Get your new product pricing right- Monica and Joe series
Why customers buy based on the perceived worth that the price represents to them, and how you should price to get your fair share of that value.
The cloud’s belly looked swollen. Rain was imminent. Monica was glad to get back to her Jackson-Square office dry, clutching her daily cappuccino from the coffee truck around the corner, especially as she’d left her umbrella at last night’s networking event which she’d attended with her co-founder, Joe.
Monica is the CEO of an ambitious startup looking to solve a common business pain she experienced at a previous company before deciding to embark on this entrepreneurial journey.
“Hey Joe, what price should we charge for the new product?
After all the effort into the user interface, we really need to weigh the price point, especially as we promised the board to launch next month!
I was considering about 15% below our competitors. We’re far better, but I want to make sure that we get traction quickly so that we develop good metrics for the next investment round”
Joe stared through the window as the first heavy drops landed on the glass.
“Good question, Monica… let me think…
Shouldn’t we go for at least 85% gross margin?
That’s what Albert, from our Board, told me as a benchmark for saas companies like ours.”
Joe turned to face her.
“Why don’t we price the product to get 85% margin and see how far we are from the competition’s price”
Conversations like that one are not exclusive of Monica and Joe!
They’re taking place right now somewhere in the startup and corporate worlds, in small companies and large, from the Bay area to Boston, Berlin, Barcelona, and beyond!
As a VC and Board member, I am usually involved in this topic thanks to my experience as an entrepreneur and business operator.
Pricing mistakes are especially tough on startups. A study of nearly two thousand B2B companies shows that pricing errors, whether too high or too low, have an extremely high 72% correlation to missing revenue targets.
What would you recommend Monica and Joe? Do you think they are taking the right approach for pricing an enterprise product? Why should they put more thought into this pricing decision?
Here’s the key question: with all the value Monica and Joe are creating for their customers, how much are they or should they keep for their company?
Let me introduce the first law of pricing:
“Customers buy not just based on price, but based on the economic value that the price represents to them”
The purpose of the price is not to recover costs, but to focus on the customer and capture the perceived value for the product in the customer’s mind.
So, if in order to set the price you need first to know the value you bring to your customer, how best to identify the value Monica and Joe deliver with their new product?
Steve Blank popularized the lean startup method and companies like Strategyzer have created tools like the Value Proposition Canvas to help identify the fit of what you offer and what customers want.
For many B2B products, one can get the dollar value of such value creators by hand through the Value Proposition Canvas because there are measurable performance attributes compared to the best alternative, that is, x times faster, y times lower consumption, z savings in labor cost.
In consumer goods, where product features and benefits like brand, reputation, and service are often intangible, the conjoint analysis is a marketing research approach used to measure the differentiation value.
On the other side, there may be value inhibitors related to the product that Monica and Joe offer, like the risk of working with such an early company compared to the best alternative. Or, it may be the learning required by the customer to adopt the solution.
With an understanding of value creators and value inhibitors, the only thing left to know is the reference value of the best alternative, the price of what the customer views as the best substitute to Monica and Joe’s product. Sometimes the best substitute for the customer may have the value of zero dollars, because it may be free to them!
The economic value to the customer results from the value of differentiating attributes (value creators and inhibitors) minus the reference value to the customer.
Let’s imagine Monica and Joe employing this concept with this formula:
The result of this formula should give Monica and Joe an understanding of how big a slice of the pie that they are keeping for themselves.
Established companies focused on profitability should stick to that optimal price.
However, for startups looking for rapid growth like Monica and Joe’s, they may approach pricing biasing toward giving away more value than is captured — at least to start with, and especially if there is an opportunity for “land and expand” sales strategies.
The goal here is that, early on, they want to get to use the product, and test the value proposition; if they price the solution below perfection, their opportunity close rates should be higher and make their customer acquisition costs lower.
The next day the sun was shining through Joe’s office window when Monica rushed in to connect her laptop to the projector they have in their shared office.
“Joe, let me share what I have been working on until late last night. Here the expected monetary value of time saved per user, considering the average salary of our target user.
Here I have calculated the expected monetary value for avoiding this mistake, that according to this research by a third party, generates a cost to the company of $1000 per case.”
Monica kept sharing insights into the gains and pains the product was addressing, while Joe played “devil’s advocate” role, challenging her thinking.
“Joe, you are right! This is another factor that I did not take into consideration. We should have that in the inhibitors for adoption. That will subtract monetary value and we will need to figure out how to reduce that in order to maximize our share of the pie!”
Monica was excited to describe the reasoning of pricing in such an articulated manner. Monica and Joe kept discussing the assumptions, made a few calls to get extra input, looked for extra benchmark information.
“That is great stuff!” said Joe at the end of such a hectic day. “I never thought that we could ask for such a price. That is very exciting! However, considering the company stage of development, we may need to set the price between these two amounts! Let’s see what the board says!”
Monica and Joe kept working for a few more days fine-tuning the pricing framework until they were comfortable enough to share their work with the board. The board supported them when Monica and Joe went through the thought process based on the economic value to the customer.
This doesn’t mean that they’ll stick with lower prices forever. At some stage, Monica and Joe should change the price seeking profit rather than growth for that product. Once Monica and Joe start to raise prices, they should not worry too much about those early customers at 20% or 50% of their eventual pricing; there are plenty of other customers in the world who will pay full price. Monica and Joe may decide to grandfather those existing folks in with their existing pricing, thank them for their early votes of confidence and schedule them in a reasonable price increase program.
Final thoughts
The right pricing may have more impact on the company’s revenue growth than many other to-do list items when building your startup dedicated to enterprises.
Understand first the trade-off you’re willing to make. Are you optimizing for customer acquisition, revenue, or profitability?
Not getting pushback on pricing is a powerful signal that your prices are too low.
Spending time on pricing should not be a one-time event at the launch of a product, but the foundation of key programmatic practice. Establishing KPIs that drive pricing will help with the efficiency of the overall sales. Tracking KPIs like these will help you identify why and when it’s time for fine-tuning your existing pricing plan:
- Competitive win rate by pricing plan
- % of deals lost due to pricing
- Average annual contract value (ACV) over time
- Average discount relative to list price by deal value
- Mix of new customers by pricing plan
- Retention rates by ACV and by pricing plan
Pricing and value are inherently intertwined. Yet, most companies use cost-plus pricing. Rather than guesswork, this pricing framework helps you organize your customer insights, bring methodology to pricing, and assist you in communicating your pricing strategy.
If you liked this article, subscribe and take a look at this other essay about sales basics for technology startup founders Remember this simple formula if you are new in enterprise sales!
About Albert Vazquez-Agusti: Since I was a teenager working with my father at his engineering office, I’ve seen firsthand how technology and innovation impact our work. We have reached a crucial acceleration point where technological change, education, and inequality are involved in a kind of race. I’ve come to realize that the real bottleneck to taking advantage of innovation is the lack of relevant managerial skills to impact business models through new technologies. That’s why I promote the development of people and organizations to support technology adoption to solve small to big problems based on my experience in Fortune 500, SMBs, Private Equity, Start-ups and Venture Capital organizations.
About Monica and Joe series: meet curious Monica and loyal Joe, my fictional characters in a series of articles about learning lessons I have experienced or observed as a founder, executive, VC and Board member.
