As a software entrepreneur you are often faced with a dilemma on how to price your software, especially if you are creating things that a market is not already established. You always must juggle that pressure to ship “something” even if it’s not exactly what you envisioned, just to gather feedback from the market and customers so you can test your assumptions and refine. This is just part of the job but one thing I notice is the increasing number of companies that show up at conferences one or two years and then disappear and it got me thinking where have they all gone and why.
My company recently introduced a new product offering, but we spent several years behind the scenes with an early beta version collecting data on usage, scaling, desired features, price points, etc. before ever deciding to pull the trigger on the “official” product. Part of our research was analyzing all our costs involved not only to build and support the product, but also to sell it. We were fortunate enough to know these prices because we were selling another product into the same customer channels. I think the biggest mistake most companies make is to neglect the fact that sales has a cost too, and that must be built into pricing in order for your company to survive. I was reminded of this fact last year when the announcement of a service called MongoFax one day just shut its doors and affected many MLS customers nationwide who relied on their service as an agent tool and member benefit. Their reasoning was that they were unsuccessful in securing another investment round and could not fund ongoing operations. The question in my mind after hearing how disappointed all their customers were was that if they found such value in a product, why couldn’t the company afford to operate through revenues from sales of that product.
I began to evaluate my own company to make sure I wouldn’t or wasn’t making the same mistakes and what occurred to me is that MongoFax failed either to:
- calculate their own value proposition and price their products accordingly or very likely
- failed to consider all costs in providing that product or service
- aggressively discounting product just to win market share in hopes to later make it up with some premium service up-sell
The only issue with that approach is you must minimally cover your operating costs or have a very large amount of capital reserves to float the up-sell timespan because you need at least a year just to refine your up-sell process and assess your customer acquisition cost, calculate churn, etc. Thereafter you need another large capital infusion to scale that process you refined until you reach the profitable side. I can only speculate on what happened to them but I can look back at my own data and share tips for others to hopefully prevent this same tragedy.
Let’s begin with a few principle guidelines before diving into the details:
- Know your customer’s needs and the problem you solve.
- Know your value proposition (typically save money or make more money, but there are others).
- Know your total addressable market (how much money available out there to go after).
- Know ALL your costs (fixed, variable operating, R&D, support, cost of sales).
- Know your target customer and who you’re selling to (sometimes not the same).
I could go on and on but these are enough to cover the point I want to make, and hopefully educate other entrepreneurs to build a very profitable business. I could spend a lot of time describing how my product solves identified problems, and my value proposition but those are for another article. Just trust that you better know these cold if you have any hope of convincing others to buy your product or service. That wasn’t MongoFax’s mistake and again I’m only speculating what happened there. The likely mistake is failing to price a product or service to build a profitable, sustainable business.
Total Addressable Market (TAM): Wikipedia defines this as the revenue opportunity available for a product or service. You should start here to determine if it makes business sense to even pursue the idea. In Real Estate, you could start with the industry TAM which I estimate approximately $90 billion/year. I look at the National Association of REALTOR’s report on new home starts per quarter and total existing homes sold per year and estimate about 9 million homes sold every year, give or take. I then look at the average price which lingers around $186,000. Multiply those together and that is sales volume but the TAM is the money that flows into agent and broker hands through commissions. You could assume 5% of this total is commission revenue and that is the TAM
Target Customer: Just because you identify someone you aim to sell your product or service to, they may not necessarily be your target customer. The person who will use your product or service on a regular basis and extracts the value from it is typically your target customer. Sometimes you deliver value to others as well, and they may be channel customer to ultimately let you reach your target customer. In our case, our target customer is real estate agents and although we sell services direct, we also sell via channels that are either resellers or real estate agent service providers like REALTOR(r) Associations or Multiple Listing Services (MLS). Knowing who your customer is, and also whether you’re selling to your customer or to a channel customer is key, because you must look at the TAM and determine what slice of that TAM does the person you are selling to represent. Only then do you know the true TAM.
