Module 5: Making Money

Thus far we have covered everything you need to know about understanding your market and customer, developing a differentiated solution that puts you above your competitors, and how you might raise awareness for your brand new solution and get it out into the hands of your potential customers. If you were creating your solution as an employee of an existing company, this is usually enough. But if you are building a new venture, that is only half of the equation. You have to figure out how to make money and make your venture financially sustainable.

There are two things to think about where it comes to financial sustainability. First, you need to build revenue streams – this is how your customers will pay you. Second, you need to understand how to manage money and possibly raise money. This module is concerned with the first and we will cover the second in Module 6.

In this module, we will cover common ways that your economic buyers can pay for your products and services. We will discuss important concept of life time value (LTV) and customer acquisition cost (CAC) – and why a minimum ratio of 3:1 is necessary for your business to survive.

We will then discuss pricing strategy, and spend some time discussing value based pricing (the only kind of pricing strategy you should be using to set the price for your solution as a new venture). We will wrap up with a discussion on how to test your prices with customers.

Revenue models

A revenue model provides your venture with a framework to charge your economic buyers for your products or services. If you reflect on what you spent money on as a consumer in the past 6 months, you will immediately come up with a few common revenue models:

  • Transactional: When you go into the grocery store to buy a gallon of milk, you pay for the milk at the checkout counter. That is a transactional revenue model.
  • Subscription: When you pay your cell phone bill every month, you are paying a predetermined amount for access to the services offered by your cellular provider. That is a subscription revenue model.
  • Usage based: When you swipe your subway pass to take the subway, assuming you don’t have a monthly pass (which is a subscription model), the train fare is deducted each time you ride the subway. That is a usage based revenue model.

This is the economic buyer’s perspective. From the company’s perspective there are many more complexities. Read on to learn more.

The Masterclass staff has written a series of easy to understand articles to demystify revenue models. Following are handy links to these articles.

Click here for the Summary link to the Guide to Revenue Models

Click any of the following links to jump to the relevant sections.

Life-time value (LTV) and customer acquisition cost (CAC)

The revenue model gives you a framework to think about how you might charge your paying customers and how often. That’s a great start. The next three things you need to think about are the following:

  • How much money you will be able to make off of each customer that you acquire for the entire time they remain a paying cusotmer (the Customer Life Time Value, or LTV)
  • How much money you spent in marketing and sales to acquire that customer (the Customer Acquisition Cost, or CAC – also known as the Cost of Customer Acquisition, or COCA)
  • Whether or not you are tracking to make more money off of each acquired customer than what you have to spend to acquire them in the first place.

Read on to learn how to calculate LTV, CAC and more.

According to Hubspot:

"Life Time Value or LTV is an estimate of the average revenue that a customer will generate throughout their lifespan as a customer. This ‘worth’ of a customer can help determine many economic decisions for a company including marketing budget, resources, profitability and forecasting. It is a key metric in subscription based business models, along with MRR (Monthly Recurring Revenue)."

Read the Hubspot article that explains how to calculate the Customer Life Time Value.

Neil Patel has a great infographic that provides 3 alternative ways to calculate LTV.

In general, a high LTV is a good thing for your business. Some common ways to extend your customer's LTV are to charge a subscription fee and make sure the customer is so satisfied that they stay on your platform for years (for example, Spotify), or to sell a product and also consumables (for example, Nespresso coffee makers and Nespresso pods), or to sell more product to the same customer over time (for example, Apple iPhones).

A high LTV can be intentionally cultivated by working on your customer satisfaction. A satisfied customer will stay with you for longer periods of time, and will buy more products and services from you, and may even promote you to their friends.

Neil Patel has a great article about tactics to increase customer engagement to generate a higher customer LTV.

In a nutshell, the Customer Acquisition Cost (CAC) is everything your company spends to acquire a customer.  However you can almost never isolate all the cost that goes into acquiring any given customer. The way to calculate it, therefore, is to take all of your sales and marketing spending over a given period of time (e.g. 1 year), then count all the customers you have acquired during that period of time, and divide the former by the latter.

Precisely what is counted and not counted as a sales and marketing expense can get confusing and controversial. Some people account for only direct marketing spending e.g. advertising costs, promotion costs, tradeshow costs and the like. For a new venture, we recommend taking a more conservative approach and lumping everything marketing and sales into the total spend (including the salary you pay your marketing and sales folks, any travel and entertainment expenses incurred in trying to make sales, etc) and the like. This makes sure you are not being overly optimistic about how much you are spending to acquire each customer because it is utterly critical that you understand by gut whether your LTV and CAC are in balance.

Neil Patel has a great article on how to calculate CAC complete with examples.

