When we pay for things, we expect to receive a specific value from the purchase. Sometimes that value is obvious, like a bar of soap or light bulb and other times it’s not. When it’s not and if there is too much perceived risk of not achieving the intended value, sometimes the seller has to offer an “insurance policy” in the form of a money-back guarantee or even not get paid until the value is confirmed (ie – contingency or success fee).
Many of us that sell products have learned about value-based pricing and the benefits from pricing our product based on the value the customer actually receives. But I’m still amazed at how infrequent I see this done by startups and early stage tech companies. Whenever I meet with them in an advisory capacity and pricing strategy becomes a topic of conversation, I always launch into an exercise I refer to as “extreme value-based pricing”. In this article I’ll explain the fundamental concept so that you can decide on your ideal pricing strategy and related pricing metric.
There are numerous units of measure to choose from when pricing your product. We refer to it as your “pricing metric” and with many products we purchase in our daily lives, the metric is obvious. For example, the fuel for our gas-powered vehicles is priced by the volume (ie – gallon, litre). The hotel room we rent is priced by the usage (ie – nights used). And when we go out to a movie with our spouse we pay per user (ie – one movie ticket per person).
In general, there are three broad options for pricing metrics:
- per Product
- per User
- per Usage
In the tech world, the per-usage metric could mean a whole variety of things including storage or network consumption, time used or numerous different types of functional actions taken.
Note: For purposes of this article, the focus is on pricing to the ultimate end consumer of your offering. I say this because things can get a little more complicated with 2-sided marketplaces and advertising-based or affiliate revenue models.
Similar to pricing metrics, there are also numerous different pricing strategies that can be deployed. And when the perfect pricing metric and strategy come together, that’s when magic can happen. In general, there are four broad options for pricing strategy.
- Value – More specifically, the value the customer receives from using your product.
- Profit Margin – This strategy optimizes for a particular gross profit margin, given the cost to produce and deliver your product.
- Competition – This strategy contemplates the competitive forces that exist from similar products that are already priced by various competitors.
- Market Share – This strategy is similar to the Competition strategy but, more specifically, aligns with a desired market share for your company.
Whether they realize it or not, most companies employ a blending of multiple pricing strategies. They do this by starting with a primary strategy and then using one or more of the others either as a sanity check or to further optimize the final price.
ALWAYS START WITH VALUE-BASED PRICING
If your customers don’t conclude that the value of using your product exceeds the cost, they are very unlikely to buy it. And if you offer a subscription-based price, they might use your product for a short period of time but will later cancel (churn). Starting with a value-based pricing strategy will give you the best chances of both landing new customers and keeping them over time.
But value-based pricing goes further than that. In order to properly deploy it you must first clearly identify and characterize the value your customers gain from using your product, and with enough specificity to come up with a price they will identify as clearly lower than the value they’ll receive.
Hint #1 : If the value formula for your product isn’t obvious, create a return-on-investment (ROI) calculator using a spreadsheet and experiment with it until you have what you need to price in confidence. Forcing yourself to identify the spreadsheet’s inputs and outputs should lead you to the key value metric.
Hint #2: The customer discovery work you performed during the early design-thinking stage is an ideal place to gain the needed insights to figure this out. After you confirm your product offers specific value to a prospective customer, ask them how they would go about quantifying the value, assuming that’s not already obvious.
As consumers ourselves it’s second nature for us to do mental ROI calculations. For example, think about your various options for commuting to work. You could ride a bike, drive yourself in a car, carpool with a co-worker, take a taxi or rideshare, or use mass transit options (bus, train). Each option carries a different combination of cost, value and risk. You might even have a primary commuting method but then vary from time to time based on a particular situation (ie – an evening event where alcohol will be served).
TIME TO BLEND
With your value-based price serving as a base, now it’s time for a sanity check and likely adjustments. You’ll do this using the other pricing strategies mentioned previously.
- Profit Margin – If you’re lucky you will end up with higher gross profit margins than needed. If not, then you can either accept the lower gross margin and offset somewhere else (lower expenses, improved CAC and CAC payback, etc) or you can raise the price but knowing your customer value equation won’t be as attractive.