MLS TAM: I just made that up, but say the TAM for real estate products/services is $90 billion per year. From there I have to carve away layers of the onion to determine specifically for my product or service what slice of pie could I actually get. If I choose to sell to MLS channel customer, I must know what they can spend. First I look at how much they bring in as a whole, which appears to be a shrinking number over the past ten years. Currently I estimate that if 1.4 million real estate professionals are paying an average of $30/month for MLS services that the total MLS market brings in about $500 million yearly. That is drastically smaller than $90 billion so the bulk of the industry money must be going elsewhere.
Of this $500 million yearly we then have to peel back what is available for your product or service. Assume that the MLS pays on average $5/user/mo just to license the MLS software from one of the many vendors. Also assume that even though $30/mo could be an average, there are some MLSs that only earn $17/member/mo or less, and others earning as high as $55/member/mo. I find this baffling that the core system and marketplace for an entire industry can only get paid $30/mo when I pay $269/mo just for 1 of 10 systems I use in my company (my helpdesk software). It is what it is, however, and something you have to deal with until MLSs identify their value proposition and sell their services (as a marketplace and tied to transaction volume) aligning to their customers and increase their total revenue.
The MLS then has to pay their staff and operations and perhaps half the remaining budget covers those expenses. I’m just guessing on that one but some may be willing to share or some might even be public knowledge if you search meeting minutes for non-profit, Association-owned, multiple listing services. For now we can speculate. What we have left if we say MLS systems TAM is $100 million, and half remaining is operating expenses, is a TAM of $200 million per year for all other services offered by an MLS. If Tax, Showing, Branded Websites or some others take up half that, it then shrinks to $100 million. Pretty soon they may only be able to purchase $100,000 worth of products annually each. Knowing this, if you plan on selling a product that is $5,000/month chances are they will not use up $60,000 year for a single product leaving only $40,000 yearly for any other services. It’s a harsh reality of selling into this channel so go in with your eyes open.
I spent a lot of time on these topics first because it’s critical you identify your target customer and channel customer and decide who to focus your precious sales dollars towards. If you dilute yourself you’ll run out of money so you better have laser-like focus and execute knowing what your potential earnings will be. Now we can focus on the fun part, pricing and cost analysis.
Know ALL Your Costs: Most companies compute their R&D, and/or support costs to come up with a price for their product. A big mistake is to not factor in the cost of sales, and this is what can bankrupt you in short order. Early on I spent a majority of my time selling products or services to MLSs, and my company exhibited and advertised at dozens of local and national conferences. I then grew my sales team with dedicated MLS sales and added advertising in trade publications. When selling products to MLS we knew they only had a small fraction of their budget remaining so if we wanted “in” we had to price within that TAM to even have a chance. Our justification for selling far below cost was we could up-sell a premium product and earn money from agents who have the larger piece of that $90 billion yearly pie and balance things out. What we didn’t know early on was both what it cost to sell to an MLS, and also thereafter what it cost to sell to an agent. Now we know them all, so our decision-making can be more than just early spreadsheet modeling.
MLS cost of sales is easy to calculate. It is often referred to as Customer Aquisition Cost, or CAC for short. Quite simply your CAC is the sum of all sales and marketing expenses to sell to them, divided by the number of sales achieved for any given period. For MLS I was paying one full salary, plus a portion of my salary and already over $100,000 yearly. Add in tradeshow, sponsorships, and travel and we had another $150,000. Add in staff and other expenses, and we were about $330,000 yearly in total expenses. Over our first 36-month MLS sales period (2008-2010) we connected over 42 MLS markets and secured 24 partner contracts. This is pretty phenomenal success that early in a very established industry. When you do the math, however, it is not as enticing.
