6 minute read / Nov 5, 2014 /
The 7 Factors to Consider When Pricing Your Startup's Product
Most startups play defense when discussing pricing with customers. They dance between asking for too little, leaving money on the table, and asking for too much, only to lose the customer’s interest. The very best companies lead their customers in that dance. They use pricing as an offensive tool to reinforce their product’s value and underscore the company’s core marketing message.
For many founding teams, pricing is one of the most difficult and complex decisions for the business. Startups operate in newer markets where pricing standards haven’t been set. In addition, these new markets evolve very quickly, and consequently, so must pricing. But throughout this turmoil, startups must adopt a process to craft a good pricing strategy, and re-evaluate prices periodically, but at least once per year.
These are the seven factors I believe founders should consider when pricing when they go to market:
The Basis for Pricing: There are three ways to justify a pricing plan. Value-based pricing charges customers a fraction of the incremental value created by the product or a fraction of the costs saved by the product. This is often seen in ad tech or any type of optimization technology. A startup increases conversions by 50% and they take 10% of the gain as their fee. Value based pricing is also employed in slightly less rigorous ways. Salesforce sells CRM seats based on an aggregate ROI of increased sales productivity for example. So does Expensify, which decreases the time to file expenses.
With cost-based pricing, startups mark up the product they sell by some margin. Many infrastructure as a service companies do this. AWS, Twilio, Heroku, etc. It’s very common in commodity or nearly-commodity industries, where customers know the prices of the components used to provide the service.
Third, competition based pricing works well in markets where the price and value of a particular type of product are well established. Startups adopt the pricing model well known in the industry.
Positioning: Positioning is the most frequently forgotten of the 4 Ps in Marketing. Salesforce exemplifies exceptional positioning. Used strategically, pricing can be a weapon, a source of competitive advantage in the market. Your company can employ pricing to communicate to the market whether your product is a premium, mid-market or low cost alternative.
Startups can choose to price below the market, to gain share and grow quickly (Zendesk, AirWatch); they can choose to price at the market price and differentiate based on product features (Dropbox and Box) ; or they can charge a premium for their product, which reinforces their positioning as the gold-standard in the sector (Palantir and Workday).
To be effective, a startup’s pricing strategy must align with its marketing case studies, website messaging, PR releases and sales pitches. If all the arrows point in the same direction, then pricing becomes an asset to reinforce the company’s position in the market.
Customer Base Size: The number of total potential customers multiplied by the selling price of the product equals the total addressable market (TAM) for a startup. Generally speaking, bigger TAMs are better. If there are a small number of relevant customers, as in Veeva’s case where the entire market is about 200 pharmaceutical companies, the average revenue per customer must be very high. At IPO, Veeva’s average customer paid the company about $750k per year. On the other hand, if there are millions of potential customers, as in Expensify’s case, the average revenue per company can be much smaller and still justify a billion-dollar-plus TAM.
Sales Team Structure: Pricing impacts the structure of a sales team and their day to day performance for two reasons. Higher price points decrease sales velocity, the number of deals closed per sales rep per unit time, and increase sales volatility, the chances a deal closes.
Inside sales teams selling $5-30K products can sustain a deal velocity of 3-8 transactions per month, depending on quota. This keeps morale high and creates a very predictable revenue forecast. No individual customer signing or balking will materially alter the company’s ability to achieve plan.
On the other hand, higher price points require more skilled, more expensive salespeople. Called field sales or outside sales people, their compensation starts at about $250k per year for on-target earnings (OTE - combination of salary and sales commission). Outside sales teams chase larger accounts, and may close 1-3 per year. But if all of them go sideways, the company’s revenues for the year will suffer materially.
Contract Length: Many SaaS startups launch with monthly pricing which encourages customers to try the product and engenders demand. At some point, most SaaS startups switch to annual contracts for three reasons. First, revenue becomes much more predictable. Second, annual contracts often include terms that require pre-payment up-front which rewards the startup with lots of cash to grow faster. Third, contracts mitigate churn rates because the customer is only making a renewal decision once per year, instead of 12x per year. Employing contracts can materially improve a startup’s cash position, unit economics and predictability.
Your Startup’s Unit Economics: Your pricing plan has to enable the company to become profitable at some point. The value of your business is the discounted sum of all its future profits. Adopting a lower price point may increase sales velocity, create lots of demand, and keep sales teams happy, but if the price point doesn’t generate enough gross margin to achieve reasonably quick payback periods, and the business suffers from an increase in churn, the company is in trouble.
Just a quick reminder:
Payback Period = Cost of Customer Acquisition/Gross Margin
The gross margin is the revenue per customer minus the costs to provide the service. A decrease in price reduces gross margin and will consequently increase payback period.
Margin Structure of the Customer Base: Compared to software companies, grocery stores are terrible customers because grocery stores have single digit margins. The margin structure of your startup’s customers matters a great deal when setting pricing. All of your product’s cost must be paid from your customers margin. The more margin your customer has, the more they can pay you for your product.
Like product development, developing pricing is a never-ending exercise. A startup’s environment, its product and its positioning change with time, and price must evolve in tandem. The best way for a startup to ensure its price is reasonably optimal to create a framework for evaluating price and revisit the data a few times per year.
This is one framework. If you have others, or additions, email me. I’d love to hear them.
To end this conversation on pricing, I’ll quote Lawrence Steinmetz who wrote a book on sales called How to Sell at Margins Higher Than Your Competitors: “The first thing you have to understand is the selling price is a function of your ability to sell and nothing else. What’s the difference between an $8,000 Rolex and a $40 Seiko watch? The Seiko is a better time piece. It’s far more accurate. The difference is your ability to sell.” Sales, marketing, product and pricing, when aligned, create powerful branding and margin-expansion effects.