Why Real Businesses Don’t Charge $5/month

12 Feb

As a business that’s trying to make money, you live and die by this evaluation: LTV > CAC.

For those that don’t know what the above means (aka me 6 months ago), it’s a more complex way of saying that in a real business, you make more from your customers than you paid to get them. Their lifetime value (LTV) must be greater than your cost of acquisition (CAC).

Let that sink in for a moment. As someone who (presumably) wants to make more money, there are two clear ways to get you closer to that Ferrari/Thailand trip/guitar studio: lower your CAC, or increase your LTV. Lowering your CAC involves things like pursuing virality, building referral engines and testing new marketing channels (which we cover extensively in Traction Book). I’ll cover that more in future posts.

For now, let’s take a look at how you can increase your LTV. Here’s a thought experiment for a bootstrapper running a SaaS software business. You hate paying for software and figure others do too, soo… you are thinking of pricing your app at $10/month. Let’s say the nearest comparable product sells for around $29/month. Where should you price it?

Let’s take a look at something completely obvious:

Yes, charging (roughly) 3x more per month means you have (roughly) 3x more revenue at the end of the year with one customer. Now before you hit the back button, let’s take a look at how this impacts your CAC.

We’ll assume for the purposes of this thought experiment that you’re somewhat of an Adwords guru and can buy clicks at $0.50. Let’s also assume that of those lucky individuals who click on your ad, 15% of them are blown away by your landing page and the value you’re offering that they sign up for a trial. Of those, 20% are so amazed with your product that they sign up for a paid account. That leaves you with a CAC of $16.67.

Not bad! In this (admittedly optimistic) scenario, you’re looking at about 1.5 months to recoup your investment in acquiring a $10/month customer, and about 2 weeks to recoup with the $29/month plan. Again, pretty intuitive.

What’s not intuitive is just how large an impact this can have on your ability to acquire more customers. Let’s say you are running your SaaS business as a bootstrapper, and don’t have oodles of VC money. In this case, you’re only reinvesting revenues into acquiring more customers. Where would this put you after a year?

Nice! After a year of work, you’re pulling in $1420 a month. Depending on your expenses, this might be enough to quit your day job – just stay away from San Francisco or New York.

Now, let’s compare the above to where you’d be if you charged $29/month and reinvested revenues into user acquisition. You know about things like compounding (you’re smart), so you take a tentative guess that charging 3x would probably result in something like 10x revenues. Let’s see how the two approaches stack up:

Um. What? That’s not a super useful comparison. Let’s try again at 6 months:

3 months?

Finally, a useful graph! Who would have thought that after a year, charging 3x more would have resulted in 819x more monthly revenue than otherwise. That gets you to your financial goals a lot faster. After just 6 months, you’re pulling in nearly $36k per year!

Making real money as a business changes a lot of things. More revenue allows you to build a real business where you have the resources to invest in things like better support and new features. One of my mentors (a guy who’s built 5 successful software companies) told me that when a company would object to his prices being slightly higher, he’d respond along these lines:

“At $5/month I can’t build a real business. If I can build a real company, I can help you to blow up your business. I can provide support, product upgrades, and create more and more value for you. At $5/month, I can’t do anything real to help you build your business.”

Something to think about when pricing your next app.

 

Want access to the spreadsheet I used to calculate the above metrics (CAC, LTV, compounding revenue growth)? Sign up for my free mailing list – no spam, emails 1-2x per month, occasional goodies I don’t post to the blog.

***

Thanks to the guys at Lean Analytics for letting me get an early copy of their fantastic book, which inspired a lot of this post, as well as Kevin Espiritu and Nate Speller for edits.

  • http://www.GettingMoreAwesome.com Rishi Shah

    Great post and analysis!
    Charging more is obviously better if you can. 

    However, there are benefits to volume. Especially when you are comparing two relatively low amounts ($5 vs $29). Lowering your price can allow you to get more customers in the door opening up lucrative up-selling potential as well as partnership channels. These are all things that are testable.

