Subscription models bring a new level of complexity—deferred revenue, monthly recurring revenue churn, customer churn—but it also brings benefits: sticky revenue streams that one-and-done business models can’t achieve, low cost of goods, and gross margins that increase with scale. One of the easiest levers to pull is the cost of your monthly subscription model.
Any freshman business student can tell you that the two sure-fire ways to increase profitability are to decrease costs or increase revenues. The SaaS structure, however, is a little more complicated—SaaS makes money on a subscription model rather than a one-time sale. It doesn’t fit neatly into the classic business school “widget” model.
With SaaS, you can increase profitability by decreasing customer acquisition cost or by increasing the value of each customer you acquire. This post by Justin Mares, co-author of Traction, looks at how underpricing your monthly subscription can dramatically handicap your revenue growth.
The magic of compounding
For those of you who need a refresher, compounding is when you have an asset that generates earnings (such as a monthly subscription), and those earnings are reinvested to generate their own earnings. Think compound interest.
Mares points out that raising the price of your monthly subscription can (depending on your customer acquisition cost) dramatically compound your revenue growth. In his example, Mares looks at a product with a CAC of $16.67 that’s priced at either $10 a month or $29 a month. If you start with one customer paying you $10 a month and reinvest revenues, it compounds to $1420 a month in revenue after only one year.
But if you charge $29 a month (remember that your CAC is $16.67) it compounds at a much, much higher rate, and after 12 months, you’re making north of $1M in monthly revenue.
This is an extreme and very simple example—in reality, raising the price of your product affects everything from customer retention to conversion rate to available market—but it proves a useful point. Underpricing your product means you’re undercutting future revenues, which in turn decreases your ability to develop new features or product lines, build a strong sales team, and scale up customer success to help you keep the revenue flowing in.
How are you thinking about price? Join the conversation on Twitter—@LighterCapital.
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