A simple argument for investing in your pricing

TLDR

Companies need to invest more in price discovery and optimization. Prices are very important, but most companies don’t try very hard to get them right.

Let’s first establish that pricing is extremely important.

Some general comments:

1. Customers’ willingness to pay signals how much they value a product or feature.

2. Price is one of two variables that determine your addressable market.

3. Price increases on existing customers are pure margin.

4. Price discrimination can find you new customers.

5. The right price structure is a competitive advantage.

Customers’ willingness to pay signals how much they value a product or feature. Some smart people have recently been pushing an idea that I quite enjoy: extending the notion of product-market fit to product-market-price fit. This relates nicely to the common Y Combinator advice that startups should charge their earliest customers. I won’t add much to that advice, as I feel it’s pretty intuitive that a startup should confirm that customers will actually pay for their product. However, I’ll simply suggest that companies should keep that habit alive for every significant product or feature they launch. Customers often ask for products or features that they think are “cool,” and companies will credulously build those things without rigorously assessing the commercial opportunity. That’s a mistake. Every material investment should be supported by a business case that includes price discovery.

Price is one of two variables that determines your addressable market. Every market model I’ve ever seen — of any degree of complexity — effectively takes the matrix product of some quantity of product against some price per product. And with only one exception that I can recall, the amount of product sold commanded vastly more attention than the price. Now of course, every market sizing model is fiction, but they’re nonetheless a very useful kind of fiction that supports important decisions. And as those decisions get made, I wonder if any company treats pricing with as much care as they treat volume, despite their equivalent importance.

Price increases on existing customers are pure margin. The math here is very simple, but still tends to surprise people. Let’s imagine we have a company with $10M in revenue and a 20% EBITDA margin. Naturally, it must have $2M in EBITDA. Now let’s assume we increase average prices by just 10% without losing any customers. That takes us from $10M in revenue to $11M in revenue. Because costs haven’t changed at all, the incremental revenue passes directly to EBITDA, which increases from $2M to $3M. Here, we see EBITDA has increased by 50%. For a stable business valued on an EV/EBITDA basis, that’s a monstrous increase in valuation. And for certain startups with dubious economic models, that pricing tweak could ameliorate their cash burn and reduce the need for venture capital.

Price discrimination can find you new customers. Let’s imagine some company sells products in a market where each customer adheres to one of three willingness-to-pay archetypes.

• Archetype A: willing to pay up to $25; will never buy if price exceeds $25

• Archetype B: willing to pay up to $45; will never buy if price exceeds $45

• Archetype C: willing to pay up to $80; will never buy if price exceeds $80

Let’s further assume there’s equally many of each archetype, say 100 potential customers in each bucket, so the average willingness to pay is simply $50.

Let’s assume you set prices at $50 per unit. You can sell only to Archetype C at $50, and as a result, you pull in $50 * 100 = $5,000.

Now suppose you revise your pricing to be $40 per unit. You can now sell to Archetypes B and C at $40 each. As a result, you can sell $40 * 200 = $8,000. That’s a 60% increase in revenue from cutting prices 20%.

Now suppose you’ve roughly identified there are three archetypes, and you’re somewhat able to match prices to willingness to pay, such that you sell to Archetype A at $20 per unit, Archetype B at $40 per unit, and Archetype C at $70 per unit. You pull in $13,000. That simple price discrimination nearly tripled sales.

Obviously real markets are more complex than this, but willingness to pay is almost universally heterogeneous — whether by segment, use case, purchasing occasion, channel, or something else. Chances are, your company would benefit from strategic price targeting..

The right price structure is a competitive advantage. Customers care how they’re charged for a product — sometimes even if their preferred structure actually costs them more. I once worked with a B2B company that sold to extremely small businesses. As it turned out, even high usage customers were averse to paying for licenses. Being locked in to a flat fee every month was too risky for them; they preferred a much more expensive pay-as-you-go credits model. I won’t attempt to enumerate every different kind of pricing model, but I hope simply to articulate that customers always have preferences on pricing structure, even when it’s a little bit irrational. And, as a result, sometimes the company with the smartest pricing structure wins, not the company with the best product or the lowest price.

So, what mistakes are companies making with pricing?

Having worked with several companies on their pricing strategy, I’d venture that most companies — particularly startups — share several characteristics.

1. They rarely invest in full-time pricing personnel.

2. They assume customers are more price conscious than they are.

3. They hand-wave their way into pricing — using very little analytical rigor.

4. They exercise very little creativity in developing pricing models.

Companies rarely invest in full-time pricing personnel. I’ve observed that pricing usually belongs to some awkward combination of functions — or worse, an executive’s office, where it’s treated as a one-off special project and/or outsourced in perpetuity to consulting firms. No need to take my word for it, though. Let’s take the technology industry (here defined as “Computer Software” and “Internet” on LinkedIn). In the American tech industry, only about 1,300 people list “pricing” in their title on LinkedIn;. that’s out of about 3.5M employees. It amazes me how much effort is invested in creating sales volume in the tech industry, with so little consideration paid to pricing.

Customers are rarely as price-conscious as management assumes. This is simply a reflection on personal experience. Prices are usually too low. I once did pricing work for a company that sold a near-commodity product. Management insisted their hands were tied, that customers would flee for competitors if they raised prices. In reality, when I talked to customers, few of them could even tell me how much the product cost. It’s a rounding error, they told me. This thing is a sliver of our expenses; we barely even think about the price. It’s a pattern I’ve seen play out several times. In most cases, you’re not competing as a perfect substitute — a modest increase in prices will not destroy your company.

They hand-wave their way into pricing. Most companies pretty much set prices randomly. They’ll either benchmark against competitors, deploy some kind of cost-plus framework, or even just arbitrarily pick a number that seems sensible. This approach seems to forget a basic principle — that prices are set by the market. No matter how unique you think your product is, you do not declare a market price and let the market coalesce around it. The market has a price (or indeed many prices), and it’s your responsibility to find it. When you simply pick a number, you’ll invariably be surrendering customer surplus to the customers you win and losing potential business from everyone else.

They exercise very little creativity in developing pricing models. I won’t spend a tremendous amount of time here, but I’ll just suggest that you don’t have to adopt the same pricing model as your competitors. You’re under no obligation to retain the model that you implemented several years ago. Customers and salespeople adapt to change more easily than people give them credit for. Be willing to take a radical approach.

Potentially a series?

Pricing is very difficult. If there’s material interest, I would do a follow-up piece detailing a few analytical approaches to pricing, likely with a focus on B2B software products. Leave a comment or drop a message if interested.