Software as a service (SaaS) and subscription pricing models dominate the business landscape. SaaS faced a challenging 2022 due to venture capital pullbacks, but the business model has moved upstream with more enterprises adopting SaaS pricing. SaaS is also a popular billing model with lower middle-market software companies, indicating its versatility and business value.
The reasons are plenty. SaaS pricing models are conducive to recurring cash flow for companies, user loyalty (since switching products creates a time and cost sink for users) and produce network effects through data collection, giving companies a natural economic moat.
SaaS company valuations have always presented investors with challenges, given their technological bent. Should these companies be valued as tech companies or as sector incumbents? Tesla is a good example of this conundrum. The car maker incorporates several SaaS-like features in its pricing but operates in a sector with longstanding valuation criteria. Should investors value Tesla as a tech company with high earnings multiples and growth premiums? Or as a car maker with cyclical earnings and valuations?
Examining these companies’ pricing strategies could offer investors an edge. Each company’s pricing engine works differently, depending on its user base and core product. Some charge one-time fees while others use complex value-based pricing models.
Examining the nuances of each pricing model gives investors a way to differentiate companies and dig deeper into their unit economics.
Insights for investors from SaaS pricing
Designing an effective SaaS pricing strategy is a challenging task for companies. Price a product too high, and you risk eliminating demand. Price it too low, and you won’t turn a profit. Examining the viability of a SaaS company’s pricing strategy gives investors insight into how effective management is and how well they understand the company’s customers.
Traditional pricing strategies like cost-plus (where the company adds a margin to production costs) and competitor-based models (where a company prices products according to the competition) don’t work in SaaS. Cost-plus works well when a company incurs significant operating costs, like with manufacturing companies.
However, most SaaS companies, especially those in the technology sector, don’t incur huge operating expenses, with product development human resources being the primary expense. Arbitrarily setting a margin and calculating prices will leave money on the table. Competitor-based models also fall apart since companies operate differently, offering different features that lead to variations in prices.
In short, SaaS pricing is a complex challenge that management has to devote resources to solve. Some SaaS companies have approached the issue by offering a single, relatively simple, product. For example, Precog, a SaaS product that helps companies extract and load data efficiently, offers single-tier pricing in line with its product. It has no frills, and this makes calculating prices simple. In turn, this makes valuing the company easier, since investors don’t have to deal with too many variables based on product frills.
The simplicity of this pricing engine is an indicator that Precog’s customers seek single solutions, making it easier for investors to spot trends and keep pace with that sector’s needs.
Of course, this model has its disadvantages as well. A competitor might disrupt the sector by offering innovative features and charging more for them. The product’s simplicity could potentially work against it. However, for now, companies that offer single-tier pricing are easy to value and compare to the competition.
Freemium and profitability
Examine the state of SaaS, and freemium pricing models are easily the most prevalent. Freemium pricing entices users to try the product for free, usually offering a trial period with all features before gating functionality behind paid walls.
Users can often continue on a limited version of the product for free and upgrade at any time. Freemium companies often attract high valuations and interest from investors, because their user counts can grow quickly. After all, who doesn’t love a free deal?
The freemium wave has been so popular that consumers are now conditioned to expect some free features in every product. While freemium can be a good way to grow user counts, revenues don’t always follow, creating a valuation gap.
Zoom is a notorious example of the dangers of the freemium model. The company grew rapidly during the COVID-19 pandemic, with users adopting the app for remote work and personal meetings. However, the company struggled to turn a profit. While Zoom has technically been profitable for four years, industry analysts regularly question its aggressive accounting methods, demonstrating the risks investors encounter with such companies and their pricing engines.
Converting free users to paid ones is tough, and investors must be wary of overvaluing user growth. Instead, investors must pay attention to whether the product offers demonstrable utility or has a good product-to-market fit. If not, users are unlikely to hand their money over. This isn’t to say Zoom is doomed. The company has reasonable network effects to counter competitors like Google and Microsoft.
Investors must keep an eye on the competitor features and analyze valuations from a product-to-market fit perspective, instead of comparing valuations across sectors or competitors.
Usage-based and blended pricing
Recognizing the dangers of the freemium model, SaaS companies have begun blending their pricing models via sophisticated engines. Usage-based or seat-based models (prices that depend on the number of seats a user purchases or the number of features they access) are common right now, as companies combine the freemium model with usage-based ones to present a blended approach.
Value-based pricing lies at the heart of these blended approaches, and estimating whether companies have got it right is challenging for an investor. Even SaaS company leaders find this to be tough. Measuring the amount of “value” a user derives from a product is highly subjective. Sales and customer success conversations can hint at the value users derive, but quantifying it is a tough task.
Many companies have therefore begun relying on a metric called Remaining Performance Obligations, or RPO, to measure whether their prices offer customers enough value.
This metric, disclosed in the notes to the financial statements, measures upcoming revenue, giving investors a cash flow estimate over the following year. It replaces the traditional “bookings” metric most SaaS companies used to report, since bookings don’t capture the complexity of a blended pricing model.
While RPO isn’t perfect, it gives investors a picture of the company’s pricing model health and removes any need to dive deeply into the engines that formulate that model. RPO is still a dense metric to unpack, but it is a much better option, compared to traditional SaaS metrics.
Pricing strategy is critical to valuation multiples
Valuing a SaaS company is challenging, and even veteran VCs get it wrong all the time. However, looking at a company’s pricing strategy and linking it to product complexity will remove much of the uncertainty in the process for investors.
When combined with traditional investing valuation processes, price strategy analysis can yield great results.