In the very beginning of a new venture, having any paying customers at all, however expensively you acquire them, is great validation that you have problem solution fit and you have identified a target segment who is willing to pay. You should expect CAC to far exceed LTV in these early stages. However, to build a sustainable business, you need to make sure that you have cost effective ways to acquire your customer on a going basis. A common heuristic for a sustainable business is to have the LTV/CAC ratio to be at 3:1 or above in the long run.

David Skok, General Partner at Matrix Partners (a Boston area early stage Venture Capital firm), has a fantastic article that pulls it all together and explains why LTV / CAC needs to be 3:1 or better to support a viable business.

SaaS Deep Dive

While basic principles of revenue generation apply to all businesses, enterprise SaaS businesses are special. Since most of these businesses use a subscription revenue model, there are specific metrics and concepts you need to take into account. Some examples include:

  • The “ARR” or “MRR“. ARR stands for “Annual Recurring Revenue”. MRR stands for “Monthly Recurring Revenue”.
  • The “CAC payback period“. This is the elapsed time when the cumulative monthly payments made by a new customer finally exceeds the CAC for that customer. A CAC payback period of 12 months or less is good.
  • The “churn“. “Churn” is the percentage of your install base that you lose every year. A good monthly “churn” is 3-5%.

The definitive expert in SaaS business model is David Skok, a Boston VC at Matrix Partners. Read on to learn from David’s musings on SaaS businesses.

David Skok has a great article that explains all of the key SaaS metrics.

Read the article

 

Each year, David Skok partners with a research analyst to conduct an annual SaaS survey. They survey enterprise SaaS companies about all sorts of metrics and then they compile this invaluable and timely data into reports that can help you understand the current SaaS landscape.

Read the 2020 SaaS survey here.

Note that 2020 was a COVID year, and SaaS businesses were disrupted just like many other types of businesses. To get a sense of how the SaaS world works before the pandemic, check out the 2018 (part 1 and part 2) or 2019 (part 1) survey reports instead.

Pricing strategy

If the revenue model is the architecture of charging customers for your products or services, then pricing strategy is the thought process with which you actually pick a number to charge. First time entrepreneurs often err on underinvesting in this process – they often come up with a number that “feels right” and end up leaving a lot of money on the table – because entrepreneurs frequently undervalue what they bring to the table.

Pricing strategy is an art and a science. It is very much worth the investment to think through your options and be thoughtful about which strategy you will start with, which strategy you will use to boost adoption temporarily, and which strategies you will use for long term financial sustainability.

In this section, we will look at 12 pricing strategies and take a deeper look at SaaS businesses which have very specific pricing norms.

Intuit has a great article for small business owners on 12 pricing strategies. These include:

  • Pricing for market penetration: Price it low (sometimes at a loss) to capture the market. This is very dangerous for a new venture as you don't have the bank account to sustain this pricing long term.
  • Economy pricing: Charge a low price to capture cost-conscious customers. This is also tough for a new venture.
  • Premium pricing: Charge a high price because you are solving a problem nobody is solving. This is a great match for a new venture that has a differentiable solution.
  • Price skimming: Start high and take the price down slowly over time as copycat products emerge. This is a common tactic for consumer electronics - the Amazon Kindle did exactly this.
  • Psychological pricing: Instead of charging $200, charge $199. "Predictably Irrational" by Dan Ariely is a good read to explain this phenomenon.
  • Bundle pricing: Offer a lower price with multiple products than if the customer bought each product separately. This can be effective if done carefully to make sure you don't end up losing money by pricing everything too low.
  • Geographical pricing: Setting the price based on the region you are selling in and the norms for your product category. This is generally not a concern for new ventures as they are typically not at a scale to launch in more than one country at once.
  • Promotional pricing: This is typically part of a marketing campaign that can combine a discount with a limited time offer to drive action.
  • Value pricing: This is the best way to think about pricing. You are charging based on the perceived value of your solution. Luxury fashion items use this strategy (because surely it doesn't take tens of thousands of dollars to make a Hermes Burkin bag.)
  • Captive pricing: This is used by companies who sell a product that takes consumables that only they can make. Dollar shave club is an example.
  • Dynamic pricing: This is a strategy that varies the price based on supply and demand. Uber and Lyft are great examples of how this manifests.
  • Competitive pricing: This is a strategy where you set price based on what your competitors are doing. This is sometimes necessary when the competitors have trained your customers to think this solution is worth the price they charge. For a new venture it is much better to think creatively about another way to charge the customer so you are not boxed into the (sometimes poor) decision making from your competitors.

Read the full article

 

One common mistake first time entrepreneurs make is to price their products based on what it would take them to create and deliver the product or service. For example, if you make a cell phone case and it costs you $0.75 to make the case, you might think that selling it for $3 is a fabulous margin.

