In many of my meetings with early stage companies, somewhere around the middle of the discussion when we move from “market and product descriptions” to “the operating plan and go-to-market strategies”, one of the first items that comes up is the price, with the company suggesting something along the lines of “an annual subscription of $1000 per year”. The problem is that this is not a “price”, this is “Pricing”, and I think that the distinction between them is extremely important, especially in very early stage startups.
Price represents the value that the product or service brings to the customer while pricing is the method by which the company determines the price.
Now don’t get me wrong, I think that the process of pricing is crucial for the scaling of companies and has a significant influence on value creation (definitely with the move to recurring revenue models etc.) but it should always come after determining the Price that the market is willing to pay for the product or service.
Moreover, through the lifetime of the company, pricing can often change. Many companies have done this successfully and continue to improve their pricing mechanisms on an ongoing basis, but a company can only exist once the price of its product is determined and can justify the operational model behind it.
So what is the right price? In my mind the optimal price should be defined as “the maximum amount a customer is willing to pay for a product or service”. A customer will always be willing to pay an amount which captures part of the value that is being created (the other part being the net benefit that the customer is gaining).
The pricing, however, can vary, and the same value can be extracted in several ways, such as perpetual licensing vs recurring revenue; monthly vs annual service contracts etc.
Let’s look at a couple of examples:
A marketing-tech company improves its customer’s website conversion by 10%. If the customer has $1m in revenue, this means that the value gained from implementing the solution is worth $100K in revenue. The customer will therefore be willing to pay probably around $25k per year for the solution (bear in mind that the customer has additional costs like implementation, training, changing processes in the organization and the COGS associated with the excess revenue).
But while the Price is a direct result of the value, the Pricing method could be very different:
Pricing option #1 – annual contract of $25k
Pricing option #2 – Revenue Share of 25% of the excess revenue
Pricing option #3 – $12.5k per seat / year (assuming two marketing people are working with the service)
All three are legitimate SaaS pricing options, and furthermore, they can change over time and be tested against the market. But in all 3 cases the customer eventually pays the same amount, which is equal to the maximum it is willing to pay for the net value created.
A cyber-security company protects customers’ end points from advanced malware attacks. A customer needs the solution to be installed on a thousand desktop computers. Based on the internal risk management profile of the customer (rarely visible to the vendor), the overall budget allocated for security products is $1 million. As this particular product is one of ten different security products deployed, the customer is willing to pay $100,000 for the solution. Here there are once again different legitimate pricing methods, but they all translate to the same value:
Pricing option #1 – a perpetual license of $300k (assuming lifetime value of 3 years)
Pricing option #2 – $100 per end point / year = total of $100k / year
Pricing option #3 – $50 per end point / year + $50K for the central management console = $100K year
At the end of the day, it is the Price and not the Pricing method that determines the viability of the business model of the company. Once the Price is figured out, the rest of the parameters can be determined, like the customer’s profitability model, the investment needed to scale, and so on. If your product or service cannot provide enough value to justify a high price – no pricing acrobatics can ever fix that.