A couple CEOs have asked us a version of the question: do you think we’ve priced our product correctly? Typically, I answer that they need to determine how elastic their consumers are. Apparently, a sort of maniacal focus on elasticity is a trend that started last year in public company earnings announcements. But I think I’ve been wrong to answer like this. Elasticity is an optimizing function once the pricing strategy is set. I’m realizing more and more that for many startups the basic gist of how pricing works is more important than how client volumes change when aggregate prices change.
The reality is we see more customers underpricing than overpricing even in the current inflationary environment. This is the result of fears around churning customers, slowing conversion rates, and ultimately losing revenue/cash. These fears tend to be overweighted. With good account management, most customers can be saved and the benefit of raising prices will far outweigh the negatives. It is the reason most public companies have seen significant revenue growth in the post-pandemic period.
So here it is: pricing a product is one of the more important decisions a company will make. It directly impacts the success and profitability of a business. Price too low, the company will see high volumes, which are unsustainable to support, and also increased burn because the economics don't work. Price too high and sales cycles get too long. Not enough people buy the product/service. There are several strategies that a company can use to determine an appropriate price for its product. There are three main pricing methods that are taught in business school:
1. Cost-Plus Pricing: Cost-plus pricing is a straightforward pricing strategy that involves adding a markup to the cost of the product. This markup includes the desired profit margin of the company. This strategy is easy to implement, but it doesn't take into account the market demand or competition. One benefit of cost-plus pricing in an inflationary environment is that it auto-adjusts. As costs rise, so do your prices.
2. Value-Based Pricing: Value-based pricing is a strategy that involves setting a price based on the perceived value of the product to the customer. This means that the price is based on how much the customer is willing to pay for the product. Startups can determine the perceived value of their product by analyzing the benefits it provides to customers and the problem it solves for them. In practice, startups have a very difficult time with this methodology. Understanding what your intrinsic value to your customers is and then narrowing down their willingness to pay takes a lot of work and data crunching.
3. Market-Based Pricing: Competitive pricing involves setting a price that is similar to the prices of competitors in the market. This strategy is useful when startups are entering an established market and want to remain competitive. However, this strategy may not be effective if the company's product has a unique value proposition that justifies a higher price. We see this pricing strategy used most often. The drawback is that, as a startup, you may not be able to provide your service for the prices that reflect scale. Usually, by following market-based pricing, startups will underprice their service and fail to articulate what truly differentiates them.
What strategies are you using to price your product? Within the backdrop of a higher inflation environment, it’s important to understand which of these strategies your company is implementing. Even though the growth rate in inflation is slowing, prices are still rising at 5%-6% YoY. See the chart below:
The above list answers the question “How do you come up with a price to charge your customers?”, below are 4 strategies around how to present pricing to your customers, which can sometimes be just as important:
1. Bundling: As mentioned earlier, bundling involves selling two or more products together as a package deal. Bundling allows businesses to offer customers a discount for buying multiple products, making the purchase more appealing. This strategy is especially effective when the bundled products are complementary or are frequently purchased together.
2. Tiered Pricing: Tiered pricing is a pricing strategy where a business offers multiple pricing levels for the same product or service. Each pricing level provides different features, benefits, or levels of service. This allows businesses to offer their products to a wider range of customers, from budget-conscious consumers to those who are willing to pay a premium for extra features or services.
3. Pay-What-You-Want (PWYW): PWYW is a pricing strategy where customers can choose to pay any amount they want for a product or service. This strategy is based on the idea that customers will pay a fair price for a product or service they value. PWYW is commonly used in the music and digital media industries.
4. Freemium: Freemium is a pricing strategy where a business offers a basic version of its product or service for free, but charges for advanced features or additional services. This strategy is commonly used in software and gaming industries, where the basic version of the product is free, but users have to pay to access additional features.
5. Dynamic Pricing: Dynamic pricing is a pricing strategy that involves adjusting prices based on demand, competition, and other external factors. This strategy is commonly used in industries such as travel and hospitality, where prices fluctuate based on seasonality, events, or availability.
