Three approaches to value based pricing for SaaS: Approximate, Derived, Direct
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
A lot of people think they are applying value-based pricing (VBP). Not all are actually doing so. In many cases, people are attempting to estimate Willingness to Pay (WTP) and using this to set price levels. This is not Value-Based Pricing; if your consultant or software partner claims it is, head the other direction.
Actual value-based pricing begins with an economic value model, most often the Economic Value Estimation or EVE model developed by Tom Nagle and his co-authors in the foundational book The Strategy and Tactics of Pricing, now in its 7th edition.
An EVE model looks like this:
Formally, it is a system of equations defining how a solution can improve a customer’s profit and loss statement. In some cases, in asset-heavy industries like mining or property management, one can extend this to the impact on the balance sheet. In the current environment, we sometimes look at the impact of pricing on cashflow as well.
Like any equation, a value driver has a structure (a mathematical form), constants, and variables. The variables are dependent on the customer and can change over time. Implementing a solution will in fact change the value of the variables so that there is a ‘before’ and ‘after’ state. This change is not always instant, so value can evolve over time.
Critical questions when designing pricing are to test
How value changes across different ranges for each variable
If there are any interactions or correlations (positive and negative) between value drivers
Which variables account for the biggest change in value
Ibbaka Valio has been developed to help answer these questions.
Once one understands how value is created and who it is created for one is in a position to design value-based pricing. There are three basic approaches.
Design pricing that approximates value (the most common approach)
Derive pricing directly from the value model
Implement a process where the price is directly based on the value
Approximate VBP (Value-Based Pricing)
Value Driver Based
This is the most common approach to value-based pricing. In a sense, it is the lowest common denominator. It is used when one cannot find variables in the value drivers that can be used in the pricing model (the approach taken in derived VBP).
Basically, one looks for value-based market segments. These are groups of customers who get value in the same way and who buy in the same way. Then one designs a package for each segment.
In some cases, there is a large range of values for each segment. In this case, one often uses a tiered or Good Better Best (GBB) packaging architecture to match each package to a value range.
One then looks for one or two (sometimes three) pricing metrics that generate a price that approximates the value over as wide a range of use cases and users as possible.
To make this work, it is important to document actual value delivery and then adjust pricing over time.
This is sometimes confused with pricing based on Willingness to Pay (WTP). WTP-based pricing and VBP can sometimes overlap, but they are fundamentally different. Why? WTP is malleable and shaped in part by value perception, framing and anchoring effects, recent competitive moves, and overall economic conditions such as fear of inflation. It does not have a direct foundation on the value required for value-based pricing.
See Why value-based pricing means something.
Derived VBP (Value-Based Pricing)
Variable Based
This approach gives a good correlation of value and price and when well designed is fair to both parties. It is a compelling way to connect pricing to value, supporting algorithmic and continuous improvement.
As with Approximate VBP, one begins with value-based market segmentation. In this case the analysis takes place at the level of variables rather than value drivers. One is looking for segments defined by having one, two, or three variables account for most of the difference in value, generally at least 70%.
One limits this to 1-3 variables as more than this leads to overly complex pricing models that are hard for buyers to understand and salespeople to explain. They are also hard to optimize and maintain over time.
In many ways, this is the most powerful approach to pricing. When it works, it is fair to buyer and seller, can be optimized over time using machine learning, and is easy to explain.
It works best when a small number of variables
track value
can be predicted in advance
can be tracked by the application
Direct VBP (Value-Based Pricing)
Process-based
Some have said this is more of a pricing process than a pricing model. Pricing is customized for each customer based on the following process.
Which value drivers are relevant for this customer?
What variables should be used for these value drivers?
How much confidence is there in the value claims?
Has the solution been delivered in a similar context?
How well is the customer’s situation understood?
Can the value delivered be tracked in the application?
How much of each value driver should be captured in price?
What is needed in the solution to deliver the value?
The price is then constructed from the selected value drivers, with the estimates for the variables, and a target value ratio for each value driver. This is a granular approach and requires open conversations between buyer and seller. It requires trust.
If one can apply this 5 step process and the contract is large enough to support the process, this is the best way to apply value-based pricing. It is a short step from here to the outcome or performance-based pricing goal.
When to apply each approach to value-based pricing
The decision on which approach to use turns on several considerations.
The growth motion
Product-led growth companies will generally rely on Approximate VBP
Relationship-led growth companies will generally use some form of Direct VBP
Sales-led growth companies can use any of these approaches and when possible should use Derived VBP
The Average Contract Value (ACV)
ACV < $10,000 use Approximate VBP as part of a PLG growth motion
ACC > $10,000 up to $100,000 can effectively use Approximate VBP or Derived VBP
ACV > $100,000 see if Direct VBP is possible, this will optimize long-term revenue and customer relationships
The structure of the value model
Variables in the value model are not suitable for use as pricing metrics (pricing variables), use Approximate VBP
A few variables in the value model account for most of the variation in value (perhaps after market segmentation), use Derived VBP
Different customers rely on different combinations of value drivers and the ACV > $100,000, use Direct VBP
This leaves a wide grey zone, where ACV < $100,000 and there is a profusion of value drivers with no one value driver contributing most of the value. This is often evidence of a lack of focus. In this case, choose a subset of the possible market, one where a coherent set of potential customers get value in the same way, buy in the same way, reference each other, and respond to one of the six standard go-to-market motions (Product-Led Growth, Sales-Led Growth, Partner-Led Growth, Relationship-Led Growth, Service-Led Growth, Community-Led Growth). Design a packaging model for these narrow segments; price using a minimum number of pricing metrics (no more than three).