Sitting in the SaaS trenches is not an activity for the faint of heart. While monthly recurring revenue (MRR) can weave a tale of success beyond belief with the multiple to boot, you’re more likely to suffer under the almighty relentless weight known as Customer Acquistion Costs (CAC).
After sitting in over 150 SaaS board rooms at this point, more often than not executives look at this predicament and face the need for acquisition with, “let’s spend and discount our way out of the hole and solve revenue and lifetime value (LTV)....eventually.”
This is like saying we’re going to solve the Israeli/Palestinian conflict with some streamers and a pizza party; or we’re going to make our steam engine go faster by putting jet fuel in our water hopper. It just doesn’t work, and we have the data that proves this out. Discounts are the laziest path to a customer conversion and have serious ramifications for your SaaS unit economics over the long term - to the point of reducing SaaS LTV by over 30%.
To illustrate this, let’s go through the data (so we don't bury the lead :)), before discussing why discounts don't work effectively in SaaS and how you should use them if necessary.
SaaS Discounts: Short Term Gain; Long Term Failure
We recently launched ProfitWell (free SaaS metrics for Stripe), and started to notice some common themes with a number of companies’ MRR growth curves and how they tracked against their quarterly goals.
While the in-app graphs are much prettier than the excel one below, you’ll notice that the first group tracked fairly closely to that quarter’s particular goal throughout the quarter, while the second lagged behind until the last couple of weeks of the quarter.
(Our minimal group was comprised of 55 companies and our aggressive, 33 companies. We also reduced change due to day of the week)
Being SaaS super sleuths, we started to investigate why the second group acted in this manner, and discovered that while there are a plethora of different variables and factors influencing a company’s growth, that second group utilized discounts heavily with their sales and marketing teams to hit their numbers.
Taking a step back, this should all be ok, right? Isn’t hitting your number the ultimate goal? Well, not exactly.
If we dig deeper into the metrics, we started to discover that these customers who came in through discounts had: 1. A lower willingness to pay and higher price sensitivity, 2. Churned at a much higher rate than the core group, and 3. Had dramatically lower lifetime value than the core group. As you can see in the table below, the average difference in lifetime value was upwards of 32.41% less.
To put this in perspective with your business, essentially those discounts are completely short-term gain that will very quickly diminish over time. Yet, why is this so bad? Department and grocery stores win out all the time with discounts – shouldn’t that work in SaaS, too? Well, let’s go even further to see why this is happening.
Discounts Don't Kill LTV; People Do
Discounting strategy in and of itself isn’t a bad practice. As human beings we’ve been trained with hundreds of years of retail pricing training to react pleasantly to a deal that makes us feel special or like we’re beating the system. In fact, in some industries it’s the only way to win, especially when battling for soccer mom and dad’s attention at the supermarket or department store. We saw this clearly when former Apple head of retail Ron Johnson took over as CEO of J.C. Penney and eliminated discounts for more premium (and confusing) pricing.
His move failed miserably though (costing him his job), because he flew in the face of retail price conditioning, losing out to other stores’ weekly circulars. More plainly - he just didn’t understand his customer.
This is where the rubber starts to burn up on the road for SaaS companies, because these practices don’t transfer well. The reason retail discounting works so well for customer acquisition and the bottom line is that a department store or supermarket isn’t looking for a recurring purchase. They’re looking to get you through the door to pull the purchase trigger as quickly and efficiently as possible. Granted, they want you to keep coming back for your one-time purchases, but every time a purchase is complete and consumed the process begins again.
SaaS differs in the fact that your customer acquisition happens once (hopefully). You’re not consistently battling every last week of the month to keep your brand top of mind to your customer for another conversion. Instead, you’re simply battling to retain that customer and potentially expand the amount of revenue they’re giving you. They’ve already been actualized.
Your Time to Recover CAC Will Outweigh Any Additional Signups
A fair reaction here is that this shouldn’t be a problem, because in either situation you’re still acquiring a customer, right? Can’t you can always fix your unit economics later? Well, this is where the scary implications of discounting in SaaS start to come into play, particularly with needlessly killing your SaaS momentum and training both your customers and your team to devalue your product.
As alluded to above, CAC is a scary beast when dealing with SaaS products. Unlike a retail product you’re not covering 100% of your costs upon purchase, which means your time to recover CAC and get into profitability increases substantially. Let’s look at the impact of simply providing a 20% (super common) discount on a $500/m customer that costs $6000 to acquire.
In this scenario, you’re recovering your CAC 3 full months in advance without the discount than with. Yet, this assumes 0% churn, right? In reality your churn for these types of customers is much higher typically (as shown above), because they aren’t coming in to use your product for the right reasons and at the right value. This means you’re not even going to get to the point where you can likely recover your CAC, no matter the increased volume you may get from a discount.
