Startups and established firms both deal with cash flow issues. For startups, effectively managing cash can mean the difference between living to fight another day or closing up shop. For others, it could mean funding new product development to leapfrog a competitor.
With the start of the new year, it may be time to take another look at how you price your product or service to improve margins and cash flow. Software-as-a-Service (SaaS) tech startups can provide a useful model that shows how tweaks in pricing and terms can have a dramatic impact on cash flow and profit.
Pricing Structure Options
SaaS firms operate using some combination of following three pricing methods:
- Linear Pricing (LP) – This is a pure consumption model where, for example, each transaction or say some analytics “event” costs $0.10. You pay for what you consume.
- 2 Part Tariff (2PT) - In this case, the analytics software has a base platform fee of say $10,000, and each analytics event processed by the system costs $0.10. The same model as above, but you can charge a platform fee in addition to consumption.
- 3 Part Tariff (3PT) - This also includes the base platform fee, but it is now $25,000 because the first 150k transactions/events are free. However, each additional transaction/event costs are slightly higher at $0.15.
With pricing, you are trying to balance the value delivered (both real and perceived) with a price point that captures that value using a cost-plus model or value capture. Looking at the three SaaS examples above, there is lower risk and clear value in the Linear Pricing model as the customer has visibility into and can control, the monthly cost my managing their consumption. The risk for the vendor is high variable usage that causes support challenges and monthly fluctuations in cash flow.
The 2 Part Tariff helps mitigate this risk by including an upfront platform fee to provide a cushion to guard against potential monthly fluctuations in consumption.
By including a bundle of “free” transactions in the platform fee in the 3 Part Tariff, you have the flexibility to negotiate the number of transactions you would be willing to provide, without compromising on the platform fee level. Sales teams like this approach as it gives them the option to offer something of value without creating a potentially unprofitable account.
In the SaaS world, contracts are typically structured using per unit of consumption (message, analytics event, telephony minute), per person(user), or enterprise license agreement.
Introducing Annual Contracts
Getting customers to move away from a transaction or monthly payment model to an annual contract can have a dramatic impact on your cash flow. Using SaaS firms as an example over a hypothetical 24-month period, you can see in the chart how the various types of payment options can impact your cash position month to month. This chart from Tomasz Tunguz at Redpoint Ventures show how annual prepay creates a cash cushion from month 1 to 12. The gap jumps again at month 13 when annual renewals hit, dramatically changing the financial condition of the company versus the monthly, semi-annual options that stretch out payments.
Positioning for Annual Contracts
To be clear, getting your customer to commit to a year’s worth of payments is no small task, particularly if you operate in a commodity market or your value proposition is not clear and compelling. Price points clearly matter, as your customers have cash flow issues of their own to manage, and are not likely to cut a large check without feeling like there is real value in doing so.
You first need to determine your positioning in the market before you consider changes to pricing. Looking at this through the eyes of startup companies could prove useful. Tunguz provides a summary of the alternative options used by successful startups:
"Startups can choose to price below the market, to gain share and grow quickly (Zendesk, AirWatch); they can choose to price at the market price and differentiate based on product features (Dropbox and Box); or they can charge a premium for their product, which reinforces their positioning as the gold-standard in the sector (Palantir and Workday)."
Once you understand how you want to position yourself, you can then start to reevaluate your pricing and contract terms to see if there is an opportunity to bundle products and services, create more value, and have your customers commit to longer-term agreements that benefit all parties.