I recently helped a client with their pricing for a subscription-based software product and thought I’d share my thoughts on this very important topic.  Investors love the subscription-based model (also called recurring revenue model) where you sell a product once and then charge the same customer over and over again.  Generally speaking, it is less prone to business cycles so provides a more steady income stream.  Salesforce.com is a great example of this model.  I’ve been working with subscription-based models for 20 years, starting with the earliest days in the cellular industry, then moving into wireless applications and 5 years ago into software.  Here are some lessons learned:

·        PREDICTABILITY trumps all other pricing factors.   If customers have to guess what next month’s bill will be based on their usage, they’ll grow afraid of using your product. 

·        Discounts for TERM CONTRACTS (6-month, 1-year, 2-year contracts) drive short-term revenue but severely restrict long-term revenue. This can be a danger in young companies when cost structures are constantly changing (adding headcount, marketing budgets, etc.)

·        VOLUME DISCOUNTS for subscription services don’t drive adoption and thus should be minimized.  In fact, at a certain point there is an inverse relationship to adoption.

More on Predictability, Term,and Volume pricing for subscription-services:

On PREDICTABILITY:

One of the hardest aspects of subscription-based pricing for some businesses to grasp is the importance of predictability.  There is a tendency to want to align pricing with one’s costs.  If your costs go up, shouldn’t your customer’s?   The problem is that human beings hate uncertainty.  They will pay more to be able to budget and know what that monthly bill will be.  This places a high burden on start-ups to estimate future costs well so that a sustainable, predictable monthly bill can be developed for customers.  The biggest mistake made here is severely under-estimating your costs.  If you have 20 employees and only a few customers now, you have to think about what your company will look like with thousands of customers and employees later - No easy task. When I started with Nextel we had 3 markets (Los Angeles, San Francisco and Chicago were our first), 52 employees, and just a few pre-sold subscriptions.  In no time, we had network costs for 25 markets, customer service costs to support 50,000 customers,and  2,500 employees!  It’s therefore important to get solid cost estimates on what the biggest dogs in your Industry are experiencing.  Hopefully there are public companies you can use as a model.

 On CONTRACT TERM:   

There are 2 ways to collect subscriptions: 1)  the cell-phone model has you sign a 2-year agreement, but then charges you every month against that contract;  2)  The Salesforce.com model has you sign a contract and pay for the entire contract amount up-front.   #2 is preferred by investors and start-ups –money in the door today when it is needed.  But it usually requires greater discounts on the contract term as an incentive to get people to sign up for a longer term.  They need to see a greater value for signing a 24-month contract vs. a 12-month or 6 month contract.   Once you discount to receive that larger lump-sum, your long-term revenues have been impacted and you will have limited your pricing flexibility.   And that larger discount may prove unnecessary if switching costs are sufficiently high enough. 

What does it cost a customer to move from your product to another vendor, or to their own in-house solution?   If switching costs are high in either time, money, or disruption to their business or personal life, then term discounts should be pretty low. They will stay to avoid those costs, so there is no need to highly incent them.  For example, there was a time when you could not keep your phone number when you switched from one cellular carrier to another, so carriers didn’t have to deeply incent you to sign a 2-year agreement.  Your incentive to stay was the pain of having everyone who knew your phone number or had it programmed into their address books to have to change it – What business professional wanted their network to sustain that pain? Now that it’s fairly painless for customers to switch, carriers are pushing for longer and longer contracts to ensure you won’t leave.

When you have a subscription-based model, it is always a good idea to plan for longer-term contracts in your pricing model, whether or not you need them today.  When a product is new and you have no customers, you're still trying to sell - so prospects are more interested in trial s and short-term contracts.  However, once you start dealing with an existing customer base with contracts expiring, a 24-month contract great to have.  In order to protect future margins and avoid being surprised by requests for a 24-month contract from existing customers, start by including a 24-month contract in your pricing model.  But understand, you DO NOT have to discount much if there is sufficient pain to switch.  If a customer is already with you and shows interest in a longer term deal for  a discount, then really they don't want to go anywhere - They just feel obliged to beat vendors up to get as much savings as possible.   So don't think the difference between, say the 12 and 24-month agreement needs to be as high as the difference between your 6-and 12-month agreements, for example.  The latter is much more important to get adoption.  Once you have adoption, absent a major competitive threat and a drop in switching costs, further discounts are just giving away margin.  Even a 5% discount might buy you that 2nd year - yet I've seen companies cut their price on that 2nd year by 30 to 50%.

On VOLUME DISCOUNTS: 

Every big business expects to pay less per unit than a small business.  Obviously Costco expects to get the best pricing from Coke, for example, because it moves a lot more  than the little mom-and-pop convenience store down the street (as I write this Costco has stopped selling Coke in order to prove it's point and get better pricing).   But in a subscription-based software business, volume discounts to a Fortune 500 company doesn’t necessarily drive adoption of your product internally. The question to  understand is whether your product offers any other benefits besides cost savings that create a separate incentive for the organization to standardize on it - for example, streamlining business processes, transparency, or compliance versus what they are doing today.  If the product accomplishes these larger objectives, they have a reason to standardize, and offering them huge volume discounts won't be necessary.  If, however, it's easy enough for a company to have multiple vendors selling similar wares within different parts of a company, then volume discounts on actual usage would be in order.   

before deciding on what your volume discounts should be, startups once again need to be cognizant of future costs.  Many small companies are so excited about that "big fish" sales win that they don't recognize that many times large customers COST MORE to manage than smaller guys.  My experience is that you will have more training classes, more customer service issues with larger businesses trying to secure user adoption.  Yet most start-ups assume the opposite is true so their cost structures become upside-down.  How much of a discount should exist between a sale of 10 subscriptions to a small business and a sale of 100,000 subscriptions to a Fortune 1,000?  Well, go back to my first point - is there another reason for the company to standardize on your product other than just price?    What are the switching costs?  Don't look at your pricing in a vacuum

Also, when determining your deepest discount for your largest customer, make sure you think BIG when it comes to the largest possible number of employees using the product and build your pricing model with that in mind.  You don’t want to be surprised by success and have to redo your pricing model because someone actually WANTS to buy for their entire firm.   Price it in your plan from the start. 

These are general strategic thoughts and lessons-learned after 20-years developing subscription-based pricing.    To fully develop pricing for your product you obviously need a complete understanding of the competitive landscape and your future cost structure.  

Though not specific to subscription pricing, take a look at these additional tips as well as this free ebook.