customer more flexibility? Either way, when you look at the competitive market and think about what customers will be willing to pay, you need to try to match up featuresets and explain to your customers the full picture of what they are getting for the price you offer.

COGS

It is important to consider your costs, and you should definitely consider all of the expense categories that I mentioned above. If you are selling below cost, your business will eventually fail―despite the old adage “but we’ll make it up on volume!” There are some exceptions, however:

You may choose to sell below cost (a loss-leader) to gain some additional market traction or as a Proof of Concept, and then raise prices later, or make up the loss with another product. This has to be handled very deliberately and carefully.
For some expense types, the cost-per-unit may fall dramatically as you produce more units―essentially, you can amortize the cost of some expenses across each unit sold, or get better volume purchase deals for your inputs. Thus, you may initially be able to sell below cost by assuming sales volume increases eventually put you in the black. Note the “assume”―be careful!
Note that COGS essentially sets a floor price, and you have to make sure you stay above that floor AFTER all discounting. In the pricing model defined above, note that MSPs might get a net 70% discount; a 3-year deal to a large customer through distribution is roughly at a 73% discount. And Sales may apply additional discretionary discounting on top of that. For that pricing model, as a rule of thumb I would set a price minimum of something like 5X or more of the calculated COGS to ensure that most deals don’t lose you money.
The price set by COGS may be influenced by the expected license term as well as the licensing model. For example, if you believe that new customers will sign up, stay with you for 3 years, and only after that maybe switch to a competitor, that may influence COGS if setup costs are front-loaded. Similarly, if you are using a subscription model then you might divide the total revenue you want to get from that customer over the 3 years evenly; if it’s a license+maintenance model you might want to charge 80% up front for the license, and then 10% each year for maintenance. As you actually get into the market and have actual customers, checking your average customer lifetime and revenue per customer will be important and you may want to occasionally revisit how this influences COGS (and your pricing).
Although COGS is important, don’t fall into analysis paralysis. Ask the right people, check your historical average costs, make some SWAGs, and come up with some sales estimates for per-unit amortization of fixed costs. Come up with a number, set your floor, and move on.

Pick your price!

Armed with a floor price defined by your COGS analysis, a rough target market price defined by the competition or other market analysis, adusted based on your pricing strategy and messaging, your next step is to just… pick a price! You can always change it later. You will then run that price through your model to generate the individual SKUs within the model. Note that in my example model above, I started with essentially a fully-undiscounted starting price: direct monthly metered. It may be more natural to think about selling your product as a standard pre-pay subscription―no problem, just start there and back out the discounts to calculate, for example, your MSP pricing as needed.

Once you start selling your product, you will learn pretty quickly whether your price works or not―if it’s wildly off, your prospective customers will tell you. Don’t be afraid to ask, either, but take answers with a grain of salt. Same for your sales team: if they lose a deal, they’ll blame the product, the price, whatever. It will be you (or your product manager’s) job to tease out whether price was really the main factor in a lost deal, or whether the product needs work, or marketing, or sales training, or whatever. You can always offer temporary discounts to see if it really is a price consideration, which is better than reflexively changing your price at the first sign of complaint.

A word on price increases: inflation is a thing, and you will eventually have to raise prices. Also if you realize you priced your product too low to begin with. Based on my experience, you can raise product pricing by about 10% and you will only lose a few existing customers (~2%) who object to the price increase. This is usually a net win. But don’t do this too often, or your churn will go way up. You can also play games with holding existing customers at their current price while increasing net new pricing, but this will make your billing WAY more complicated over time. At a prior company, we actually had pricing protection built into our purchase agreements (a good thing, as customer generally HATE getting yanked around by price increases), but that pricing protection did allow occasional small increases. During COVID times our costs increased significantly, and eventually we felt we had to pass some of that pain along to our customers―which exceeded the price protection, caused pricing disparity between new and existing customers, and caused lots of internal annoyance. Also, If you do raise prices, I recommend proactively telling your customers about all the amazing features you have added to your product over time as a way to soften the blow.

If you’ve gotten this far, you’ve made it to the end of a pretty lengthy discussion about pricing. Congratulations! Feel free to ask questions in the comments below, and I hope you found this informative.