This is almost never the right way to think about pricing. Think about it: if your cell phone case protects your customer's phone against water and breakage, you are basically offering an insurance policy to prevent damage to their very valuable $700 phone. Why wouldn't you charge what the customer feels is the right amount? For cell phone cases, it seems that people are generally willing to pay $10 or so. In that case, charge $10 - you are not obligated to pass on your savings to the customer.

Pricing your product based on cost is known as "cost-plus pricing". We definitely do not recommend this method - you should calculate what it takes to produce your product and you do need to make sure there is at least enough headroom for you to make a profit, but the better way to set price is "value based pricing". In this method you develop an understanding of how much the customer values the product or service, then you set your price based on what you find.

Darshit Singh has a good article that demystifies the difference between these two approaches. Read on to learn more.

 

SaaS deserves a special mention for pricing strategy because there are industry norms and tactics that are very specific. Some examples include:

  • Free trial: Try the product free for 14 days then start paying a monthly fee. Almost every SaaS product offers this option.
  • Freemium: Have access to a basic level of functionality forever that is still valuable to a subset of customers. Pay a subscription for premium features. Airtable is a good example.
  • Flat fee versus usage based: Some enterprise SaaS solutions offer a flat fee per payment period, others charge by the amount you use each payment period. Companies can price each option in a way to drive conversion to one of the options.
  • Offer 3 options: Many companies offer 3 main options and drive people towards the middle option via the Goldilocks principle: the low end option is too bare bones, the high end option is too expensive, and the middle one is just right.
  • Mixing web-based fulfillment with inside sales: Some companies offer options for web-based fulfillment (where customers can pay right on the webpage) up to a certain price point, beyond which they offer an enterprise version and direct the customer to fill out a lead form to be contacted by a sales representative. This allows the company to do business in a low cost manner for lower value customers while reserving the sales team's time to work with big clients.

Neil Patel has a great article with real life examples on this topic. Click here to read the full article.

Testing pricing

Once you set the price for your product or service, you need to test it with your prospective customers to see how they feel about it. Of all the ways you can test pricing, asking them face to face is definitely not productive. This is because people will sometimes lie in order not to hurt your feelings. Online surveys are slightly better because they are anonymous. However, it does not produce a measurable behavior that indicates purchase intent so it is not entirely trustworthy

To get the most accurate result the best way to test pricing is to offer to sell your product at a price – and then capture prospective customers’ emails through a pre-order form (or better yet, if you can sell your solution and deliver a pilot, the best test is to actually complete the transaction and get the customer to pay you).

Read on to learn more about tactics to test purchase intent and pricing elasticity.

Monadic price testing refers to the technique in which you show a single product concept to the potential customer, name a specific price, then ask the customer this: "On a scale of 1-5, where 1 is very unlikely and 5 is very likely, how likely are you to buy this product at this price?"   The result will give you a sense of how receptive the customer feels about your product at the price you named.

This method is meant to show one customer one combination of the product concept and the price. Because the customer does not see more than one price at once, they are less likely to be biased. This is good. However, this method does not give you a good sense of how high you can go. A way to get a sense of that is to set up an experiment with a large cohort who are recruited from the same market segment, and show them the same concept with a price that is randomized between, say, 3 predetermined numbers. That would yield data about the pricing elasticity of your cohort.

Pricing Solutions has an article that explains this method in greater detail. Read on to learn more.

The sequential Monadic test is exactly what it sounds like - you are showing the same customer a series of Monadic tests where you show the same product concept with different price points. You can either start with a high price and keep showing them lower prices, or randomize the price they see.

The benefit of this method is that it theoretically gives you data about the ideal price point for each respondent. The reality is that the respondent catches on with the second number and it generally does not produce great data. If you decide to do the Monadic test, we suggest you just run the classic Monadic test at different price points in an A-B or multivariate style on a large cohort instead of the sequential Monadic due to these limitations.

Survey Monkey has an article that explains the mechanics of how to issue a Monadic and a sequential Monadic test.

There is another well established way to test pricing - the Van Westendorp pricing analysis. In this test, survey participants are asked four questions:

  1. At what price do you think the product/service is priced so low that it makes you question its quality?
  2. At what price do you think the product/service is a bargain?
  3. At what price do you think the product/service begins to seem expensive?
  4. At what price do you think the product/service is too expensive?

Respondents write in the numbers to each question and the results across respondents are plotted on a chart. Typically the charts for #2 (great value) and #3 (expensive) will intersect at some price, and #1 and #4 will also intersect close to that price. This price is supposed to be the optimal price for this product.