    • http://twitter.com/jwmares Justin Mares

      Thanks Rishi! Very true if you’re doing upsells and such, that’s not something I considered here. I was looking at it from a boostrapper’s perspective, who often have 1 product. 

      Of course you should test it, I was just surprised at how big the difference was between the two prices when you add in compounding.

  • Jonas Wilhelm

    Pretty interesting and although you are not accounting for the fact that at $29 the conversion rate would be much lower, the point still stands clear. 

    What do you think we could charge for companies to use http://www.Startrigger.com? 

    We built a database basically of top students who are looking for internships and other opportunities. As we are iterating on the design + functionality now, we are looking to introduce pricing and are a bit unsure what to price at. CAC is high but we are a network business ( more students =  more companies & more companies = more students) so the primary objective is to get companies and students to sign up. 

    • http://twitter.com/jwmares Justin Mares

      Sure, but how much lower? That’s the question. If you charge 3x more, you can afford to have a conversion rate that’s 3x lower: aka 3% instead of 9%. Which one is easier to hit?

      If you’re trying to address a 2-sided market problem (which it looks like you are), you want to keep friction as low as possible. So charging period may not be the right thing to do. Sangeet has some really good analysis on this stuff - http://platformed.info/two-sided-market-seeding/

    • http://twitter.com/amyhoy Amy Hoy

      “the fact that at $29 the conversion rate would be much lower” –> that’s not a fact, that’s a supposition.
      It’s a common experience of many people selling high-quality products to value-minded folks (e.g. businesses) that low price does NOT increase conversion. In fact, low prices can decrease conversion, because some people look at a low price and think things like:

      “If they can only charge $x, it can’t be that good.”

      “If they only charge $x, they probably aren’t spending on the infrastructure, backups, etc., we need.”

      “If they only charge $x, they will not be able to afford to give us good customer support.”

      “If they only charge $x, they probably won’t be able to stay in business.”

      “If they only charge $x, they must not be very professional.”

      The math is a fact… whether or not that price would increase conversions, or drop conversions, or not affect them at all, is just a guess. And guesses aren’t as good as data.

      In my experience: When we doubled the price of our ebook, our conversions did not fall by anything like half. When we increased the price of our SaaS, our conversions didn’t change at all. 

      • http://twitter.com/jwmares Justin Mares

        Wow, thanks Amy. Really appreciate the great contribution!

  • Bsnyder

    The problem is your CAC is a function of your price.

    • http://twitter.com/jwmares Justin Mares

      No?

  • http://influads.com/ damiansen

    What about the higher amount of clients that you can get with a cheaper price? If the comparison was so single-dimensional, charging a higher price would be an easy, straightforward choice

    • http://twitter.com/jwmares Justin Mares

      Right. But then you have to look at how price influences demand. Charging 10/mo is only worth it if you can get 3x more customers at that price. Which likely isn’t true (at least not that I’ve seen with SaaS). Unless of course you’re going for volume to upsell/monetize in another way.

      Good point though.

  • Anonymous

    Very interesting but too simplistic. I think for some products or services this is the right analysis and all you need. However as is pointed out below cost has an impact on conversion rates and CAC. Other things to consider are 1) in a digital world you may have zero incremental cost and 2) the ability to offer multiple products/services or tiers for people in different value brackets. 

    The analysis also depends on your potential market size and your COGS. But one point is very clear which is to have a business model that when successful will enable you to have a sustainable, kick-ass product. If you set the price too low so that this doesn’t work out then all your hard work goes down the drain. So thinking through this and understanding the variables will definitely help.

  • Foljs

    Why the BS assumption that you get new customers by Ads?

    If customers are not coming to you by word of mouth/blog posts/searching for you, you dont ave much of a business.

    I dont use the SaaS I use because I saw it in some ad.

    • http://twitter.com/jwmares Justin Mares

      You != every customer.

      • http://www.yanado.com/ Ivan Mojsilovic

        Some people never get it :)

        Your post is true. We did the same. We had quite low prices and some number of customers. We saw that we get customers not because of the price, but because of the service (product, support etc).So we raised the prices. We get same number (new ones) of customers as with much lower ones. Revenue went up. 

