PRICING
“The principal point of cleverness is to know how to value things just as they deserve”. (F. de La Rochefoucauld)
The price is the monetary expression of value for your product/service. In a “perfectly competitive” environment, supply and demand meet to determine the instant price. It is apparently straightforward. Startups, bringing truly innovative products with no history of similar products to the marketplace do not operate in this environment. For a tech start-up company, pricing is one of the most complex challenges, as there is no history of transactions and, hopefully, no real equivalent product in the marketplace, only history of what your target market has done before your product/service is introduced. A startup has no market power. Pricing its product or service well will help it acquire some market power. At J&M Lab we attach the upmost importance to pricing as a key element to make a startup successful.
Launching a product or a service at a certain price can either make your company fail or succeed. I have witnessed many failures due to hastiness in determining a pricing as an afterthought on the back of a napkin.
2. Why Pricing is a Strategic Issue
Many companies gamble on pricing, following quick conclusions drawn from holding focus groups built from an estimated target market. It results either in poor pricing or in missed pricing opportunities. Either way, the business is damaged.
Pricing is a multifaceted prism. It is inherently part of positioning, both product positioning and company positioning, hence identity. It is a complex decision process, and not a residual decision taken on the fly. The Goal of pricing strategy is to align Price with Value. As a start-up, your priority #1 is survival, i.e. staying in business and build a successful going concern. Pricing is the #1 parameter you work on to achieve this goal, mitigating your risk.
Two major issues often conflict in start-ups, forcing entrepreneurs into compromises: financial health vs. market conquest. Once you have established your reputation, your brand becomes a major asset, you can then both dominate a market and have financial health. This rarely happens when your company is a start-up.
Strategically, you must assess your identity: is your company seeking a vast market through an offer of commoditized products or services? Or is it attempting to build a brand of exclusive products to the most affluent segment of the population? Is your product being sold both to businesses and to consumers? Is it dedicated to small businesses or to large organizations? Is it replacing a product becoming obsolete? Is your product/service delivered in many different fashions? Will many versions exist in your product roadmap?
Other strategic considerations include pricing to retain customers for longer periods of time, variable pricing by feature that customers value.
3. Why Tech Startups Must Focus on One Pricing Method Among a Broad Spectrum.
Many pricing methods have been used for generations, each for a specific purpose. All are valid in the way they extract a price for a good or a service. A quick round up of the most common methods introduced below gives the opportunity to highlight the particular approach that tech startups are bound to select.
a. Different pricing methods.
i. Cost-Based Pricing:
For the record only, some businesses, for instance IT consulting firms, charge on a cost + basis. It is simple and allows each sale to be profitable. It is widely used by small and large companies alike, in services as in manufacturing. It is a safe, finance-originated view that disregards the market forces. Needless to say, it is of no interest to technology startups. Commodity manufacturers with a low-cost structure are attracted by cost-based pricing as they can offer the lowest price on the market. The only differentiator is their price. This is a dangerous proposition, as there will always be, a few years down the road, one company that will manage to operate with a lower cost structure than their business and make them irrelevant
ii. Competition-Based Pricing
When a product cannot be well differentiated from other products in its market, suppliers are pricing their products within a narrow range. A startup company launching a product with similar benefits than competitors, using a revolutionary technology, can be tempted by this method if its costs are lower than competitors’ by an order of magnitude. It can either use its competitors’ price range and generate a higher margin or reduce the market price significantly until the main players exit this market. However, this is not the way to optimize cash flow in the long term. A price war may ensue: if competitors are large companies with more resources than your venture, they could decide to lose money for a period during which your young company will end up suffocating.
iii. Demand-Based Pricing
It is a pricing method based on the customer’s demand and the perceived value of the product. Very much in favor in retail, with multiple variants, from introductory pricing, to differentiated discounts, to promotional prices, to penetration prices, to loyalty programs. The transportation and hospitality industry have gone further in the granularity to offer different prices to different consumers for the same service in order to optimize the occupancy rate of a hotel, or a flight. It is called yield management and has been around for almost forty years. Generally, it is useful when industries need to sell inventories, before their value reaches zero. Most of these methods go under the umbrella of what is deemed dynamic pricing.
iv. Value-Based Pricing
Value-Based Pricing, though it is one among the demand-pricing methods, deserves a special mention. It is a method that allows to maximize revenue by charging each customer the exact amount they are willing to pay. This method is perfectly fitted to high technology products and services from innovative startups.
By the nature of their business, these startups introduce some products and/or services that are unique. Hence, finding out what a customer assigns as value to their product or service is highly rewarding. In the late 90s, a supply-chain solution company, i2 Technologies, was a master at it. They sold their solution to their first US car manufacturer for millions of dollars. They were erasing a major pain point that no other company had well identified and focused on.
It is obviously difficult to establish a price according to this method. It takes a long time to reach the right price.
The graph below illustrates the main differences between major generic pricing methods:
4. The Long Process of Value-Based Pricing
a. Solving the Target Customer’s Problem
To solve your customer’s problem, whether it is a perceived problem or a problem the customer may not fully realize it impacts her business, the first thing on your check list is to know your customer. You must gather as much quantitative and qualitative data as possible from a direct interaction as well as from outside available sources. Get the maximum intelligence on your market, including on products and services that claim to address adjacent pains to the ones your product addresses. What is the next best alternative to your product? Draft a matrix of their value propositions. Understand the pricing grid they use. Understanding the pains and the full process of your customer’s business, with the cost involved in time, human resources, money, opportunity cost (a difficult information to gather) is the only way you can ultimately craft a sharp value proposition.
Dig deeper and find out how new entrants (future competitors) could disturb the market with a substitute at a certain price. This is often hard to assess. Assumptions may replace hard data. You have absolutely no influence on it.
Your product or service must fit like a silk glove in addressing the pain you have identified as the one the customer will be ready to pay a lot to alleviate. And of course, your company must be the only one to provide it. That is why all startups are seeking to acquire a monopoly in their niche markets, to grab the highest reward from its pricing, in other words to capture the maximum value.
b. Quantify the Value for your Customer
How to measure accurately the customer’s perceived value for your product/service? To have an appreciation of the amount your customer will be willing to pay, you will likely iterate and test your value proposition to address the pain points of your target customer until you deliver the “must have” value proposition.
c. Pros and Cons of Value-Based Pricing:
i. Pros:
• It allows to own the market
• It contributes to build the brand
• It increases customer retention
• It maximizes revenue and cash flow for the lifetime of the product/service.
• It is the way to generate the highest profit
ii. Cons:
• It is a long and arduous process
5. Value Creation and Value Capture
Capturing value is what pricing allows you to do. It is fundamental to all enterprises, and essential to startups. Maximizing the capture of value for the value created for your customers is what makes great businesses. Make sure, however, that you do not put the cart before the horse. The priority for your business is to create value, i.e. provide a perceived benefit to potential customers. As soon as you realize your solution, whatever it is, does create value, you simultaneously start to work on the long process of capturing the maximum value for your enterprise.
6. Pricing is an Ongoing Process
Pricing strategy changes during a product lifecycle. It is important to anticipate rather than react to extend as much as possible the product lifecycle. The same is true for competition. If you make a move, don't expect your competitors to stand still. You may have destabilized them with an unprecedented offer, and some will drop out of the market, but not all. Markets are dynamic and competitors react, sometimes in unpredictable ways, to your moves. Understanding where your business fits in the market, how much power you have and what options you have allow for some careful or creative moves.
As a summary, never underestimate the time you must dedicate to pricing. It is time well spent.