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.

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.

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.

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.

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.

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.

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).