To my wife Ethel,
who gave me
the space and time
to write this book.
Virtually every purchase decision you make is based on price. The subject of “price” is usually the most important factor when it comes to deciding on a purchase. Through price, the product or service communicates its quality, whether it’s a luxury product or a commodity; whether it’s overpriced or if it’s a real bargain.
The aim of this book is to provide insights in the different pricing methods, strategies and tactics to set pricing, as well as plenty of case studies where these methods are successfully applied. This is not a book for people that are looking for complex economic theories around price setting. It is rather a no-nonsense, ready-to-apply comprehensive guide for creating and reviewing your pricing strategy that will serve as a work of reference for a long time to come.
The book is called Lean Pricing, not only because it’s targeting Lean Startups, it’s rightfully called Lean because it contains a practical, hands-on approach that can be used right away. It is intended for everyone who wants to think structurally about their pricing strategy. The aim should be to review, set up or optimize his or her current pricing strategy. It’s for decision makers and influencers that prefer to use proven methods and leading practices that have been commercially tested in the market.
Whether you launched a startup, or work for a big tech company, is not important. As long as you believe that pricing plays a key role in your success, this book will be able to guide you with insight and inspiration.
We see time and again that businesses can accelerate if we offer them method support. This book will help founders structure their pricing strategy, offering the certainty that no important steps are skipped in the process of setting a winning pricing strategy.
Often pricing methods have a scientific and academic background containing a truckload of statistical research and formulas that doesn’t help to make them accessible. This book was written with the idea of making relevant models and frameworks accessible. We have selected and created 11 core-methods of setting and validating pricing. We cover multi-axis pricing and the freemium model in detail. The book is written with a clear distillation explained in laymen’s’ terms:
What you will learn:
When we use the word “startup” in this book, we mean by that technology startups — including but not limited to — digital business models such as software, embedded systems, SaaS (Software-as-a-Service), online, internet and web services. In fact, any business searching for scalability using digital technology as a lever can be considered a startup in this definition.
This book is a toolkit that will positively influence your pricing strategy. You will find that it pays for itself after reading a few chapters.
“If I have seen a little further, it is by standing on the shoulders of giants.”
Isaac Newton
One of the biggest lessons we have learned within the startup landscape is that even though pricing, together with the business model, remains by far the lever that most impacts revenue, the subject is a sensitive one. How much extra revenue would all those startups have made during their lifetime if they had charged 10% more per month? The number would be surprisingly high. How many customers would not have signed up because of that extra 10%? That number would be surprisingly low. Pricing is a strong — but underused — tool available to capture your share of value created for your customers. Basically, it’s about getting paid what you’re truly worth.
Entrepreneurs usually learn about pricing as part of an economics class while taking a business course. Unfortunately, many of the macro concepts taught, do not always reflect the realities of how consumers or businesses make decisions in real life. Price-setting, based on competitors and costs, is tackled next, as if pricing mysteriously emerges from the combination of “the market” and “internal costs.”
While it makes sense for a product in an existing market to use the competition as the reference point, it will not help with a new product or service. Why? Because software, web services and SaaS companies produce intangible assets where the correlation between the hours worked to create a product and the value delivered is not linear.
Creativity is not easily expressed in “Quantity,” like labor hours. One can create a great app over the weekend that will significantly improve the life of a consumer while somebody else might work six months on a similar app yet will create significant lower value. That’s why the first app can charge more than the second one despite the fact that the work to create a similar app is only a fraction of the latter.
Another observation we made while coaching startups to grow, both at home and abroad, is that successful entrepreneurs master not just sales and marketing, but are also finance savvy. They are masters in promoting their products and services, often at a price point that will initially be perceived as high, especially in a brand new category of service offerings. They learned not only to control costs, but also how to price, position and sell added value way beyond supply and demand, economists’ favorite key factors. An entrepreneur should know his or her numbers by heart.
The economical aim of a business is to create value by producing products or services with a value bigger than the efforts to create them. To capture that value, the business model and pricing are key. Optimizing the value of each and every prospect is the most critical activity to make a business model work.