- Yearly spend: $330,000
- Deals/year: 8
- Cost / deal: $41,250
- Term of contract: 24-months
- Cost / month: $1,719
Now the first year we only closed 2 MLS markets until we were more established and thereafter averaged 10 per year. Ignoring the first year (well someone has to pay for it), we could bring down CAC per MLS to $33,000 each deal just in cost of sales, and then on a 24-month contract you need to earn at least $1,375 per month just to get back your cost of sales. Not a single penny of this minimum amount goes towards your actual product or service, or your ongoing support and R&D costs.
Imagine if MongoFax invested similar and had a CEO and one dedicated sales rep to cover MLS sales nationwide, and purchased similar tradeshow booths and sponsorships. They sell their product to a decent-sized MLS with 2,000 members and that MLS offers them $0.50/member/mo. They may have done the deal thinking they are now earning $1000/mo recurring revenue for their product when in reality, they just signed a deal where they are already losing $375/month, and on top of it have to provide a product and service and ongoing R&D. It doesn’t take a math genius to figure out what happens next as you continue to sell more of these contracts.
Agent Cost of Sales: Some companies will do these aggressive deals at a loss for the opportunity to sell a premium version of their product to agents to make up for these losses. What I suspect occurs is once again they fail to calculate their cost of sales and dig themselves even deeper. Make no mistake, you will still have to sell every agent account regardless of channel so plan on investing in your own sales and marketing efforts. Early on I hired telesales staff and worked to refine scripts. We refined email campaigns and watched open and click-thru rates and kept moving the needle higher. It did seem, however, that we still needed personal interaction to close the deal although over the years we now gain more unsolicited online orders.
My sales staff manually dialed 100-140 people each day which I thought was great, and then I evaluated where they spent their time. Over 65% of the time they had an answering machine so 65% of my payroll was leaving voicemail messages. Of 140 calls, they contacted 30 people, and got 7 demos and every 3-4 days they closed a sale. One rep could close at most 10 sales in a month, and they cost $3,000/mo, so my cost just to sell an agent was $300/sale. My product was $20/mo. I would only earn $240 the first year and still be at a loss for 3 additional months before I recover my cost of sales and begin to earn revenue on my product, support and ongoing R&D.
To remedy this, I invested in an auto dialer system costing $150/agent/mo. Now they could make 400 calls per day, automate the voicemail part, reach 90 people daily, do 30 demos and close 1-2 sales. Agents then averaged 20-22 sales/month, bringing my CAC down to about $135. This means at $20/mo product after 7 months of service I pay for my cost of sales and begin earning revenue for the actual product, support, and ongoing R&D. If I wanted to scale sales of this product, I’d have to set aside enough cash to float realistically the first 10 months of every rep’s paychecks before expecting to break-even. You really want to recapture your investment per rep within 2-3 months. Either raise your prices, lower your wages, or roll the dice.
Accounting For Churn: Without long-term contracts, however, you have to calculate churn (cancelled customers) and how much you need to sell to maintain existing customer levels and continue to grow. There’s another term called Lifetime Value of Customer which is the average months you retain a subscriber multiplied by the revenue per month. There’s a saying in real estate “1/3 coming, 1/3 staying, 1/3 going” and it references the constant turnover of people getting into real estate and getting out of it. As such, it’s very possible even if your product is awesome, which mine are of course, that you could have upwards of 30% churn annually. This means you still have to sell enough to replenish lost customers and sell even more to grow.
If you do not constantly invest in selling new customers eventually that premium subscription revenue will dwindle and if you do not retain customers far beyond covering the cost of sales (7 months average in my example), then you don’t even begin to chip away at that loss in cost of sales for MLS. Thankfully for me, I had an established business already, plus some very patient investors (thanks again) so we had ample resources to collect these data points, adjust and adapt to make sure we don’t fall into those same traps. I do fear, however, that most companies forget to compute their cost of sales and never get out of the hole and there are many more MongoFax stories out there.
I will write another article soon taking what you learn here and educate you on how to take this information to compute your pricing for license agreements so you do not go out of business in software. Thanks for humoring me in my lengthy write-up. Know your numbers folks!
– Mike Sparr, CEO and Founder, Goomzee