Forbes has a good article that explains how it works.

However, it is important to note that this is a controversial technique and many pricing experts do not recommend it. Some known problems are people lowballing the solution, some solutions not really having a "too cheap" floor and the like. MMR Strategy has an article that explores some of these points.

Conjoint analysis is a systematic way for you to test the value that your customer places on each feature in your product. Respondents are shown a sushi menu of features with price tags attached to them, and they will select features based on the price tags. As a technique, it is fairly advanced, however it has withstood the test of time and is generally more trustworthy than other survey techniques.

Qualtrics has an article that explains how this works.

No matter what survey technique you use to test pricing or purchase intent, you still will not get a good answer, because people answering surveys do not have skin in the game. The only real way to test pricing is to offer to sell (or pre-sell) the product at a given price. This can be done by setting up a landing page with the product concept, and a call to action that says "Sign me up for the wait list", "Preorder now", or "Buy now". The closer to "Buy now" the better the data. If the customer saw the product concept and the price you named, then clicked your call to action and gave you their email address and contact information (or even better - actually bought your product with a credit card), you have truly validated purchase intent because you have captured an observable behavior, and not what they say verbally or in an online survey.

You can even A/B test your pricing. Hubspot has an article that outlines the pitfalls and benefits of this technique.

Financial literacy 101

The first step is to acquire a baseline level of financial literacy.  You can and should eventually take a course in accounting or finance. For first time entrepreneurs, the bare minimum is to understand basic principles behind a Profit and Loss statement (P&L), also known as an Income Statement.

Schwab has a simple introductory article to explain what the three financial statements are:

  • Income statement or profit and loss statement (P&L)
  • Balance sheet
  • Cash flow statement

Read the full article

 

Quickbooks has a great article that demystifies the Profit and Loss statement.

  • Pricing for market penetration: Price it low (sometimes at a loss) to capture the market. This is very dangerous for a new venture as you don't have the bank account to sustain this pricing long term.
  • Economy pricing: Charge a low price to capture cost-conscious customers. This is also tough for a new venture.
  • Premium pricing: Charge a high price because you are solving a problem nobody is solving. This is a great match for a new venture that has a differentiable solution.
  • Price skimming: Start high and take the price down slowly over time as copycat products emerge. This is a common tactic for consumer electronics - the Amazon Kindle did exactly this.
  • Psychological pricing: Instead of charging $200, charge $199. "Predictably Irrational" by Dan Ariely is a good read to explain this phenomenon.
  • Bundle pricing: Offer a lower price with multiple products than if the customer bought each product separately. This can be effective if done carefully to make sure you don't end up losing money by pricing everything too low.
  • Geographical pricing: Setting the price based on the region you are selling in and the norms for your product category. This is generally not a concern for new ventures as they are typically not at a scale to launch in more than one country at once.
  • Promotional pricing: This is typically part of a marketing campaign that can combine a discount with a limited time offer to drive action.
  • Value pricing: This is the best way to think about pricing. You are charging based on the perceived value of your solution. Luxury fashion items use this strategy (because surely it doesn't take tens of thousands of dollars to make a Hermes Burkin bag.)
  • Captive pricing: This is used by companies who sell a product that takes consumables that only they can make. Dollar shave club is an example.
  • Dynamic pricing: This is a strategy that varies the price based on supply and demand. Uber and Lyft are great examples of how this manifests.
  • Competitive pricing: This is a strategy where you set price based on what your competitors are doing. This is sometimes necessary when the competitors have trained your customers to think this solution is worth the price they charge. For a new venture it is much better to think creatively about another way to charge the customer so you are not boxed into the (sometimes poor) decision making from your competitors.

Read the full article

 

Following are some example revenue models for typical tech companies (hardware and software).

REVENUE FORECAST EXAMPLES

Following are some example operation expenses models for typical tech companies (hardware and software).

HARDWARE SOFTWARE ENG OPS PLAN TEMPLATE

https://www.entrepreneurship.org/learning-paths/the-art-of-startup-finance

Unit & overall economics

For the first concept (revenue) it is important to understand the idea of “unit economics”. The “unit” is the construct with which you charge your paying customer for one unit of your solution according to your pricing architecture. Unit economics refers to the money you make per unit sold (at the Average Selling Price – ASP) and the money it costs your company to produce that unit (Cost of Goods Sold – COGS).

Freshbook has an article that explains Cost of Goods Sold (COGS) for traditional businesses selling tangible goods or services.

SaaS unit economics can get arbitrarily complex. For advanced entrepreneurs, read this Profitwell article on the full details surrounding SaaS.

Toptal has a good article explaining unit economics for traditional businesses selling widgets or other types of tangible goods.