In our last lesson, I talked about various types of revenue models and how you might go about deciding on a revenue model that will work for your startup. In this lesson I want to focus on one of the most important parts of your revenue model, your pricing strategy. Price and value are at the center of the word cloud for this lesson as you might expect. The key question you have to answer is how much of the value that you're creating for your customers will you be able to capture for your business through your pricing strategy. Setting the right price seems like it ought to be pretty easy, right? All you need to know is that your price has to be higher than your cost of producing and delivering your product or you won't make any money, and your price has to be less than what your customers are willing to pay or you won't make any sales. So, why is pricing so complicated and why do so many entrepreneurs struggle with it? Well, I'm going to talk about three basic pricing strategies. The first and probably the most common is cost-based pricing. With cost-based or cost-plus pricing, you base your price on the actual cost of making and delivering your product or service plus a desired profit margin. This is what retailers do when they mark up an item by 40 percent over what they paid their supplier. This is what a law firm does when they charge their clients an hourly rate for an associate's work, which is based on some percentage in addition to what they're paying that associate. One problem with cost-based pricing is that entrepreneurs frequently underestimate their real costs. It may cost them more to acquire each customer than they realized and they may not be able to accurately forecast what the cost of supporting that customer will be. It can be difficult to fully allocate overhead costs to each customer, especially when the customer base is still small. It's also important to recognize that some of the company's costs are going to be fixed. Meaning that they remain fairly constant regardless of how many customers the business has and others are variable, meaning that they change directly with sales. Office rent for example, is generally fixed and costs of goods sold is variable. However, these can change over time as the business grows and invest its capital in new ways and a cost-based pricing strategy would need to take this into account. The biggest weakness in cost-based pricing is that it only looks at costs. It doesn't take into account the value that's being delivered or the customers willingness to pay. Competitive pricing is when you base your price not on your costs, but on the prices that your competitors are charging for similar products or services. Customers have options, and competitive pricing recognizes that customers will typically consider similar products to have similar values. One approach might be to set a lower price than your competitors in order to encourage adoption and capture market share. Another approach might be to set a higher price than your competitors as a way to signal that yours is a higher-quality product or it has important features that the competitors lack. But competitive pricing can send the wrong message to the market. Customers often consider price as an indicator of product quality. If one product is cheaper than all the others, it must be cheaper in quality too. If all of the competitors' products are priced similarly, customers may perceive that they're all pretty much the same in quality. However, companies may choose to set their prices lower than the competition simply because they're trying to capture market share. That works best when their competitors have cost structures that make it difficult for them to follow suit. In a value-pricing approach, the price is set in order to capture as much of the value that customers derive as possible. You probably can't capture all of that value, because that would mean that customers no longer have a reason to purchase. However, if you have very few direct competitors and the customer problem you're solving is acute or if there is some external force, like a government regulation, that's pushing the customer to purchase, you may be able to capture a large part of that value by charging a fairly high price. This is what the five-forces framework we discussed previously is all about. How much value can you capture by charging higher prices? Your price will generally have to be lower if your customers have a great deal of negotiating power, if there are substitutes to your solution, if you need to discourage new entrance to the market, or if there's a great deal of rivalry in your industry. Value pricing starts with an understanding of the real value that you're providing to your customers. Are you helping them make more money by increasing their sales or allowing them to increase their prices? Are you helping them save money by eliminating costs or increasing their efficiency? Are you helping them save time by giving them information or performing a function more quickly than would otherwise be possible? Are you reducing their risk by eliminating the potential for human error or helping them comply with legal or regulatory requirements? Or are you providing some non-monetary benefit like status or prestige? Remember who your early adopters are. They understand that they have the problem. They have a budget to purchase a solution and they have tried and failed to find another solution. This means that they should be willing to pay the highest price. Don't rush to offer discounts to drive early adopter sales. Instead, you should be making sure that both you and your early adopter customers are on the same page regarding the value they can get from your solution. This starts during customer discovery, when you should be doing all that you can to understand the value that they perceive in your solution. You don't have to ask “How much would you pay for my product?”. Ask them about their options and what your solution would mean to them, how it would make their life easier or better. Some customers are going to value your solution more highly than others. It may be possible for you to charge different prices in order to capture as much of the value as possible. One way to do this is with a three-tiered pricing system. This is the old Sears model of good better and best. You'll always find that there are some customers who are just looking for a basic solution and they want to get it for the lowest possible price. There are others who want to buy the best product available and they're willing to pay a premium price for it. Your mainstream customers will probably be in the middle of these two extremes. So, why not give them what they want? The real-estate photography company that I've spoken about has a silver, gold, and platinum pricing strategy. The silver package is basic. No special lighting, you don't get your choice of photographer, and there's no special photo editing. Just basic, good-quality photography, good enough to post on realtor.com or your own website. The gold package is the standard package. Better lighting, more flexible scheduling, you get a more experienced photographer, and the photos are touched up in the studio so they look great. The platinum package is high-end for realtors who are really trying to showcase an expensive property. Only the best photographers, special lighting, and extensive studio work so the grass always looks green and the sky is always blue. As with most three-tiered pricing systems the expectation is that most customers will choose the middle option. So, you want to make sure that that's the option that works best for your company, too. You can also vary your pricing based on seasonality, even on the time of day. If you're able to do this in real time based on supply and demand on a day-by-day or hour-by-hour basis, that's called dynamic pricing. Look at what Uber does. During non-peak times they charge a lower price and they raise the price dramatically using surge pricing during peak times. This is a technique for spreading out demand, so that you can make the most efficient use of your resources in capturing as much of your customers willingness to pay as possible. I skipped over this pretty quickly a few slides ago, so I'll repeat it here. The best pricing advice I've ever heard is this. When in doubt, try raising your price. I think it's much more common for entrepreneurs to make pricing mistakes by setting their prices to low, than by setting them too high. If your price is too low, you're leaving money on the table. You're giving away profit that you really need or you're making your losses is bigger than they needed to be. With prices that are too low, it will take you longer to reach break-even, so you'll have to rely on outside investors for more money. You'll also be sending the wrong signal to your customers about the quality of your products or services. You may even be turning off prospects who are willing to pay more for the ideal solution. Because pricing strategy is such a mystery for many entrepreneurs, I want to point you in the direction of some books that might help. "Pricing on Purpose" by Ronald Baker and "The Strategy and Tactics of Pricing" by Thomas Nagel. The last time I looked, Thomas Nagle's book was selling for $71 on Amazon and Ronald Baker's was going for $67. They're both more than four times the price of "The Lean Startup" which goes for $15 in hardcover. These authors know something about pricing. So, this ought to tell you something.
