Pricing strategies are often the last thing entrepreneurs tackle before launching new businesses. It’s a tricky problem to get right. Price too high and you lose potential customers. Too low, and you lose money. To point you in the right direction, here’s a quick step-by-step product pricing strategy to help entrepreneurs get it right.
Step 1: Choose ONE customer segment to target
For illustrative purposes, let’s say you are launching a new software product that allows companies to digitally engage with their customers to improve customer satisfaction. The companies who would use this software will all be different and have varying needs in terms of cash flow, use, etc. That’s true for most businesses. But to get started on your pricing strategy, you must break your customer base into segments (by things like size, customer-base, or use), and then choose one customer segment to target. Usually, you’ll want to choose the largest segment. But, if you offer a riskier or niche product, then choose a smaller segment to serve as a test sample before reaching out to the masses. For our example, though, let’s focus on large ecommerce sites with a large, fragmented customer base.
Step 2: Choose the competition
Next, you need to find competitors to measure yourself against. If you know exactly who your competition is, great. You can move on to the next step. If you are unsure, I suggest you survey your customer segment to better understand who else they might go to for similar products that solve similar issues. At Holden Advisors, we believe simply asking your customers questions about your business helps tremendously. There’s nothing like a candid conversation with the people you serve to help you understand how your product affects their lives.
Don’t be fooled into thinking you have no competition. There is no such thing as no competition! In any business, you will always have direct and/or indirect competitors.
For our example, we found Sprinklr to be a strong customer engagement platform competitor to measure ourselves against.
Step 3: Quantify the value of your product
Quantifying value means understanding how your product financially impacts your customer. This is crucial because financial impact allows you to calculate a price point and maintain that price against undisciplined discounting.
Say your software company has a highly differentiated software compared to Sprinklr. In that case, you would be justified in setting a higher price (since it provides more value to the customer). But setting prices isn’t just about proving positive differentiation. If you are entering a market, an undifferentiated product will justify a low-price strategy. The key is to find your product’s value points and learn how they impact your customer’s revenue and/or cost. This will help you properly quantify the financial impact.
So how do you find value points? Once again, you ask your customers using surveys, interviews, or in-market testing. We prefer interviews because we can ask detailed follow-up questions in person. You could do a survey, like a conjoint study, to determine willingness to pay, but that tends to underestimate what a customer would actually pay. There is a difference, for example between how much someone says they will pay for a watch versus how much they would actually pay. That’s why the personal nature of the interview works better.
Let’s say through your interviews you determined that your software company had a better AI engine than Sprinklr, which decreased customer churn by 5% and increased the average order size by 3%. Now that you know the value in terms of percentages, you can calculate what it means in dollars to the average customer in the target segment.
Note: In the interview process, remember to keep it simple, though. You want it to be an honest conversation between a sales person and the customer, not a math lesson.
For our software company, the numbers may look like this:
Segment: Large e-Commerce sites
Typical # of customers per year served: 15,000
Average order size per customer: $220
And now for the math:
Increased order size by 3%: $220 x 1.03 = $226.6; 15K x $6.6 = $99K per year
5% reduction in churn: 5% x 15,000 = 750 customers saved; 750 x $226.6 = $169.9K per year.
Financial impact of using our software as compared to Sprinklr: $99K + $169.9K = $268.9K/yr
Step 4: Price as High as You Can
Now that you know the impact in dollars, price as high as you can. You don’t want to take all the value. That wouldn’t leave anything for your customer to feel good about. Instead, you want to negotiate as high of a price as possible while also maintaining a good relationship for long-term growth and partnership. So, in this case, you want to take a portion of the roughly $270K per year your target customer gains from the use of the software. This is called the capture rate.
For an average market, we typically see capture rates at around 40%. If it’s a highly competitive market, or the numbers are estimated and not proven, this percentage can be lower. For start-ups, however, it needs to be much higher. Do not attempt to price low to instigate demand. Here’s why: Typically, for startups, the initial product that’s launched is not the final product, so you need to build in some breathing room for product adjustments based on market needs by pricing higher.
Increasing the price after you launch is difficult and could be disastrous, so don’t be afraid to set your price as high as you can. For our fictitious example of a software startup, we would likely recommend you take as high as 80% of the approximate $270K per year increase in value. This would mean a price point of $215K ($270K x 80%) above Sprinklr’s price point for this segment.
Now, go make some money!