Understanding the buying and usage behaviors of a given customer segment is perhaps the single most valuable piece of business insight that a startup can acquire. The real challenge is not to convince every single person on this planet to buy from you but to find prospects that are genuinely interested in your services, services that help them solve their problems and needs.
Small or new companies are not the only ones allergic to dealing with pricing — the same applies to big companies, too; setting fees and prices is as dreadful as hives! It might come as a surprise given that price is a reflection of the value that a business creates. Nothing is more critical to a startup than its pricing strategy. In fact, for most startup founders a prospect’s most terrifying question — even after a great sales pitch — is “So, how much do you charge?” It’s a simple question that can be intimidating for new entrepreneurs, because let’s admit it: we’re really bad at pricing.
In practice, most of us calculate prices by first using competitive research, and then cost estimates. Pricing is an afterthought. Typically it goes like this: we charge an amount 10% less than Competitor XYZ because we want to win market share fast to gain traction. A similar thought might be: we charge 10% more than Competitor XYZ because our product is significantly better and offers additional features to justify the higher price. Although this might be a good starting point for a pricing strategy, it’s likely that it will lead to underpricing your product or service.
The challenge with pricing is that:
The result? Loss aversion typically pushes startups to charge less than what their product or service is worth. This means that the price stays where it is with two important questions going unanswered:
The big mistake startups make is charging too little. They don’t draw enough income and go out of business. An even bigger mistake is charging too much. They don’t attract enough customers and go out of business. That’s why pricing is strategic. Pricing is about a company’s long-term sustainability. The good news is that you can guess with pricing, be wrong, but still be right enough to build a great, sustainable business.
Be crystal clear about what you want to achieve with your pricing strategy: you want to generate enough revenue from selling your products and services so that you not only cover the costs, but also fund innovation and growth.
Payment is a powerful validation of your business model. Until a customer is putting his money where his mouth is with an actual purchase of your product or service, the positive feedback during the development phase of your product or service is meaningless. Not only does price validate your business model, the price customers are willing to pay validates how well you nailed the solution. In other words, the better the problem/solution fit, the more a customer is willing to pay.
One of the reasons that pricing is such a sensitive topic in business is that it impacts nearly everything a company stands for. Pricing determines your market position: whether or not customers will buy from you; the sales and distribution channels you can use; your company’s growth and adoption rate; your financial soundness; and if you can provide the service level expected by your customers. In other words, pricing affects every relevant aspect of the business.
From a marketing perspective, price is the main way a startup communicates its value to customers. For B2B this is particularly important as enterprise customers are suspicious of newcomers who are perceived to be instable. A low price might draw questions about the quality of the product/service delivered, the customer support provided, or even the financial future of the provider. Your price is part of your product.
Pricing is at the heart of your business because it affects both everything you want to do and everything you actually do. Prices provide crucial points of orientation for both buyers and sellers. But it’s a big mistake for a business to believe that price alone drives sales. Your ability to sell is what drives sales. But a pricing strategy is a key to sales strategy.
Pricing determines your market position.
© Uli-B / Fotolia
Setting the price for a product/service is a constant challenge during a business’ lifetime starting from day one, or perhaps, even before the company was launched. Although the problem can sometimes be more urgent — for instance, when launching a new product version, creating new functionality or releasing new features, entering a new market or segment or creating a new distribution channel — it’s not a new problem. Setting or changing a price thanks to new conditions is part of the core issue, the lack of a pricing strategy, that is.
Approach pricing strategy as a process, not just something to review with a new event, like a competitor’s price change. You should be the only one who controls your pricing! Never allow competitors to determine your pricing. They have no interest in your long-term survival except to bring you down fast. Similar to product development, developing pricing is a never-ending process. A startup’s environment, its product and its positioning change with time, and price must evolve in tandem1.
A pricing process uses an array of methods and tactics to arrive at the optimal price, the single most important number in your business. The different methods and tactics available to you are the subject of this book. Unless you want to sell commodities, pricing is unique to every company; the value every company offers is unique to a certain degree.
