As another eventful year draws to a close, it’s not just the festive season that awaits us. With global inflation soaring, it feels like a waiting game, counting down the moments until the impending recession hits. Some argue it already has. And along with the looming recession comes some tough decisions for business owners. They’ll have to decide if—and how much—they should raise prices in the coming year.
But inflation is nothing new, and while some big names in SaaS (like Slack or Salesforce) increased their prices this year, many didn’t. So why might 2023 be the time to change? Morad Elhafed, Forbes council member and general partner at Battery Ventures, points out that it’s been a long time coming—it just wasn’t always as obvious to us.
“Along with rising revenues, internal costs are growing. Even before the current inflation trend, prices rose steadily—but they were obscured by faster customer growth,” explains Elhafed.
That glorious growth can be attributed to the transition of organizations to a hybrid SaaS solution during the COVID era.
“If you look at 2014-2018, coming out of that great financial crisis, there was about 10%, 12% of the companies were in what we call a native cloud environment. Today, it’s closer to 35%.” says Robert Smith, Vista Equity Partners CEO and Founder.
But inflation was always inevitable post-pandemic. The situation was not helped by Russia’s invasion of Ukraine, which raised global prices across the energy, food, and transportation sectors. It continues to cause supply chain issues and chip shortages that affect hardware production, impacting the tech and IT industry.
Now, labor costs, talent shortages, and rising cloud storage costs are on the tip of everyone’s tongue. They’ve caused many SaaS companies to take a step back from adopting innovation; sustaining innovation will outperform disruptive or category creation in 2023.
Whereas traditional businesses pass costs onto customers using a cost-plus pricing model, this doesn’t work quite the same in SaaS. Value-based pricing tends to be the strategy of choice in subscription-based businesses. And because of SaaS long contract periods, if operating costs go up during the customer lifetime, it puts your profits at risk. This is why inflation has the highest impact on SaaS businesses using the freemium pricing model.
Let’s spare a thought for Amazon. While still the world’s largest online retailer, it also recently became the world’s first public company to lose a trillion dollars in market value as a result of multiple factors including inflation.
As usual, there’s no clear cut answer on how to remedy inflation and whether to raise prices or stick. What works for one business won’t necessarily work for another, but these are some common considerations that will help business leaders at the beginning stages of internal pricing strategy discussions.
Learning from past recessions
Typically, businesses deal with recessions or periods of high inflation by cutting costs. For SaaS businesses, that often means their labor force ends up (quite literally) in the firing line. True to form, many big players have executed their largest layoffs ever this year, with Twitter infamously reducing their employee count by half before hiring some back in a bizarre and chaotic twist.
A move like this may seem extreme, but software CEOs are well aware of the dangers of inflation. And it seems no one in the industry is immune from the effects. Even historically steadfast Microsoft has predicted a slowdown through at least the end of 2022—despite rolling out its own price increases of 15-20%.
Twilio took a similar approach to forecast and cut their annual revenue growth targets in half, citing macroeconomic forces. But COO Khozema Shipchandler remains positive, saying “we’re still growing really fast in spite of the economic headwinds that we’re facing, and I think as the economy recovers, we’ll be one of the first out.”
That being said, the SaaS industry as a whole isn’t showing much sign of slowing down. Gartner has forecast industry growth of 20.7% to a total of $591.8 billion in 2023, its vice president analyst declaring cloud computing as a “bastion of safety and innovation”. A comforting thought in these uncertain times.
Even during the Great Recession of 2009, SaaS didn’t much falter. In fact, some businesses actually thrived. Take EchoSign, for example. It had its best quarter in history! Though a closer look at the metrics does reveal some disturbance. SMB churn increased as businesses struggled to stay afloat. And while enterprise customers still renewed, upsells became harder. Those on a per-user pricing plan were reluctant to add more seats.
