Pricing Power: How Small Changes Can Have Big Impacts

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Inertia is defined as something that remains at rest or in uniform motion unless acted upon by some external force.

Though software companies can fall prey to inertia in a multitude of ways, one of the most common ways in which inertia manifests is with respect to pricing. Specifically, once companies establish their prices, they often don’t revisit them, or at least don’t revisit them regularly enough. Even when they do, many companies remain deeply fearful of changing (specifically, increasing) the prices charged to existing customers, usually for fear of impacting customer attrition rates.

However, as I will argue below, in certain circumstances raising the prices charged to existing customers is one of the fastest, most effective, and “lowest friction” ways to unlock a nascent revenue and profitability opportunity that may lie within the base of customers that you already possess.

Pricing software is notoriously difficult, and tends to include aspects of both art and science. Any decision related to increasing prices should be thought through with careful deliberation and analysis. The result of that analysis could be a decision to raise prices regularly and/or significantly (as it was in my own specific case), however in other cases the decision could be to do just the opposite (keep prices flat and/or provide discounts upon renewal).

Regardless of where your company falls on this spectrum, what’s most important is that your pricing decisions are the result of thoughtful analysis, not simply a result of inertia. If you haven’t revisited your pricing in 1-2+ years, then there’s at least a possibility that incremental revenue and profitability are being left on the table.

Why is it Important to Contemplate Price Increases?

Among other reasons:

1. The Long-Term Impacts of Compounding: Albert Einstein famously said that “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”. Though we’re not talking about interest per se, small but regular price increases have the potential to exhibit an identical exponential effect to that of compounding interest over time. Though any given price increase in any given year can be small, over time the accumulated effect of compounding can be profound. This is particularly true if your average customer lifetime is considerable (say, 10 or more years), which isn’t uncommon in the enterprise software space.

2. Revenue and Profitability Implications: Growing revenue is hard. Growing profitability is even harder. To increase either, there are a countless number of levers that any CEO can pull, all of which will have varying degrees of impact. Increasing prices is one such lever, however it is somewhat unique for two primary reasons: First, its impact is felt extremely quickly: A $2/user/month price increase generates incremental revenue for the company much quicker than, say, a new product release ever could (all other things being held constant). Second, under the right circumstances, price increases tend to fall straight to the bottom line: That same $2/user/month revenue uplift also becomes a $2/user/month profitability uplift. Both points of course assume that your price increases don’t create any incremental customer attrition, which may or may not be a realistic assumption for you. Naturally, one would choose to increase prices only if they’re confident that the incremental profitability gained from price increases will exceed the incremental profitability lost via customer attrition over their average customer lifetime. To understand where your company lies on this risk spectrum, you must better understand the degree of pricing power that you possess in relation to your customers. More on this to come.

3. The Very Nature of Pricing Software : As mentioned, pricing software contains aspects of both art and science. It goes without saying that regardless of how a company arrives at its prices, they must make sense in the context of the company’s competitive environment, growth strategy, broader economic model, their customers’ willingness & ability to pay, and countless other considerations. With that said however, even if your prices make sense in the context of these considerations, there’s likely a degree of subjectivity that you used in arriving at your prices. If you currently charge, say, $20/user/month, why not $21? Why not $19? Even companies who use highly quantitative methods to arrive at their prices are still likely doing so on the basis of various assumptions, and ignoring the fact that not everything in the realm of software pricing can be done through a purely analytical and quantitative lens (though of course this lens is an important one).

I learned this lesson first-hand when my VP of Sales ran an experiment to test his thesis that we were underpricing our software, despite the fact that our prices made perfect sense in relation to all of the considerations above. For one month, he simply increased our prices by 20% across the board for all new licenses purchased (“better to ask for forgiveness than permission“, he said to me). We noticed no negative impact on our win/loss rate or customer acquisition numbers (or any of our key metrics, for that matter) and no discernable reaction from customers and prospects when reviewing sales calls. So we made the one month experiment into a two month experiment. After we noticed the same lack of impact in month two, we simply kept our prices at these higher rates, and enjoyed the effects of the costless revenue that we were adding to our income statement.

But we shouldn’t have stopped there. We chose a 20% increase somewhat arbitrarily, so why not 25%? Why not 30%? Of course, at some point, our price increases would be too high relative to the willingness and ability to pay of our prospects, but they key insight was that we didn’t understand exactly what that willingness and ability to pay truly was. We had simply grown to become comfortable with our existing prices, which is a dangerous place to be.

Value Created vs. Value Captured

Naturally, the more value that your software creates for customers, the more able you are as a vendor to capture some of that value via the prices that you charge. With software you’re not selling a physical item, so a “cost plus” pricing strategy doesn’t work, as you should essentially be aiming to sell your next unit of software at as close to a zero marginal cost as possible. Instead, software companies would be wise to better understand just how much value they create for their customers so that they can follow (either conceptually or explicitly) a “Value Created vs. Value Captured” pricing method: In the (highly simplified) example below, consider a software company who charges $40/year for a product that creates roughly $100/year of tangible value for their customers. Of that $100/year of value, the vendor captures $40/year via pricing, leaving the customer with a net-gain of $60/year ($100/year of value minus $40/year of cost).