As a results, you may lower your CAC slightly by getting better signup velocity through the discount, but for a lot of these customers you’ll never recover those costs anyway. This causes a scary implication for your cashflow (heavily influenced by your time to recover CAC), especially if you’re a cash strapped company on the funding train.
What’s sometimes worse for larger companies with more established brands is that you start to train the market that your product isn’t worth what you think it’s worth in terms of your price. I know at face value that can sound silly, but when’s the last time you saw Tiffany’s put a giant banner on their website announcing the entire site was 20% off? You haven’t.
Internally, the ramifications can be even worse, because malleable discounting enforcement allow sales team to use discounts as the path of least resistance to closing a sale. The lack of value selling diminishes the culture of profit, and will end up biting you in your balance sheet over time.
When Should You Discount?
Never. Well – that’s not necessarily true. Discounts do work as promotions and deals during certain times and for certain situations, but you need to make sure they follow a couple of simple rules:
1. Discounts need to be discrete: Never put a giant banner on the front page of your website announcing just how low your prices can go. This only works for retail environments. Plus, this aggravates the hell out of customers paying full price.
2. Discounts should be segmented: You shouldn’t be announcing to your entire base that you’re giving a promotion or discount, because you’re likely missing opportunities for those individuals who would gladly pay full price. Instead, make sure you’re figuring out which type of customers need deals to get them across the goal line, and only target them with particular discounts.
3. Discounts should be time boxed: If you ever find yourself giving lifetime discounts, then you should likely just lower your price. The purpose of a discount should be to lower the activation energy required for someone to convert, but your product should then stand on it’s own and justify the full value of the price. As such, discounts and promotions should be limited in scope and time to ensure you don’t get into a hefty CAC problem.
At the end of the day, discounts can be an exceptionally powerful tool in your sales arsenal, but you need to remember that discounts are a scalpel, not a sledgehammer. Use them wisely and in a targeted manner and they can do wonders, but you should always be looking for a way to make sure you’re justifying your value properly and selling on that value.
How can you acquire new customers without resorting to discounts?
Instead of taking the easy (and typically painful route) of discounting, use the following strategies to acquire customers that will pay for the value of your product and have high lifetime values.
- Create an entry-level tier
Your revenue model should be based upon a value metric, meaning that as your user utilizes your product more (bandwidth, installs, contacts, etc.) they should be charged more. An entry-level tier allows you to drive users into your main product while capturing users with a lower willingness to pay. This gives you an opportunity to entice them at a lower service level until they are ready to convert to a higher and more ideal tier for your company's bottom line.
The biggest benefit of pricing tiers is that it allows you to target many different segments of the market. By offering a piece of your product's core value scaled down to a lower price, you get to cater to more price-sensitive users without undervaluing your product.
Note: An entry-level tier does not necessarily mean a freemium model, which is an acquisition strategy and not a revenue model. Read a deeper analysis of freemium models here to learn about strategic implementation.
- Add value instead of providing negative discounts
Even though people love discounts, it doesn't mean that you should cut your prices. On the contrary, adding more features, units, seats or services can feel like a better value without losing that original price point. Psychologists have proven that people would rather receive 2 for 1 as a promotion, than 50% off. So considering adding more features and benefits to bring in new users.
- Improve your marketing segmentation
Understanding the trigger features and value propositions that are important to your customer is crucial in how you sell to them. Value among different market segments, company sizes, locations, etc can get very specific, which is why you should optimize your pricing strategy to provide value at these different levels. It is a big undertaking to revamp your entire pricing strategy to include marketing segmentation, especially if your users are conditioned to respond to discounts. So start incrementally, by offering packages that meet company specific company size. For example, a start-up package for up to 20 seats and an enterprise package for up to 2,000 seats.
- Encourage annual subscription plans
The economics of annual subscription plans demonstrate that SaaS companies can offer an annual plan at a lower price than the total sum of 12 monthly rates—and still benefit greatly from the contract. If only 10% of your users switch to an annual plan, then you can increase your cash flow and become profitable immediately. Annual plans also greatly improve retention rates.
The economics of discounts are not always black and white. The complicated nature of discounting has been around since the start of commerce, and where the SaaS world is concerned, discounting can have drastically negative effects on your product or service's value.
The foundation of your SaaS lies in the product's value—both perceived and paid for. Don't jump to discounts for the quick wins, because they don't pay in the long-term. Analyze your best and ideal customers, monetize them correctly, and build loyal customers that retain and grow with your company.