Typically in pricing discussion, some argue for higher pricing, while others argue for lower prices. You might decide to start with a low price and then slowly raise it. Or you might decide to do the opposite — a premium price point to create brand value and a quality image from the first day on. The thing is that customers don’t care, they will not notice if a newly launched startup is doubling prices week after week. What is important is to have a process in place and to monitor what works and what doesn’t.
Combining different methods and tactics will help you find the optimal price. Some methods will be more appropriate than others; certain tactics may not be applicable. But understanding how they work and experimenting is the right way to tackle the price-setting challenge. Getting a pricing process in place is a litmus test: it demonstrates a company’s ability to understand the value it creates for customers. In fact, it’s surprising that VCs and investors don’t drill down further in the pricing process to find more detail. It becomes crystal clear where a startup should position itself in a given market once the startup understands their prospective customers’ decision-making process, and once they understand the creation and capture of value generated.
Price-setting practices are highly contested processes within companies. Often they are the outcome of negotiations and opinions of different people inside and outside the company with different interpretations of price and pricing strategies, making price setting based on the social dynamics. The primary goal of a pricing strategy should be growth and profitability. Uncertainty around an optimal strategy makes pricing a reflection of the social order in the organization and the openness of the founders.
Prices are shaped by interpretative processes within the organization, while a pricing strategy should — from the start — consider the different methods for approaching the price. They should decide on which tactics to employ, how to measure market feedback, and the impact of the price on a given customer segment (i.e. making sense of market signals). There is no one surefire, formula-based approach that suits all types of products, businesses or markets. This is a constant process. There’s no pricing season in a market in constant change. Remember Darwin: It is not the strongest of the species that survives, nor the most intelligent. It is the one that is most adaptable to change.
Tapping the full promise of pricing requires a process to drive real and sustained pricing performance. With such a foundation, a company can establish and strengthen pricing activities by creating deliberate decision processes, articulating clear targets and goals, and managing risk. Such profit-sensitive decisions deserve a process with thorough underlying analytics. You can’t just throw some numbers on a page and never change them. Instead, pricing – and more concretely determining value – needs to be a core aptitude of any startup team.
In open market economies, price is the result of supply and demand, however, it would be naive to assume that they alone are sufficient to set a price. It doesn’t mean that supply and demand are not factors in pricing, but don’t underestimate the other forces and elements that make up the market. Economists often are accused of practicing “economism” or applying economics to fields that can’t be fully explained by economic theory — like being unable to imagine a successful price strategy without considering aspects outside economics, like psychology.
At the end of the day, pricing is a number. See it as a financial expression of the value of a product or service. Precisely because it’s a number, looking suspiciously like math, people incorrectly assume that pricing is an exact science — a field capable of accurate predictions and facts — a field that can be harnessed with forecasts in Excel, sensitivity simulations or other measurements. But as Bill Gurley famously stated: business isn’t physics, it’s at best a “good guess”.
Finding that pricing sweet spot isn’t just about doing the “math”. Just because it’s math, it doesn’t mean it’s good math. Yes, you have to run the numbers when it comes to costs and profit; but they aren’t the only considerations in setting your price. Price formation also embodies sociology. It is the outcome of individual preference, and therefore, a result of the social forces operating within the market.
Pricing reflects public opinion on the good’s value. Additionally, most prices are at least partly determined by psychology. Prices are carefully designed to influence our purchase behavior and to steer us in a specific direction and towards certain items to make us spend more than we intended. Pricing is a function of marketing — one of its most fascinating aspects.
Quantitative analysis can form the scientific foundation to set a pricing strategy but good judgment combined with a vision are required to make the final decision on setting the price. That’s the art.
For any tactic that works well for one company, we can show you the opposite tactic working equally well at another. That’s why it’s an art to find your best pricing strategy and the optimal way of representing the price to your prospective buyers.
