How to Find Product-Market Fit From Your Pricing Strategy

As part of my work, I talk to many seed-stage SaaS founders. At the seed, most of these founders are thinking about how to get to product-market fit. The one in zero to one. They’re launching their product with a select few companies to really nail their pain points. And often times, pricing and the business model take a backseat when they offer their customers the product for free or at an extreme discount. While investors don’t expect founders to nail pricing at the seed, it’s useful to start thinking about your revenue model early on. After all, pricing is both an art and a science. And with the right pricing structure, it can also be your proxy for assessing product-market fit. Here’s how.

As a quick roadmap:

1. How to use the pricing thermometer to understand value-based pricing
2. The difference between buyers and customers
3. What is your value metric? And why does it matter?
4. How pricing influences positioning
5. How to approach building a tiered plan, with a mini case study on Pulley
6. Net dollar retention, what product-market fit looks like in dollars
7. The SaaS version of engagement metrics

The pricing thermometer

Every product manager out there knows that customers don’t always know what they want, so asking them for a solution rarely nets valuable feedback. Rather, start with the problem. What are their frustrations? What sucks? What’s the last product they bought to attempt to alleviate their problem? Subsequently, what’d they like about that product? What didn’t they like?

There are two perspectives you can use to approach pricing: cost-plus and value-based. Cost-plus pricing is pricing based on selling the product at a given markup from its unit cost. The biggest mistake founders often make here is underestimating how much it costs to produce a product.

On the other hand, there’s value-based pricing. An approach where you determine the economic value of the service you are providing and give it to your customers for a bargain. Superhuman, for instance, prices the fastest email experience at $30/month. Or in a different light, a dollar a day. If you are saving more than a dollar of economic value a day by responding to emails faster than ever, then the product is worth it. The biggest pitfall here is that founders often don’t fully understand the value they’re bringing to their customers, which is a result of:

1. They don’t understand your value,
2. Or you can’t convince them of the value you think you offer.

To visualize both of these approaches better, let’s use the pricing thermometer, as YC calls it.

The greater the gap between two nodes (i.e. value and price, or price and cost), the greater the incentive. If you’re selling at a price far greater than its unit cost, you are far more motivated to sell your product. On the flip side, if your product is priced far below the value and benefits you provide, a customer is more motivated to purchase your product.

Buyers vs Customers

To take it a step further, if you’re planning to scale your startup, what you’re looking for our customers, not buyers. Buyers are people who purchase your product once, and never again. They learned from their mistake. Your product either didn’t deliver the value you promised or the value they thought you would deliver. Customers are repeat purchasers. Why? Because they love your product. It addresses your customers’ needs (and ideally more) again and again. Your customers’ satisfaction is evergreen, rather than ephemeral.

When you only have buyers, you have to push your product to others. It’s the epitome of a door-to-door salesperson. Think Yellow Pages.

Value-based pricing is playing to win. Cost-plus pricing is playing to not lose. While the latter is convenient strategy when you’re a local business not looking to scale (i.e. coffee shop, local diner, local auto parts store, etc.), it’s incredibly difficult to scale with, especially as customer needs evolve. As you scale, your customers might include anyone from Microsoft who wants you to bring a sales engineer to integrate your product to a 5-person startup team who’s just testing your product out. With cost-plus pricing, you’ll be forced to determine price points on a case-by-case scenario. With value-based pricing, you can systemize dynamic pricing based on evolving customer needs. As their value received goes up, the price does too.

As the name suggests, to generate pull, we have to start from value. In this case, your value metric.

Your value metric

What is a value metric? A metric that helps determine how much you should be charging based on the value your customers are receiving. Equally so, a metric that allows you to have an infinite number of price points, or a dynamic pricing model. There’s a great Medium piece by Pritish Jadhav on building an algorithmic model for dynamic pricing.

But in efforts to not get too technical here, and inspired by Patrick Campbell, there are two types of value metrics:

1. Process-based (e.g. per user, per 100 videos, per time spent) – a function of usage
2. Outcome-based (e.g. # views per video, $ earned per customer, # customers) – function of outcomes

Analogizing to a math equation we may all be familiar with from our algebra days,

Frankly, your customers care about results, not billable hours. They care less about the divisor, but more so about the quotient. Outcome-based value metrics are 50% more effective in driving expansion revenue than feature differentiation (i.e. Price A has 5 features, Price B has 8 features, etc.). Process-based only drive on average 30% more expansion revenue than feature differentiation.

If your product can help your customers delivers on the results they care about, then it’s completely fine to charge more. It might seem like a no-brainer, but understand that the price you pick still has to be greater than your CAC, especially for large corporations. If you’re spending $10-20K to acquire Airbnb or Amazon as your customer, you need to charge them for more than that. If you’re charging less, you can’t afford to deliver the value that large customers ask for, like having a sales engineer fly out to help them integrate the software or creating a customer portal for them.

Once you know your value metric, the next step is how you’re going to convey that to your customers.

Positioning based on value and price

I wrote an essay last month where I said: It’s much easier to compete in the market of one – the only one – than in a market to be the best one. It’s much easier to swim in a blue ocean, where you can see the bottom of the ocean and water is crystal clear, than in a red ocean, stained with the blood of battle. As the folks at Sequoia once wrote, “People tend to overvalue things they already have, a pattern known as the endowment effect. This is something that enterprise companies should be particularly aware of. It’s going to take an extra effort to get a customer to rip out something they already have even if what you’re selling is demonstrably better. That’s one reason why it’s easier to sell to a greenfield customer than to win one away from a competitor.”