- Competition – If you’re lucky you will end up with a price that’s equal to or lower than equivalent competition. If not, then you can either accept the fact that the competition has an even better customer value equation or you can reduce your price to be more in line.
- Market Share – This method of blending is more philosophical than economical. In fact, if during the Competition evaluation you discover that your value-based price is lower than the competition then you also have a built-in market share gain pricing strategy. If you really want to get aggressive on gaining market share, you could lower the price even further. It’s also possibly obvious that the market share and profit margin strategies are in competition with each other.
This blending exercise rarely works out perfectly, with each strategy in ideal alignment with the others. So prepare to make some trade-offs and where you find yourself misaligned with one or more of the strategies, think about the improvements and optimizations you can make somewhere in your product strategy or operating plan to bring things into better alignment. Here are a few examples:
- Product cost reduction
- Product functionality improvements, including highly unique, exclusive or innovative features
- Reduced customer acquisition cost (see related article titled “Visualizing the Interaction Between CAC, Churn and LTV”)
- Reduced expense-to-revenue ratio
- Improved sales productivity (shorter sales cycles, better win/loss rates, larger deal sizes, etc)
Extreme Value-Based Pricing
Now that you understand the exercise, including the importance of starting with a price that equates to customer value, let’s take the exercise to an extreme. The idea here is to put the company 100% at risk with regards to monetizing your product. In other words, if the customer doesn’t get any value, you get ZERO. If the customer gets partial value, you get partial payment. If they get extreme value, you get extreme payment. In this way, you and your customer are perfectly aligned.
This is what contingency or success fee pricing is all about. Some employment recruiters will accept an engagement that calls for a success fee. If they don’t bring you a job candidate that ends up getting hired and stays employed with you for at least 90 days, they don’t get paid for their work. But if they do have success against these criteria, you pay them 25% of the new employee’s annual salary (or whatever their contingency rate is). Civil trial lawyers sometimes do the same thing when working with a client to sue another party.
If you were to only get paid if your customer receives value, what would that look like? What would the pricing metric be and how much would you charge per metric unit?
Before getting to this section describing extreme value-based pricing, you might have fallen a little short when identifying your value-based price. Here’s an example using a company named Shockwave TeleHealth that offers a telemedicine service to doctors. During their customer discovery they find out that doctors are eligible for insurance reimbursement when they and their patients use telemedicine for follow-up visits. If instead they do the follow-up visits via phone call, there’s no reimbursement. Better yet, a telemedicine visit is more convenient for the patient and also introduces some efficiencies for the doctors in the practice as well as their staff.
Shockwave TeleHealth decides they will charge $500 per month per doctor that decides to use the service. If only 3 doctors out of a 7-doctor practice decide to use the service, the practice will only be charged $1,500/mo rather than $3,500. They determine this strategy is both fair and better prices the service to the value delivered.
After launching the service they realize they are still leaving the doctors at risk and it’s causing an inhibitor to closing deals. The doctors make, on average, $50 from the insurance reimbursement for each telemedicine visit. This means that as long as a given doctor conducts more than 10 telemedicine visits per month, their value will exceed their cost. But fewer than 10 telemedicine visits leaves them with negative value. The doctors are forced to predict their future usage frequency for a new and unproven service, which is also dependent on the patients’ willingness to use a telemedicine service.
Shockwave TeleHealth then evaluates extreme value-based pricing alternatives. In doing so, they are reminded that the doctors only get value when the telemedicine service is actually used. So in order to put the company 100% at risk, it means only getting paid per telemedicine visit. Voila! They have their new extreme value-based pricing metric. Rather than per-doctor per-month, they decide to price the service based on telemedicine appointments completed. Since the doctors stand to gain $50 each time from the insurance provider, Shockwave decides to charge $20 per telemedicine visit. It means the doctors only get $30 net per telemedicine visit but with zero downside risk and unlimited upside potential.
