One of the things I see on a remarkably frequent basis is startups that appear to be charging well below both the purported value of the offerings and what the market should be willing to pay. More importantly, it is well under the price required to sustain a viable business model, unless the company achieves massive scale and ridiculously low customer acquisition and service costs. Neither is likely for the average startup. And one thing I know for sure – it is far harder to walk a price up, than to walk it down!
It’s not difficult to discern why startups price low, and it usually comes down to lack of information, experience or courage. More specifically:
- The company doesn’t have good data on, or even an understanding of how valuable the offering is to the customer. The ROI for most software and tech related offerings is usually at least somewhat intangible. So, pricing it is somewhat of an art form, but starts with some sense of measurable baseline value.
- The product is creating a new market, and there isn’t an established market price, or it is so differentiated from previous offerings as to create effectively the same problem.
- Traditional market metrics (number of users, size of company, etc.) aren’t germane to the offering. The most appropriate or logical metrics don’t have a history of usage so no one is sure how to price against those metrics, or what it will look like when a company buys at scale.
There is a rather infamous story about how ASK, one of the first successful ERP suppliers, priced its products back in the early days of software. They used what became known as “the flinch test” pricing approach. When asked about price, they would say, “Its $100,000.” If the customer didn’t flinch or otherwise show negative body language, they would quickly add, “For the general ledger module. The Payables module is an additional $50,000.” The process would continue until the customer pushed back or started to appear uncomfortable. At that point they would concede the remaining modules for free.
According to Lindsay:
- 50% of the time salespeople under price versus what the market segment will bear;
- 30% of the time they price correctly; and
- 20% of the time they over-price (not good because these customers will defect, or you are getting lower then deserved volume which sub-optimizes overall margin).
I can attest from my time on the entrepreneurial/operating side, as well as what I see as an investor, that the numbers are far worse for startups. According to Lindsay, “There is no such thing as a pure commodity market in B2B, as many other terms and considerations surrounding the sale of the product or service influence the price. There is also no such thing as ‘one price’ for a given product or service, as most B2B transactions are highly negotiated. Differentiated pricing always exists.” The same is also true for many consumer products and services.
Ms. Duran says that one of the biggest keys to pricing correctly is perceived fairness, which is more complex than you might think. It includes:
- Buyer’s sense of value matches asked price;
- Price alignment with circumstances and use of product;
- Buyers charged a similar amount to others buying under the same circumstances;
- A systematic repeatable way to get a better deal;
- Transparency and perceived logic (i.e.: large, strategic customers get a better deal than infrequent smaller customers);
- Taking into account buying velocity, amount of spend per period and annually, lifetime value, number and accessibility of substitute offerings.
Ultimately, you want to make sure that the pricing allows the buyer and seller to “live to transact another day” – both feel like they got a fair deal and are willing to do business with each other again.
So how does a startup put out a market-aligned price? It all starts with data and confidence. Both can come from:
- Experience with beta and early commercial customers where there is a specific process in place to measure the efficacy and ROI of the solution;
- Prior industry experience around the cost drivers and/or revenue lift associated with the addressed business processes;
- Existing pricing models for offerings or substitutes, that the new product will supplant;
- Early thoughtful A/B testing of various pricing options, especially in more consumer-oriented high-volume markets.
There is also what I call the golden rule of pricing. While it is most germane to B2B transactions, it is still applicable in consumer scenarios. The golden rule is simple: perceived value (measurable benefits + discounted soft benefits) = 10x price. If the customer thinks that the economic or financial gains from using your offering will deliver 10x its cost, they convert at a high rate. The psychology is complex, but the reasons behind the necessity for the large multiple include:
- Personal capital the buyer must expend to overcome organizational (or spousal) inertia;
- Offsetting other ancillary costs involved in using the offering (implementation, training, dismantling of old processes or systems, etc.);
- Belief or worry that the change costs are higher than expected;
- Fear that the benefits won’t actually be as high as expected.
Another test I apply in the B2B world is the “headcount savings” test. If a product is going to save a company ten headcount that can now be deployed elsewhere, I’d expect the price of the product to be at least equivalent to the fully loaded cost of one of those heads, maybe even two or three. I’m often surprised at how frequently a product’s asking pricing is unnecessarily below even that metric. A similar test can be applied to many consumer offerings that save people time.
Once you have a price point in mind that is backed by rational ROI metrics, there are other rules of the road to follow:
1. Offer choices or multiple plans: It’s a remarkable psychological fact, but give people choices, and they are much more willing to arrive at an agreement on price. It empowers them and allows them some flexibility to optimize for their own situation. Caveat: don’t get too complex or cute – your sales channels and back office need to be able to manage whatever you put out there.
2. Price higher and discount: There is a reason retailers have been playing the discount game for decades. Everyone wants a “deal,” and they don’t want to feel like they paid too much. In the B2B world, there are purchasing departments whose sole job it sometime seems is to get a big discount. So build the discount into your pricing!
3. Extract non-monetary value for price concessions. If you are going to discount your price, especially if it’s a price that other customers buying under similar circumstances have been willing to pay, there should be a quid pro quo. It’s fair, and ultimately these “asks” can benefit your buyer, too. Typical trades include asking them to:
- Be a customer reference;
- Do a case study;
- Test a new product or feature;
- Speak at a conference;
- Allow use of their logo in your marketing activities;
- Host a seminar.
4. Don’t do things that will limit, discourage or risk the customer’s expanded use of product (or encourage them to cheat).
5. Create a “deal envelope” within which your sales force can have full flexibility in pricing. This streamlines and takes friction out of the sales process (buyers hate it when you have to “run it by the manager”). The envelope should provide a range of acceptable prices — a starting (high, but defensible), a target (ideal to seller), and a floor (bottom-line or walk-away) price — that gives the sales team some wiggle room to factor in their first-hand knowledge of each deal circumstance, i.e. a highly competitive deal.
6. Offer “all you can eat” usage or access programs with a limited time frame, and a true-up at end of the period. Agree on a level of use upfront (i.e.: 1,000 users), but allow unrestricted use until a reset or true-up period date is reached (usually one year, but can be other time frames as well).
7. Don’t get super aggressive on volume discounts in the price book. It’s a myth that there are significant economies of scale in many product categories, especially with software. Large customers are very demanding, and often want features and capabilities and support that won’t be used by the entire customer base, but you will still have to accommodate them and incur additional costs.
At the end of the day, you want to avoid “cost-plus” pricing, and instead base your price on value delivered, while being market-aligned and ensuring your prices make sense and are perceived as fair by the buyer. As a startup, you want to be on the “grow market share” side of the pricing efficient frontier curve, rather than the “maximize margin” side, but there is no reason to be too far away. At the end of the day the very best way to fund a startup is with customer dollars, not VC dollars!