Why entrepreneurs may have to pay a high price for mis-pricingShripati Acharya
When introducing products into the market, entrepreneurs think of a lot of things – what is the right product, how to test it, who is the customer, what is my sales cycle and so on.
The one thing entrepreneurs usually do not think about is what is the right price.
This is understandable since founders, especially deeply technical founders, are most comfortable with identifying and solving difficult problems. They are least familiar with pricing. Pricing in such cases becomes an after thought. The underlying belief is that once the product is ready and deployed with the first set of customers, then a price point can be talked about. Besides, one can always start low and then raise the price so why bother with this headache now?
This is potentially a dangerous trap. One of the strongest levers which have a direct impact on the value of the company is pricing.
Even a 20% increase in price can dramatically move the needle on margins and convert a ho-hum business into an attractive one.
And when the company is an innovator and first mover in a new industry or segment, going in too low can have the effect of significantly reducing the total available market for itself as well as for any other company that might enter the market down the road. In other words, mis-pricing can have the impact of driving profitability out of a new industry segment.
So how should one go about pricing as a startup?
What we are discussing here is primarily written with B2B companies in mind though some aspects would be relevant for B2C companies as well. In an existing market, competitive products can provide a good guideline for pricing. For category creating companies, however, this is a more challenging task.
Which of the following activities would provide the best indicative price in a new market:
a) Focus groups
b) Online pricing survey
c) Asking initial pilot customers
d) Starting free and then gradually raising price
Answer: None of the above.
With no comparable price points to benchmark, customer responses in focus groups and pricing surveys can be wildly off the mark. Pilot customers can provide a wide range of prices depending on their initial experience, and their price expectations will usually be low as an early adopter working with a pre-production version. Starting free, instead of resulting in a smoother adoption, can backfire. A customer who does not have enough skin in the game might not invest the required resources in learning and trying out the product. Free can also lock you in a low price band for an extended period of time.
So what’s the way out of this maze?
- Start out with an objective to understand what value is realised by your target customer.
Even when there are no direct competitors, the customer is substituting a set of tasks with the new product and in the process reaping a better/faster/cheaper benefit.
Looking at ‘before and after’ scenarios are helpful in identifying the value creation in the customer deployments.
- The second way to arrive at a number is to simply guess at what might be acceptable to the customer. You can start high and then lower the price as needed to ensure a sale or start low, and keep raising the price for every successive deployment until you start facing stiff resistance. Either can work as long as the process of price discovery is very disciplined. Having a capable and adaptive sales organisation is key to achieving a good price discovery.
- Another way to arrive at a price is to look at what sales channel your company will use to build a profitable enterprise. Imagine a SaaS product offered at $5/month and another at $50/month. Assume that online marketing is the customer acquisition strategy. The online marketing spend that would make sense for a $5/month product is vastly different than for a $50/month product. A higher margin business can sustain a much more aggressive customer acquisition strategy and provide more room for experimentation in marketing. This approach will help provide a lower-bound for your prices - the minimum price to run a profitable business.
If the product is underpriced, your business will be forced to under-invest in sales, which can lead to a vicious cycle of stagnant sales that impede further investment in the business resulting in further erosion in sales. If the SaaS product requires an enterprise sales force, the pricing has to be sufficiently high to reflect the higher costs of a dedicated sales force - direct or channel sales - and a longer sales cycle.
Simply put a higher life-time value (LTV) provides the ability to profitably sustain a higher customer acquisition cost (CAC).
Here are three activities you can do to escape the mis-pricing trap:
- Be deliberate about price discovery and have a point of view early in the product cycle. For category creating products, in-depth understanding of the value creation for the customer is crucial. If you are getting strong pressure to lower the price, ask yourself if you are talking to the right buyer or if the value proposition can be better positioned to appeal to the customer.
- Do not couple pricing at early trials with pricing for later customers. For early proof of concept sales, entrepreneurs often offer a very attractive price or even make it free. While this is required to get initial traction and feedback, it is important to not be anchored into a low price point for subsequent sales. Remember that pricing is directly related to cost of sales and consequently the sales process.
- And once you have a starting price, review price points at regular intervals (monthly or quarterly depending on the product cycle). Engage sales actively to solicit customer feedback to help with pricing decisions. It is easier to mis-price in new markets, so faster pricing iteration is required when you have no existing benchmarks. If your sales team is closing sales too quickly (a short sales cycle), it might even be an indicator that there is room for you to raise prices.
Finding the right price range might be the single most impactful thing you can do to increase the value of your business. It is well worth sweating over it.