The other benefit of this approach is that it causes Shockwave TeleHealth to put extreme focus on service utilization. Doctors that use the service 20 times per month are significantly more valuable than ones that use it fewer than 5 times per month. What are the differences between the high versus low utilization doctors? The answers could lead to marketing and lead generation strategies, improved customer on-boarding and training tools and better customer success processes. All good things for building a well-oiled, scalable and profitable machine.
When Value is Tied to Avoidance
Much of this article is centered on customer value and most of the examples given relate to some incremental and quantifiable value (ie – new source of income for Shockwave TeleHealth’s physician customers). But some startups have value propositions that relate to some form of avoidance. In other words, avoiding some negative outcome or dramatically reducing the odds of some negative outcome. In these cases, it might be much harder to find a viable value-based pricing strategy and nearly impossible to take it to the extreme.
Here’s an example. A company named Shockwave Superhero has a technology that helps reduce several forms of violent crime. An extreme value-based pricing strategy would compensate Shockwave Superhero only if the rate of violent crime is reduced. This requires a benchmark to serve as a starting point. In other words, a city might currently experience a monthly violent crime rate of 1:500,000 citizens. Shockwave decides to charge $500 per month per 1% reduction in the violent crime rate. This might seem straight forward but the over-simplification glosses over a few challenges with these types of avoidance-based value propositions:
- Demonstrating improvement might be much harder with some customers than others (ie – one city at 1:800,000 versus another that is already in much better shape at 1:200,000)
- What if other measures are being taken at the same time to improve on the benchmark? Your product could be achieving its results but other unrelated actions are having a negative impact and it’s causing your company to not get paid.
- How valid is the benchmark and how possible is it to measure improvements over time? Who is responsible for conducting the measurements?
- Once considerable improvement has been achieved, the opportunity for continued improvement diminishes.
Sometimes we go through the extreme value-based pricing exercise but due to the extreme risk it puts on the cash burn rate of the company, we aren’t able to swing the pendulum quite that far. That’s OK. It’s the value from the exercise that you are looking for. Understanding the absolute, ideal value-based price from the customer’s perspective will surely help you in the long run.
Perhaps you start out like Shockwave TeleHealth but while working on various business model optimizations to allow you to migrate towards a more extreme value-based pricing strategy and metric. If you never go through the exercise of determining the most extreme value-based price, you will be flying without full and clear vision.
Note: See related article titled “Thought About Raising Your Prices Lately?”
Next Best Thing
Sometimes we aren’t able to find a pricing metric or strategy that meets the “extreme” definition outlined in this article. You might discover this disappointment when trying to create your ROI calculator spreadsheet. Perhaps you’re only able to identify “soft” and non-quantifiable value and benefits.
This not only makes it harder to come up with an ideal pricing strategy but also makes it harder to sell your product and message your value proposition in the most compelling manner. Maybe that will change over time as your product and company evolve. And I still believe that going through the exercise of trying to discover an extreme value-based pricing strategy will prove helpful, even if not successful.
Freemium and Free Trial Offers
I’ve mentioned in some of my other articles and videos that freemium and free trial offerings aren’t as much pricing strategies as customer acquisition strategies. But just as we identified money-back guarantees, success fees and contingency pricing as a way to reduce risk on behalf of the customer, we can use freemium and free trial offers to accomplish the same.
The customer gets a period of time to experience the value of the product without a financial commitment. In the case of a freemium offer, they aren’t getting the full functionality, so the key is to make sure the customer can mentally extrapolate the incremental value from the paid features to cause them to make that jump (ie – conversion). In the case of the free trial, they’re getting full functionality but for a limited amount of time.
See related article titled “Optimizing Free Trials Conversions Using Nurturing“
For those of you that don’t have an ideal value-based pricing metric or can’t go to the extreme as described in this article but are still finding customers hesitant to take the risk, consider a freemium or free trial offer to help reduce that risk.
Pricing strategy is an iterative exercise that might never end for your company. That doesn’t mean you’ll whipsaw yourself and your customers with different pricing metrics and methodologies every year but it likely means that as your product, company, competition and market evolve, so will your pricing strategy. Make sure to keep your eyes and ears open while including various KPI’s and associated metrics on your dashboard to alert when things change that might relate to your pricing strategy.
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