Entrepreneur lesson #5: Your offering price is wrong

Image by Gerd Altmann from Pixabay
Image by Gerd Altmann from Pixabay

Few topics lead to such heated debates in startups as the pricing of the offering. There are at least four dimensions that play a role in the discussions: money first or customer first, based on value or cost, premium first or low-end first and direct versus indirect monetization. The first dimension is concerned with the dichotomy between a group that would like to earn back the investment in the offering as soon as possible by charging a high price to customers versus a group that focuses on creating a large customer base as soon as possible by charging a low price, or even providing the offering for free.

The second dimension is concerned with the principle of pricing. The cost-based model assumes that you can divide your R&D cost by the prospective customer base and add some margin to it to calculate the price. The value-based approach aims to assess the value that the customer gains from adopting the offering, eg in reduced effort required by the customer, improved revenue, and so on. The price of the offering is then set as a percentage of the customer value, eg 50 percent.

The third dimension is concerned with customer segmentation. For some offerings, it makes sense to address the premium customers first as these tend to be less price sensitive and care more about early access to innovative, value-adding functionality. In other cases, it can be better to start with the low end of the market as the offering lacks features that more advanced users would demand and take for granted. Customers at the low end of the market, however, tend to be much more price sensitive.

The fourth dimension is concerned with the business model. Some offerings are organized such that the primary customer base is offered the product for free or at a very low price. The data generated by that customer base is then monetized with a second customer base. In such situations, the “customer-first” strategy is obviously the right approach for the primary customer base. The challenge is, however, that this model often requires significant funding as it typically takes quite a bit of time and resources to grow the primary customer base until it has reached a size that allows for any significant revenue from the secondary customer base.

These four dimensions aren’t fully orthogonal and have interactions with each other, but they all have implications for the pricing of your offering. Many of the pricing discussions and conflicts I’ve seen are caused by parties having different implicit assumptions about the best model to use.

One factor that has huge implications on pricing is the existence of anchoring points in the industry. Consequently, understanding pricing by incumbent competitors as well as new entrants is very important as customers will have expectations on price setting. Your sales team will need very compelling arguments in case your price setting deviates significantly from the expected levels in the industry.

In general, three principles seem to work for many of the companies I work with: simplicity, continuous business models and separating monthly/annual recurring revenue (MRR/ARR) from setting-up fees. First, it’s very easy to get carried away with all kinds of line items and factors that need to be covered in the business model. The challenge is that customers easily get confused about what the cost of the offering will be and this uncertainty constitutes a hurdle for closing a deal with them. So, the simpler and clearer the business model is, the better. In most cases, this means two or three tiers next to an enterprise level.

Second, although transactional business models have the advantage of receiving all revenue upfront, most businesses look to build a continuous relationship with customers and in those cases, recurring business models such as subscription or usage-based monetization are more preferred. The worst-case situation is where you make money off your customer once but have then obligated yourself to provide continuous upgrades for an extended period of time. That may work if you can charge very high fees for the initial transaction, but in general, that’s not feasible if you’re not a brand like Apple. You can address the upfront revenue challenge by offering steep discounts for upfront payments.

Third, in most cases, customers adopting your offering require some help in getting set up. It’s tempting to offer the setup for free as you’re really focused on MRR/ARR. This is a mistake as it can easily become quite resource consuming and you’ll likely have to hire a team of customer success folks. It’s much better to separate the MRR/ARR and the setup work and make sure that you get paid for both.

No matter what price you initially decide upon, it’s almost certain that you got it wrong and that you’ll need to adjust. Consequently, it’s very important to view pricing through the lens of experimentation. Rather than casting it in stone, you should see this as a process where you determine the right price through a sequence of trials where you learn from feedback from the market.

Pricing is a very complex subject that can be wrestled to the ground only through experimentation in the market. It’s important to think through your pricing strategy, but treat your conclusions as hypotheses that need to be tested in the market and with your customers. Don’t paint yourself into a corner by casting your pricing in stone. In the end, the purpose of a business is to create a customer base and that customer base has to cover your cost and margin.

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