© pressmaster / Fotolia
The marketing mix consists of four Ps: Place, Product, Promotion and Pricing. This translates into the right product (satisfying needs) sold at the right price in the right place (distribution) using the most suitable promotion (conveying the value). The cost of your product or service is the amount you spend to produce it. The price is your financial reward for providing the product or service to the market. The value is what your customer believes the product or service is worth.
Pricing is the most important P of the four Ps of Marketing. It transmits the most crucial message your company can give: what you think your “stuff” is worth, or well beyond what an advertisement campaign can communicate. Pricing needs as much attention as the other three Ps, not less.
The role of marketing is to add value to the brand, differentiate it from the competition and make the product and services highly desirable.
What’s the difference between a $25,000 Rolex and a $25 Seiko watch? The Seiko is more accurate. Marketing is what makes a product worth more than the cost of production. That’s why pricing and marketing are intertwined and impossible to separate. You need skill, discipline and dedication to put as much creativity into your pricing as you put into your product design or website.
Contrary to Place, Product and Promotion, the other three P’s of the marketing mix — all costs — pricing generates sales revenue. Equally important, pricing is the only one that can be quickly changed for an immediate impact.
Since you will be dealing with buyers, whether consumers or in procurement, you’ll need a professional pricing process on your side of the equation. Do your customers buy just on price after comparing providers, shopping around until they find a great bargain? Customers aren’t as price-sensitive as you think — but they are value—conscious! They only buy on price when you haven’t given them a reason not to; the value is that reason.
Communicating, expressing and highlighting the value is the main task of marketing and sales, and highly important for a startup. It’s advisable to keep improving these skills: writing, speaking and negotiating. Yet, startup founders back away because they fear rejection once the price is out on the table. They feel vulnerable.
One of the key elements that SaaS companies must consider is not to think in terms of product delivery, but in terms of services offered. The last “S” of SaaS is more important than the first one. This should be the central message in all communication. The industry is aware of this fact but the market isn’t yet. That shift is important in establishing value and thus the price. On a side note, any software delivered as a service is considered a service according to GAAP (Generally Accepted Accounting Principles).
© Kamil Ćwiklewski / Fotolia
Unlike a business that produces physical goods, startups offer a product or service based on intangible assets. Examples of intangible assets are music, literature, movies, pictures but also patents, franchising and software. Building a business model on an intangible asset combined with digital technology makes it highly scalable, i.e. growth is not a linear link with headcount.
In the manufacturing world of physical products, increasing demand doesn’t increase prices, it usually lowers them because a higher volume reduces production cost. This is counterintuitive for startups where cost of goods and cost of warehousing is non-existent: the incremental cost for serving an additional user is near-zero, and thanks to the free ride of the internet, distribution cost is zero.
Manufacturing-based business models therefore are not good pricing benchmarks for startups; the rules are too different. Startups often operate in new categories of product and service without any price point reference anyway.
Let’s compare startups with another sector that creates products based on intangible assets: contemporary art. How do you set a price for a painting? The cost of the paint? The cost of the canvas? The number of hours that the artist painted? Obviously, prices for contemporary art have no correlation to the production cost of the product. So how do art galleries price it? Is there a pricing strategy or is it random?
Interestingly, one unwritten rule galleries use to set the price of the same artist — irrespective of quality between the works — is size. Another rule is never marking down the price for an artist’s work even if it does not sell. The work of a new artist is priced based on what has been charged for works by other young artists with similar materials and styles. These rules became a framework for pricing used in that specific industry and are practices mutually accepted in that domain.
Now back to startups, remember that programmers and coders are the new artists in this digital era. Yet they face a bigger pricing challenge than the traditional artists: research proves that physical contact with an object increases the subjective value and our longing to possess it2. The challenge of setting a price for intangible assets is the very core of this book and will be tackled in the chapters to come.
Pricing in a digital world, however, has a great benefit: for startups, the menu cost is near zero. Menu cost is an economics term that refers to the cost a company incurs after changing its prices. The name stems from restaurants needing to print new menus for every price change. Because of this additional expense, companies sometimes prefer not to change their prices too often or for too small an increase.
A startup’s “menu” is the pricing page