In the only podcast dedicated to the ‘Subscription Economy’, hosts Tom Krackeler and Rachel English talk to innovators, entrepreneurs, and analysts about the business shift towards recurring revenue.
Our guest Tom Tunguz is a Partner at Redpoint Ventures. He also writes daily, data-driven blog posts about key questions facing startups including how to fundraise, startup benchmarks, management best practices and team building.
Rachel English: Congrats on your upcoming new book, ‘Winning with data’. What can we expect to read in there?
Tom Tunguz: It’s been a fun project to write with my co-author, Frank Bien, who’s the CEO of Looker. We were approached by Wiley, who’s the publisher late last year and we were able to write it in about three months. It will be out on June 20th.
The book has three big sections. The first is a history of the data world: how databases evolved, how major technology companies have added new flavors of databases into that ecosystem and what that means for businesses. The second section is a description of how the top companies in the world use data to create competitive differentiation. We talked to companies like Uber and ZenDesk about their internal processes about how to create sustainable competitive advantage. It’s really the dissemination of data within the organizations. There’s one example in there about how an e-commerce company uses data in the morning to influence their marketing campaigns in the afternoon. A lot of great stories. The third part of the book is about taking the best practices in the book and implementing it either for yourself, for your team or for your company. The goal is to share as many best practices as we found during our interviews.
Tom Krackeler: Companies are talking about new consumption and usage-based pricing models. You write about what it takes to have pricing power. Tell us a little bit about what we even mean by pricing power and how you go about applying it.
Tom Tunguz: Pricing power is when a company or product in the market basically can charge a fair price for its products. That’s because of two different things. The first is it creates a lot of value for its users and the second is it’s differentiated from other products in the market, so either substitute or new entrance. When you have a product that creates a lot of value and is differentiated from everyone else, it has control over its pricing. It can increase or decrease and the demand for the product should be within a certain bench and should be relatively elastic. It shouldn’t change.
When a company or a product or a startup has pricing power it means you really have product market fit because you’ve identified something that’s really useful for customers and they are willing to pay for it. It’s a great validator when you can establish that.
Rachel English: What are the big common pricing mistakes that you see companies make?
Tom Tunguz: There are lots of different ways to mess up your pricing but let’s just talk about three. The first one is a really complex or unintuitive model. A great manifestation of this is if you go to a website and there’s a list of 200 features across your three different pricing plans, and you’re asking the customer to try to figure out what are the pros and cons of each of the pricing plans.
The second is a pricing plan that’s unintuitive for the customer and unpredictable. For example, if Slack were to charge by the number of messages that people send, that’s completely unpredictable. In some instances it’s tied to value and usage but it’s just really hard to estimate and that’s just going to slow your sales cycle down.
The one question I always hear is what should our price be? How do you figure out the right price, right? That’s a really hard one to answer. The reason it’s hard is because the right price is always changing. One of the mistakes that I think start ups consistently make or founders can often make is they tend to ask the wrong questions to discover their price. The typical question you might hear is, “Hey. What are you willing to pay for this?” Even if you pose the question to your friend or you’re buying a candy bar, you’re negotiating against yourself and you know it.
One technique to get around this or at at least to get a little more insight is a relative pricing question. If you ask your customer, “What are you willing to pay for Hubspot relative to Salesforce?”.
Tom Krackeler: A lot of enterprise companies want to give their account executives the ability to construct a proposal that allows them to capture all the willingness to spend, and to say this is the baseline product, and add extra services. That seems to go against the complexity versus simplicity recommendation you make, but are there cases where if it’s an enterprise sale, the rules are very different than if it’s a self-service purchase?
Tom Tunguz: For sure. There are really big differences. You can cut the market into three big buckets. You could have the small and medium business where you’re really looking at self-service and the main method for getting someone to buy is through marketing of product or customer success/customer support rather than sales. The average value of a customer isn’t large enough to justify a lot of customization.
In the mid-market which is probably like 20k to 50k, maybe 100k ACVs, that’s where the inside sales model reigns. That’s where you have Sales Development Representatives and Account Executives and they are trying to close deals in 30 to 90 days. It’s pretty common to see things like land and expand. “Why don’t you start using this product in your department and then we’ll offer you an expansion 6 or 12 months down the road.
Then at the very highest level of the enterprise level, when you’re spending millions of dollars, the customers are buying bespoke software. It’s like a bespoke suit. The pricing models are not really models any more. It’s made to order and each quote is custom.
Tom Krackeler: You write a lot about measuring companies and you’ve said that “Not all revenue is created equal.” In the SaaS world, we often think that recurring revenue is more valuable than professional services revenue, etc. Is it just about high margin versus low margin revenue? What goes into how you think about valuing revenue when a company comes to talk to you or you’re coming to take a company to the next fundraising round or even going public?
Tom Tunguz: The first is margin and the gross margin. The median for a publicly traded size company is 71% gross margin but you have a huge variance. Sometimes you see companies at 90% gross margin and sometimes you see companies at around 40% gross margin.
Higher margin is better, it gives you much more money to spend on growth and research and development. You have your revenue and then in order to get you gross margin or your gross profit, you subtract out all the cost of goods sold (all the things that you pay for in order to deliver your software). Once you subtract those two, you get gross profit and underneath that, you have sales and marketing, research and development, and general and administrative. The bigger the margin you have, the more you can spend on sales and marketing and research and development. That’s a pretty important competitive advantage and that’s why higher gross margin businesses are valued at a higher level than lower gross margin businesses.
The second thing is there’s a notion of a quality of revenue. If I’m a $100million a year revenue business and I have this account expansion and I’m growing like 150% a year, and that revenue is recurring, then I basically have an annuity. I have almost a guarantee that this revenue is going to continue. That certainty is really highly valued as opposed to a company that either has transactional revenue or has high return revenue.
Listen to the podcast to learn more on Tom Tunguz’s thoughts on pricing strategies, churn, metrics to measure your SaaS business and lots more! And subscribe to the podcast – you can find us on iTunes, Stitcher and other apps!