Estd 4.22.2023
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Since 2020, U.S. inflation has experienced significant volatility, peaking at 8.3% in 2022 due to pandemic-related disruptions, supply chain issues, and geopolitical events. Efforts to control inflation, including Federal Reserve interest rate hikes, have helped to moderate it to around 3.3% by mid-2024.
In the SaaS industry, decision-making about price adjustments often revolves around discussions on inflation. However, a closer examination reveals that the real driver behind pricing changes is not inflation but regime change, characterized by shifts in interest rates.
Inflation is typically measured by the change in the price of a basket of goods and services over time. From January 2000 to June 2022, (as illustrated in the Fig.1), we observe significant price increases in sectors like hospital services and college tuition, while technology products, specifically computer software, have become more affordable. This trend highlights an important point: inflation impacts industries differently, and for SaaS companies, the usual inflation metrics do not directly correlate with software pricing dynamics.
As SaaS products mature and the market becomes more crowded, companies face a common challenge: commoditization. This means that the unique features that once commanded high prices start becoming standard, available from many competitors at lower prices – resulting in deflation. Additionally, Moore’s law applies and the underlying storage and hosting costs become both cheaper over time as well as amortized over large customer bases.
Example of Software Deflation: DocuSign
DocuSign is an example of this dynamic. Early on in its lifecycle DocuSign was able to charge premium prices for its e-signature product line. But as the market grew, more companies like PandaDoc and HelloSign entered the scene, offering similar services at lower prices. This increased competition led to commoditization, where digital signatures became a standard offering, not a unique feature.
It led to:
In the below graph, ( see Figure 2), you will see the relationship between SaaS valuations and the 10-year treasury rate. It's evident that SaaS valuations are highly sensitive to interest rate changes. Low interest rates have historically encouraged investment and higher valuations for growth-oriented SaaS companies. As rates rise, however, the cost of capital increases, pressuring companies to prove profitability and efficient cash flow management.
Given these insights, SaaS businesses must reconsider their pricing strategies. Rather than merely adjusting prices in response to general inflation, understanding how regime changes influence customer behavior and investment becomes crucial. This knowledge allows for optimizing operational efficiencies and realigning pricing models to better match the economic conditions customers are facing.
Based on another piece of research by Jamin Ball, for a cohort of software companies the FCF (Free Cash Flow) has consistently gone up in response to higher interest rates. See image below:
Efficiency in SaaS is also measured through metrics like revenue per employee. The data in Jason Lemkin’s blog post indicates that the average public SaaS company now generates about $300,000 in revenue per employee.
For some companies like Canva, this figure is even higher, reaching $500,000 in revenue per employee even at $2B ARR and 4000 employees.
To put this into perspective, in the past year 2022-24, the benchmarks for employee efficiency have risen significantly. In 2023, the average revenue per employee for companies at scale was around $188,000. This number has now increased, with companies like Canva setting new standards. The higher revenue per employee indicates that each employee is more productive, allowing companies to operate with fewer people and better margins.
At the same time, for the same reason of trying to maximize margin and cash flow, companies are also relooking at software spend. Median software NRR is now the lowest since 2020, see image below. Here we see the other impact of increasing FCF, a close relook at spend and thereby a concurrent impact on Churn and NRR.
What we therefore observe is a double sided knife problem.
That,
What options do you have then from a pricing and packaging perspective?
Let us consider our options first from a packaging perspective: The image below provides a set of packaging options from a one-size-fits all model on the left to a completely a-la-carte option on the right.
If you’d like to generate more FCF, then what you really want to do is to monetize areas of your product that there is a market demand for that is currently not being well monetized. In that case you want to move more to the right side of this spectrum. This means that if you have a sort of GBB model, then you can consider creating more add-ons that could be used to fulfill upsell motions.
In many cases there are already inefficiencies in packaging that can help you here (we are not advocating you nickel-and-dime customers), where some capabilities were added to packages but actually were valued by a smaller segment of customers but because they were included in the packages, they had become blocked from being upsells. Alternatively, you can consider using an a-la-carte option for a sliver of your enterprise segment (i.e. where you see “whale” behavior) and the act of custom scoping each deal across capabilities will likely lead to an increase in Average Sales Prices/Average Deal Sizes. In the 2021 environment, for growth you would have wanted more simplicity to increase deal velocity but now in the 2024 environment you may want to focus more on granular/flexible pricing to increase deal sizes.
At the same time if churn is an issue, then a defensive maneuver to add a “lite” package option could help move customers to a lower plan so as to not lose these customers completely. See table below.
Let us consider our options next from a pricing metric perspective:
Only once packaging and pricing metric changes have been considered should outright pricing metric changes be considered (especially if they don’t provide any further value). See article by Jason Lemkin where he says, “Incessant Price Increases on The Base: They just keep going up and up and up. Especially unearned price increases on the existing customer base. Same product, same features, now priced higher. Many have raised prices every year the past 3 years. We used to hesitate here, to keep NPS up. But if growth has slowed to say 20%? Then a price increase is the simplest way to hit the plan. On paper at least. Raise prices for new customers? At least they get to choose. Force annual pricing increases on existing customers? That’s something quite different.”