How to price your startup's product?

When used strategically, pricing becomes a source of competitive advantage, a weapon in the market. You can employ pricing to communicate whether your product is a low-cost alternative, mid-market or premium. For this to be effective, the pricing strategy will have to align with your website messaging, marketing case studies, sales pitches and PR releases.

When discussing pricing with clients, most startups tend to play defense. They either dance between asking for too much or too little, only to lose the client’s interest. The best of them lead their users in this dance. They employ pricing as an offensive tool meant to underscore their core marketing message and reinforce their product’s value.

All companies start out with a unique value proposition, something that differentiates their offering from competitors and makes it beneficial to users. Your job, as a founder is to evaluate that value in pricing quantitatively. The success of your startup relies not only on creating value but also in rightly capturing its value in pricing.

Why do we undersell?

Big enterprises like Facebook and Google, became billion-dollar companies without having to charge their users anything. And suddenly, we feel like under-charging or not-charging customers is the model of success.

These companies who seemingly run infinitely without monetizing their product are the exception, not the rule. If you are the rare kind, that can make this model work, good for you. But don’t be one of those people who doesn’t monetize their product hoping VC’s underwrite their expenses until someday they realize it won't last long, deciding to flip the switch on a revenue stream only to wake up to a rude reality. You’re providing a service or a product of value. Don’t sell your team and yourself short by not asking for value in return.

Triangulate your product strategy

Start by identifying three key factors about your business. What your product offers, who your customer is, and what the conditions in your market are. Knowing your customers will help you understand whether they're the kind that look for a bargain or whether high price works as a feature for them, like at an exclusive resort. Knowing your product will help you figure out how to scale your pricing. Meaning, knowing how much it will cost to deliver your product, from the ground up. Marketing costs, salaries, materials, rent all of it factors into the making of your product, and ultimately, your pricing has to reflect it all. You must have a good quantitative understanding of both CAC (customer acquisition cost) and unit economics. The market you enter will dictate how much freedom you have to set the price. The more substitutes or competitors around, the more the market will set the price for you. Now, these three aspects of your business will help you triangulate, but how do we hit the nail on the head?

 Stop thinking of pricing as a math problem. It’s a judgment problem.

Setting a price, in theory, should be a rational economics problem. You have a product in hand that caters to a certain level of demand in the marketplace. As prices go down, the demand tends to increase. So you simply tweak your price until you’ve maximized profits. Why doesn't it work like that? The thing is, technology companies don’t usually have a finite supply of a product. And while the upfront cost of developing software or mobile services is a lot, over time the cost of producing new units tends to zero. Moreover, startups come up with new products for which there aren’t any competitors for users to benchmark against. Under these circumstances, the traditional model doesn't always behave.

Generally, most focus on the gap between how much it costs to make their products and how much they ask for them. In a concept known as perceived value, we are advised to also pay attention to the gap between the amount you charge, and the value your customers believe it delivers.

Your price should be a part of the narrative.

The price you set, influences the product's perceived value. We tend to assume that a $70 wine bottle is better than a $20 one. In that sense, price serves as a proxy for quality. In a way, you can cater to a range of tastes by offering multiple products at similar price points. Take most leading smartphones in the market. Most come in three to five different colors. Another approach is offering versions of your product at different price points. While you can go a tad crazy with your most expensive model, which would represent what your brand aspires to, most customers that value features differently and those who don’t see the value in the high-end version, can pay less for a stripped-down model. Charging different prices for the same smartphone with different storage capacity widens the addressable market with minimal additional cost. By letting customers customize their package, you get real-time feedback about product and price configurations.

But remember, a lot of choices could become overwhelming. Most don't want the onus of making the wrong choice. In fact, even variable pricing that keeps increasing with increased usage can throw off potential customers. Most will often look elsewhere if they have to make projections about future costs or if they can not effortlessly choose which product to buy.

You can justify a pricing plan in three ways.

With value-based pricing, you can charge your users a fraction of the costs saved by your product or a fraction of the incremental value created by your product. Often, this is seen in ad tech or any type of optimization technology. In cost-based pricing, the product is marked up by some margin and sold. Many Infrastructure-as-a-Service companies do this like AWS, Twilio, Heroku, etc. With competition-based pricing, you introduce your product in a market where its price and value are well established. Here, you adopt the pricing model agreed upon by the industry.

The selling price of the product multiplied by the number of total potential customers gives you the total addressable market (TAM) for a startup. Bigger TAMs are generally better. If you are addressing a smaller market of customers relevant to you, the average revenue per user will have to be quite high. When you have millions of potential customers, the average revenue per user can be much smaller and still justify a billion-dollar-plus TAM.

Decoy pricing

The context also plays a role when we make a choice. Even a price point that yields dismal sales figures might be serving the purpose of shifting what consumers choose to buy. Decoys you might encounter in your everyday life include expensive dishes in a restaurant that makes all other items seem more valuable. Another one might be an expensive price plan for businesses which will make the other plans look more reasonably priced. Decoy prices make other, often more costly deals appear like a good bargain by giving you an obvious inferior deal. The reference point makes customers more inclined to pick the seemingly lesser priced option.

Often, the decision to buy something is a split-second one we make before reason kick in. Eventually, logic works its way in, so what you charge for your product must be able to stand up to scrutiny. People will ask questions if your product seems too cheap. And when you dress up something cheap with fancy imagery, customers will see through that too. No matter how good the messaging, million dollar enterprise-software deals will always include rigorous analysis. A story can't sell that for you. It can only help you draw attention to your product.

Why annual contracts?

Most SaaS startups embrace monthly pricing initially to encourage users to try out their product, engendering demand. Some point later, many switch to annual contracts. This way revenue gets a lot more predictable and also often, annual contracts ask for payment up-front which in turn rewards you with enough cash to help you grow faster. Moreover, contracts mitigate churn rates as your user is only asked to renew their package once a year, instead of every month. By employing such contracts, you materially improve your unit economics, cash position, and predictability.

Experiment

You should be running bold experiments with pricing when your product is still in its MVP stage. Hit them with heavy numbers. Test outrageous prices and see what happens. You believe the right price is $299? Make it $499 and test what happens. Mentally prepare yourself for their reaction, but remain immune. You might charge $499, and it could have no impact on the numbers. Then you can quote $499 as your clients didn't question it when they heard the number. That might be the value they see. But choose to settle in the center of the upper bracket. You'll end up with a whole range of responses at both extremes if you experiment aggressively with pricing. A price so high most complain you’re overcharging and a price so low most don’t seem to care about the price at all.

Pricing requires a whole lot of calibrating to hit it right. Treat it like a moving target. Whenever you get it right, you'll see those numbers trending upward in your P&L sheets. It's worth the effort when you understand that each number corresponds to a paying user who has seen value in your offering. That’s when the entrepreneurship thing literally starts paying off.

Developing your pricing hypothesis

Write down the things that your consumers will think about when they first see your product. Jot down the snap-second judgments your client base would make when they see your product initially and what they'll come to believe after a lot more analysis. Your product's perceived value must be influenced heavily by complements and substitutes. When you visualize, if your product works as a replacement for something that costs $150, it's perceived value isn't likely to be much more. This should help you zone in on how broad of a market you can cater to.

Routinely remind yourself, as you work on your pricing strategy that your users are analytical but tend to make snap-second decisions. That they look for bargains but base them often on reference points that are arbitrary. Most of all, they do not want to feel responsible for making wrong choices. If you can work with these quirks while providing a product that customers are eager to pay for, you'll be on your way to building an enduring business.