The fact remains, between 2008 and 2010 over 80% of SaaS companies actually grew. And other huge SaaS names, like Calendly and Slack, were just being born. Even when times were tight, various SaaS pricing models and pricing strategies allowed customers to become familiar with the products, albeit with restrictions:
- entry level (tiered pricing model),
- upper limits (usage-based pricing model),
- reduced features (feature-based pricing model), or
- limited seats (per-user pricing model).
Once they had the customer base, then all they needed to do was upsell—much cheaper and easier than attracting new customers.
“My career has been defined by recessions, I think a lot of people’s are. Recessions have always been hard, but they’re also formative moments to focus and ultimately improve,” sums up Cloudflare’s CEO Matthew Prince.
The case for raising prices with inflation
Upon first thought, a price hike in line with the current rate of inflation seems logical and reasonable. Potential disgruntled customers aside, there are benefits to be had. The additional revenue could help account for the increased cost of labour (driven by inflation and talent shortages) that’s expected to last well into 2023. It may be what your business needs to avoid brutal layoffs.
Then there’s the issue of value perception. If you don’t raise your SaaS pricing, people may assume your product is worth less—especially when your competitors are revamping their pricing packages.
If, like 54% of SaaStr readers, you intend to raise SaaS pricing in 2023, here are some more advantages you can expect.
Increased MRR and ACV
Monthly recurring revenue (MRR) and annual contract value (ACV) will go up—data points that will please your stakeholders. Rethinking your SaaS pricing strategy will also improve your net revenue retention (NRR). This key metric for boards is vital for protecting and growing revenue from existing customers.
Nathan Latka adds a spin on this. His advice for businesses going into 2023, also supportive of a SaaS pricing increase, is to “figure out how to get your [customer acquisition costs] CAC back instantly”. The Fouderpath founder said during a SaaStock interview, “Instant CAC payback period is way more important than a really strong LTV:CAC ratio.”
In recent years, SaaS profitability has taken a back seat to growth. With venture capital aplenty, businesses were more concerned with attracting an enormous user base first and monetizing later. We can clearly see this through the rise (and, now, fall) of the freemium pricing model. But as funding has become more scarce, businesses are looking for ways to generate revenue and turn a profit. Luckily, variable operating costs are usually fairly low in the world of SaaS. This means the simple act of raising prices could increase your profit margins.
Sam Blond, Partner at Founders Fund, explains more.
“In 2021 there was a lot of emphasis on top-line revenue growth, what percentage year-on-year was the business growing, and less emphasis on things like gross margins and quality of revenue,” he says. But instead, being hyper-focused on gross profit dollars can “manifest in driving behavior in the company such that you improve gross margins and ultimately improve the value of the business”.
That would be quite the achievement in the current climate, with tech valuations in stark decline at every turn.
David Sacks, co-founder of Craft Ventures, expands upon this. He says that the most important things in a downturn “are growth, burn, and margins”.
“The best way to prepare is to cut costs and extend your [cash] runway.” Basically, you have enough in the bank to avoid asking investors for more funding. It also minimizes the risk of having a down round that could damage your business’s valuation.
Harrison Rose, founder of GoodFit agrees. Talking at SaaStock 2022, he said “I’d be looking an awful lot at your cash runway. Make sure as much as possible you’ve got over 12 months.”
But it’s not just about doing what’s necessary, according to some SaaS leaders. The impending recession is an opportunity. Inaction might mean leaving money on the table.
“Properly setting prices is an untapped opportunity for SaaS providers to squeeze more value out of what they offer,” notes James Wood, Senior VP at Insight. “While this was also the case well before the current inflationary environment, now the opportunities are even greater—while the risks of not adapting your pricing are more severe.”
There may be risks, but there are also strong arguments for not raising prices with inflation.
The case against raising prices with inflation
In a recession, the price elasticity of demand goes down (how demand changes according to a change in price). This is often accompanied by an increase in cross-price elasticity (when a buyer is more likely to change supplier due to a price change). In this case, the preferred strategy is to keep prices steady and reinforce your value-based pricing model. Upsetting customers to make a quick buck isn’t worth it. Instead, double down and invest in long-term relationships.