Naturally, customers won’t buy any software product unless they have a sufficiently high net gain. But in this example, does the net gain have to be $60/year in order to induce an initial purchase decision (or a renewal decision)? Would they still be willing to pay if their net gain was, say, $55/year? Software companies must realize that the amount of the customer’s net gain may also represent a nascent pricing opportunity for them, assuming that they have sufficient pricing power in the customer-vendor relationship. Moreover, under certain circumstances, a $5 reduction in net value may not be particularly meaningful for any one customer, but a $5 increase in value captured (multiplied by hundreds or thousands of customers) can have a profoundly positive impact to the vendor.

Understanding Pricing Power

The revenue and profitability opportunity within your own customer base could be substantial, but the size of your opportunity is likely directly proportionate to the degree of pricing power that you possess within the vendor-customer relationship. The more pricing power you possess, the greater your opportunity to successfully pass-through price increases (without undue negative consequences), and vice versa.

Below are a few variables that would be suggestive of pricing power, though this list isn’t exhaustive. The more of these that apply to you, the better:

1. Per the example above, customers enjoy a sufficiently large net-value-gain to be suggestive of a pricing opportunity in the first place

2. Historical gross customer attrition rates have been low (less than roughly 5%-7% annually). Though low attrition rates don’t create pricing power, they tend to be suggestive of it. If your historical data suggests that your product is “sticky”, it is likely so for a reason. The stickier your product, the greater your pricing opportunity

3. The majority of your customers use your product very frequently (daily or weekly); AND/OR
   • The majority of your customers use your product as a key part of (or in close conjunction with) another “system of record” (eg: an ERP or Accounting system), and that system is used very frequently (daily or weekly)

4. Your product has high switching costs: It would either be very time consuming and/or very expensive for a customer to seek out another vendor (or build your product themselves)

5. Your product is mission critical for most of your customers, and any outage or disruption to your product would cause them material financial or operational harm

6. The cost of your product represents a small percentage of your customer’s total operating expense profile (the combination of points #5 and #6 would suggest that your product demonstrates an outsized importance relative to its price)

7. Customers have historically enjoyed new features, functions and/or versions without any incremental increase to their pricing

8. Increasing prices would still keep your prices roughly in line with your immediate ecosystem of competitors

Bad Reasons to Justify a Price Increase

Be careful not to use your own internal, company-specific reasons for justifying a price increase to your customers. Valid concerns don’t always represent valid reasons to pass through price increases. Two such examples are provided below:

• “Our Margins are Low, and a Price Increase Would Help to Increase Them”: Though consistently low margins could in theory be suggestive of underpricing, it could also be suggestive of many other things, including (heaven forbid) a structurally unattractive industry where margins are falling across the board due to increasing competition and the resultant commoditization of the product in question. Consequently, if you have low margins and you’re considering price increases to be a panacea, you must first be brutally honest with yourself about why your margins are low. Depending on your answer, price increases can either make your situation better or far worse.

• “Our Own Costs of Production Have Increased, So We Need to Raise our Prices to Reflect That”: Though matching your increasing cost profile with an increasing revenue profile has the potential to be a happy consequence of a price increase, it shouldn’t be the reason to do it in and of itself. This is primarily because your customers don’t (and shouldn’t) care about the internal operations of your business, including what it costs you to serve them – if your costs are going up, that’s your problem. If you have pricing power however, matching your increased costs with a commensurate increase to revenue (via pricing) can be a very valuable luxury to have.

My Own Experience Raising Prices

In my own company, we were fortunate to enjoy a high degree of pricing power for all of the reasons listed above and more. This became slightly less true as time passed (as our immediate competitive set grew meaningfully over time), but the pricing opportunity was highly compelling nonetheless. In my case, my company had been operating for approximately 20 years prior to my arrival, and, to my knowledge, had never passed through any price increases to existing customers.

When I first suggested that we raise prices, several of our employees thought the sky would fall: Customers would leave! Revenue would drop! We’d be serving up opportunities to our competitors on a platter! Perhaps I listened a bit too closely to this chatter, as I went from highly confident to slightly terrified, though we ended up passing through the price increases nonetheless. It’s important to note here that we didn’t do this in a cavalier way – it was the result of careful, thoughtful, and deliberate analysis over the course of several weeks.

To my surprise (at the time), we received almost no pushback from any of our customers. Though we sold our software into a low margin industry (which, all else being equal, would make them more price sensitive to any increase in operating expenses), our degree of pricing power was sufficiently high such that we didn’t see any incremental increase in attrition, nor any impacts to customer satisfaction. As a result, substantially all of our price increases fell to our bottom line.

It’s important to note that this wasn’t a one-time decision. As is now common practice, we started to raise prices every year, for every customer, upon renewal. Each year, those price increases compounded on top of the increases made in previous years, and each year that revenue fell largely to our bottom line.

Though this sounds like a largely happy story, I still have two major regrets: First, the initial price increase that I passed through after acquiring the company should have been bigger than it was. At the time, we objectively had an extraordinary amount of pricing power, but I allowed my nerves, uncertainty, and lack of CEO experience push me down a more conservative path. Second, I wish I had started sooner. Among the countless things on my To Do list in those first few years, I failed to realize that with the pricing power that we possessed, price increases represented a relatively fast and low-friction way to achieve (at least in part) the revenue and profitability growth that I was seeking. Sometimes, the quickest and simplest levers to pull can be among the most effective.

In Sum

Perhaps your company is sitting on a compelling pricing opportunity. Perhaps it isn’t. What’s important though is that you perform a careful and thoughtful analysis of your potential pricing opportunity, and make a deliberate decision on the basis of that analysis. Don’t keep doing what’s always been done, just because it’s always been done that way!