        Now we improved the product, change the pricing model (charge even more) we get even more customers. Have no idea why this is happening, but I’m glad it does :)

    • http://twitter.com/robwalling Rob Walling

      I’ve sold apps based on worth of mouth and apps based on scalable approaches  (organic search, paid acquisition, content marketing, etc…). Unless a viral component is built in to your app and is needed to use the app, growing by word of mouth is painfully slow and extremely difficult to control. If that word of mouth goes away or slows down you are hosed because you are not the one driving the boat.

      I came to basically the same conclusion as Justin in this short post from June of 2011: http://www.softwarebyrob.com/2011/06/27/you-cant-make-money-charging-1-per-month/

      • http://twitter.com/jwmares Justin Mares

        Totally agree, and great post Rob. Thanks for stopping by!

  • http://ceejayoz.com/ ceejayoz

    So, to get rich, all I have to do is charge $1,000,000/month and I’ll be set for life.

    You may wish to reexamine the assumption that raising price won’t affect conversion.

    • http://twitter.com/jwmares Justin Mares

      Yep, you completely missed the point.

  • Vincent Ammirato

    I’ve been early in on a few startup products that started at $x/month (x = ridiculously small price) and watched their price go up with popularity driven demand.

    The good ones grandfathered me in on the original price and I still sing their praises and promote them.

    • http://twitter.com/jwmares Justin Mares

      GREAT point. Grandfathering is an entirely different issue, and something that appears to be very effective to make more money without losing old customers.

      Thanks for the contribution! 

      • Vincent Ammirato

        You are welcome. Glad you did not see the contribution as nitpicking.

        I could see a real business starting with $5/month for life plan…for the first x months/customers.Grandfathering (and announcing your plans to do so in advance) is a more honest way to build urgency than most marketing tactics.A nice twist would give me the power to grandfather a few people as well. I already feel special because I’ve been using your service since beta and now its huge. I feel doubly special because I’m getting it at a killer price. Give me a chance to humblebrag about it to a few, choice friends once or twice a year (randomly) by letting me get them that great price, too.

        • Anonymous

          Yep, another great point. Information marketers do this all the time with their courses and such.

    • iambateman

      This is somewhat equivalent to “20% discount for the first 30 days” yea?

  • https://www.xocashflow.com/ Josh from xocashflow

    Hi Justin,

    This is a great analysis. Mind you, some smaller apps need to be priced more competitively in order to not deter customers; particularly if they’re add-ons for other subscription-based systems.

    The xocashflow add-on that my company created to help Xero users chase up overdue debtors is growing at a more rapid clip being priced at $10/month than what it would if it was priced at three times that. One of our chief competitors is priced at $27/month and although they offer a great product, several Xero users have complained that add-ons priced almost as expensively as a core product make the whole suite too expensive, which I can understand.

    In any case, we’re a real business proudly offering a $10 app, so it is possible to make low pricing work. After all, Google’s doing pretty well offering Google Apps for $5/month.

    Kind regards,
    Josh – Team XO

    • Anonymous

      Thanks Josh, great point. Two points I’d make:

      1. As a marketplace add-on, you have a CAC that’s far closer to zero than most companies. Most companies find you through the Xero marketplace and then do a straight features/cost comparison against other addons. You don’t have to do as much content marketing/advertising to drive customers because you can pull them in from a marketplace. Definitely a valid way to acquire customers, but it’s a different ballgame than most SaaS apps as I’m sure you’d agree.

      2. Google is definitely doing well offering Apps for $5/month. But, it’s not even close to their main source of income. I have no idea what they’re making there, but when you’re pulling in $100m/day from Adwords, it gives you flexibility with your pricing. If you have another line of business pulling in millions, ignore everything I say :)

      Either way, great comment and glad to hear things are going well!

  • polk

    On chart no. 1, I love the “Left vertical axis title”

  • Gerwin