You could put net revenue retention at risk
When you get notified of a price increase, what’s your knee-jerk reaction? Most of us instinctively look elsewhere. Even if we’re happy with a product or service, the change in cost acts as a catalyst. It’s an invitation to re-evaluate our business relationship, compare suppliers’ pricing tiers and pricing models, and see what else is out there.
Many customers will resolve to stay. But it’s likely that some will churn. The difference with SaaS is that it may take 2-3 years to see the churn in your data. Churn is a lagging indicator. This is especially true for enterprise clients because of the time it takes them to deploy software and use it sufficiently to evaluate its worth. So, you may not recognize the damage until it’s too late.
So, increasing SaaS pricing might uplift your business’s MRR and ACV, but it will likely be short-lived. It’s a temporary fix. It could be the quick boost you need to reach a monthly, quarterly, or annual target you’d otherwise miss. But more importantly, it doesn’t help with new customer growth.
The bottom line? Don’t use a price increase to mask other issues.
The long-term consequences could be serious. Presenting loyal customers with a shock price increase will almost definitely hurt your net promoter score (NPS). The knock-on effect means you’ll lose referrals, case studies, and other valuable second-order revenues.
This is one of the reasons Nivas Ravichandran, head of marketing at Spendflo, urges SaaS businesses to “not follow growth at all costs”. The true cost of upending your pricing strategy outweighs the immediate gains.
With that rather foreboding caution, it’s worth mentioning that there are also great benefits to sticking with your pricing strategy.
Jason Lemkin warns that any increase, no matter how small, will trigger customers to look at other vendors. So, use this to your advantage! Keep your prices low while competitors raise theirs. This allows you to beat them on price when their customers inevitably begin looking elsewhere.
Now’s your chance to show your customers, and potential customers, just how stable and trustworthy your brand is. Focus on cultivating long-term relationships with your buyers and customers. You may not increase MRR, but you can retain your existing customers with the option to upsell them when times are less tough in the future.
If you still want that sweet MRR bump, then instead of increasing SaaS pricing you could increase your service offering. Improve the customer experience, or add value in another area of your product. Release some new features. Using a value-based pricing model, you could make the cost increase optional and frame it as an upgrade or benefit.
Another way to get a competitive edge during an inflationary period is with a usage-based pricing model. This empowers your customers to scale back when they’re under pressure to do so, then scale up again when the economy recovers and they can be more liberal with their budget. Compare this with a flat rate pricing model scenario, where the same customer would likely churn.
Robert Naegle is vice president analyst at Gartner. He suggests CIOs critically evaluate the spending they request and optimize the assets they already have before looking at price increases. “What I think this time really represents is an opportunity for many IT organizations to fine-tune their operations and look more aggressively at, ‘Are we doing the right sort of things?'” Turn the mirror inward, first.
Having effective pricing discussions
For SaaS leaders to have effective discussions around whether or not a significant pricing raise will be effective for their business, they must consider some important things.
- Is the increase necessary: could you leverage AI or automation to save labor costs and optimize spending instead?
- How is inflation is affecting your customers’ customers?
- Is your customers’ willingness to pay (WTP) increasing or decreasing?
- How does their WTP compare to the differentiated value you provide them (and has it changed)?
- What do the segments look like when you split customers according to their behavior when faced with challenges such as price increases?
- Is their industry countercyclical, i.e. can it profit well during a recession, like the pharmaceutical or educational industries?
Armed with this information, you can open a discussion about smart pricing strategies during this period of inflation. You should also consult industry data and see what competitors are doing before designing a solid value-based pricing strategy. Having a plan ready to respond to both competitors’ and customers’ responses is essential.
Ultimately, how you act in 2023 will set up what you’re able to do in 2024. Pricing changes should therefore be reversible, so your business remains agile. They should not necessarily set new anchor prices. Changes to your SaaS pricing strategy also provide the chance to layer in a new growth model, from sales-led to product-led to community-led.
Whatever you decide, the key is that price increases should be targeted (per segment) and always justified.