In the theme of endowment effects and blue oceans, the exact words you use to describe your product is crucial to setting your price point. Selling an “email” service carries a different connotation than a “chat” service. The two services arguably have the exact same functionality, but in a customer’s mind, have different competitors, frequency, and audiences. And considering all the afore-mentioned variables dictates a different price point. So, it comes down to how you position your product. In the early days of building your startup, you’re going to have to push your product to potential customers. When you do, you must be cognizant of what preconceptions they might compartmentalize you in.

Intercom’s Des Traynor shared in an interview with Jason Calacanis that Intercom used to sell its product to IBM for $49. And over a phone call, a guy at IBM once told Des, “You know, I go on a coffee run for the team that costs a lot more than your product. That’s why we’re wary of investing too much more in you. We just don’t see how you’re going to survive.” An anecdote why tiered pricing plans with an “unlimited” tier means you’re offering huge corporations, like IBM, a huge discount. And while that may seem like good bang for their buck on paper, actually proves detrimental to your company’s image and growth.

As April Dunford says,‍ “positioning defines how your product is a leader at delivering something that a well-defined set of customers cares a lot about.” Numbers, just like words, is part of the positioning function. For example,

• Prices that end in 9s suggest a discount brand, while prices ending in 0s suggest a premium brand.
• People generally think a $50 bottle of wine is better than a $10 bottle of wine.
• Decoy pricing incentivizes people to pick the “better” package. Once upon a time, the Economist magazine offered three packages: $59 for web content, $125 for print subscription, and $125 for web and print subscription. As part of a study, behavioral economist Dan Ariely found most of his students picked the third combo option when given all three choices. In a parallel study, students picked the cheaper $59 option when the decoy package was taken out of the mix.

Building a tiered plan

Once you’ve established your brand with (potential) customers and determined your outcome-based value metric, the next step is to set up a tiered plan. When you’re a SaaS company, you always have to consider two price points:

1. Where can they do now
2. What’s next (where they will be, if they become a successful business)

Much like Scott Belsky’s formula for customer retention, you have to sell for both. Using gaming terminology, sell the tutorial and the end game. Reduce friction to play the early game. For many SaaS companies, like Notion and Coda, that’s introducing a freemium model. And sell the dream of what could be. Companies, like Adobe, do this extremely well, with tutorials and a massive community online.

I’m going to borrow Pulley‘s Yin Wu‘s insights to better illustrate my point. Pulley, a platform to manage your cap table, also runs on a freemium model. Subsequently, Pulley’s customers – startups. In my conversation last year with Yin, I asked her how she came to pick 25 stakeholders as the cut-off point between free and paid users. While it’s not a hard cut-off, 25 stakeholders is typically the number of stakeholders a startup has around the seed stage. And it makes complete sense!

The seed is still around the time you are searching for product-market fit. You may have some early traction that proves your concept, but still a bit before you cross the chasm. Once startups raise their A, that is when they’ve found PMF and are ready to scale. Startup teams who get to “one” in the proverbial zero to one are more likely to survive and succeed. And therefore, increasing the LTV of a customer.

Note: As a reference point, usually LTV:CAC ratios of 3-5x are pretty solid.

NDR, what product-market fit looks like in dollars

Some of your customers will eventually upgrade their subscriptions. At the same time, some will downgrade, or churn off – either because they run out of cash to pay or no longer find value in your product. It happens. To measure all of the vertical movement, VCs love tracking your NDR. Your net dollar retention.

NDR = (starting MRR + expansion – downgrades – churn)/(starting MRR)

Simply put, it’s the percent of revenue you’ve retained from the prior year, accounting for customer movement. Here’s a quick example. Let’s say you start off with $100K MRR; 10 customers each paying $10K. 2 of them churned out. 2 of them upgraded their subscriptions from $10K to $30K. All of that comes out to a net retention of 120%.

If your net retention is greater than 100%, that means you’re seeing an increase in revenue from existing customers. That is to say, if your company never acquires any more customers, your business will still grow. If your net retention is less than 100%, then you need to double down on customer support/success or rethink your target customer. The best SaaS companies have 120%+, with the best five having an average of 139% and an industry median of 109%.

For non-SaaS products, Lenny Rachitsky shares some amazing benchmarks between good and great retention.

Because net dollar retention accounts for “engagement” and churn, for SaaS companies, it happens to be one of the best predictors of product-market fit. On the other hand, if your MRR is increasing but your NDR is less than 100%, then you have a leaky funnel. I would go back to the drawing board and see where the churn is happening.

The SaaS version of engagement metrics

Speaking of assessing engagement and churn, in the consumer social/app world, one of the key metrics we look at is the engagement rate. Namely, DAU/MAU – the percent of your monthly users who use your product on a given day. An amazing proxy for stickiness. 25% usually warrants a meeting. 40% means investors are calling you. 50% will most likely lead to the fastest term sheet you’ve ever seen. Here’s one VC who’ll write that check.

Of course, in the SaaS world (enterprise and bottom-up), most employees don’t work a third of every month. So rather, the MAU needs to be based on a period of 20 work days, or four business weeks. Equally so, adjust for holiday breaks. Equally so, rather than engagement curves, focus on engagement crests. As a SaaS company, your engagement curves are going to look like a volatile mess with insane troughs at the end of every business week.

Take it from the guy who knows his SaaS metrics, David Sacks at Craft Ventures. He elaborates more about what to look for in SaaS engagement metrics.

The golden number for SaaS DAU/MAU for customers is 40-45%. And DAU/WAU at 60%. With your top customer accounts with a DAU/MAU of 60-70%.

In closing

For many founders, pricing is this mysterious black box, but it doesn’t have to be. And hopefully this essay helps you to demystify what it takes to set up your pricing strategy. As with all things startup, do A/B test different strategies to help you best deliver the value your customers are looking for.

Of course, feel free to reach out to me any time if you have any questions.

Photo by Angelo Pantazis on Unsplash

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