6. Penetration Pricing: Penetration pricing is a pricing strategy where the company sets a low price initially to gain market share and attract customers. This strategy is commonly used by startups that are entering a new market or launching a new product. Once the company has established a customer base, it may gradually increase its price. If you have a healthy balance sheet, strategically underpricing to gain customers can be a powerful tool. The key is not to forget why the product is priced as low as it is.
Take a look at the first list and figure out which bucket you’re currently in. The best bucket to be in is value-based pricing, but only if you have an accurate read on what your intrinsic and perceived value is. To get an accurate read on what your intrinsic and perceived value is, you’ll need to know how you’re different and why people pay you. It’s harder than it sounds.
If you’re not there yet, that’s okay. The next best approach is likely to be a mix between cost-plus and market pricing. I.e. start with cost-plus pricing and then compare it to market prices. If you’re significantly higher than the market, you’ll need to either give up margin OR change which customer segment you're targeting (move upmarket).
Now, take a look at the second list. What strategies have you used to present pricing? Are you bundling your products & services? Are you using a freemium model? If you’re not sure, look through the list and decide which bucket you think would resonate most with your customers. Think through the end-to-end customer journey and ask yourself whether this pricing model allows you to deliver the most value.
Pricing is one of the most difficult strategic problems early-stage founders face. All we can say is don’t get discouraged. Larger companies spend millions of dollars trying to perfectly optimize price. At a smaller scale, there are easy wins that get you 80% of the way there. Feel free to reach out to us with any questions. We do a lot of pricing work with our customers and are always happy to share insights.
Feel free to reach out with feedback or if you just want to chat about the market conditions or technology.
e: rob@bobsbookkeepers.com
e: matt@bobsbookkeepers.com
Thanks everyone, Rob & Matt
You can read January’s letter here – FRAME 1: WATCHING CYCLES REVERSE, February’s newsletter here – FRAME 2: INDISTINGUISHABLE FROM MAGIC and last month’s here: FRAME 3: CUSTOMER ACQUISITION COSTS AND THE MACRO MARKET
We're hearing from portfolio companies that they're cutting back on their marketing budgets to preserve runway. There's also some news to suggest larger companies are also being cautious with their marketing budgets. This creates favorable conditions for companies that go against the grain and spend on marketing. Ad dollars will likely go further while consumer spending remains strong.
- For B2B: technology is advancing rapidly. Our aggregate S&P graph above shows this. Look to automate your outbound strategy for B2B in order to capitalize on business spending trends, which remain strong. There is still appetite for investments from businesses in technology and contract labor. There seems to be less appetite for spend on headcount. Conversion rates on professional services and other software vendors should see a tailwind in 2023.
- For B2C: it's important to note: even though there has been an overall increase in business spending, the majority of the increase is concentrated in COGS. Operating expenses have been flat to down. Marketing budgets have been slashed. This is good news for B2C companies as we covered in the bullet point above. Bidding for SEO terms and digital marketing efforts have likely scaled back.
Exit opportunities (whether that be M&A or IPOs) for later-stage companies have dried up. There's not as much appetite to exit at lower valuations. There is a push for companies to get profitable and extend runway. New entrants into the market will find it hard to raise capital. All things equal, there will be less competition for digital ads from new entrants with large budgets from strong venture funding events.
Venture capital dry powder is rising. There's a ton of capital on the sidelines. It will have to be released. We'll continue to monitor the macro market for shifts, but it can't stay on the sidelines for too long or 7-year-to-exit time frames will be pushed out and returns will fall, making it difficult to raise new funds. Once the dry powder is released, many of the trends laid out above will reverse.
Bob's Bookkeepers is a team of financial experts providing bookkeeping and strategic financial guidance for startups and later stage companies. We have a deep understanding that no startup's needs are the same. That is why we offer tailored services to navigate the complexities of sustaining and growing your company. We leverage our 20 years of working with startups to provide insights and guide founders. We use technology to assist companies in better managing their finances to sustain and grow. You can contact us here.
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