How to set up an effective pricing strategy
The following questions will help guide your pricing strategy decisions, starting with a top-down approach and ending with cost structure.
Whether your startup product is a B2B Software-as-a-Service (SaaS) platform, a marketplace, or a B2C mobile app, getting your pricing strategy right is one of the most common and difficult challenges facing early stage founders.
Early stage tech startups almost always under value their products, which is largely a reflection of their own confidence in the product rather than the value of the problem they are solving. By under-valuing your product, you are not only leaving money on the table, you are also lowering your perceived value in market and risk turning off more sophisticated customers who will be more valuable to your startup in the long run.
On the other side, in the introductory phase of your product launch, you won’t have the credibility of existing products in market so a higher price may become a barrier for potential customers to trial your product. As well as gaining precious revenue, early adoption is essential to demonstrate traction, validate your product and start gaining organic growth — all important indicators for potential investors.
Getting this wrong can have a double hit on your back pocket, resulting in a drop in both revenue and investment potential. So what’s a startup founder to do?
An effective pricing strategy goes beyond simply using direct costs as a guide to the path to profitability and need to be carefully considered within the context of the problem you are solving for your customers.
The following questions will help you guide your pricing strategy decisions, starting with a top-down approach, your market positioning, and ending with your cost structure.
The strategies in this guide will help you:
Minimise adoption friction
Attract your ideal customers, who are most willing to pay for your product
Maximise your revenue and investment potential
Help you gain critical mass within your initial customer segment
Give you a strong base to build from and achieve scale
How do you use your brand to motivate buying behaviour?
No matter what customer segment you are targeting, the pricing strategies for your startup must be congruent with the brand story you are telling to your customers. It is imperative for you to understand the motivation for your customer’s buying decision.
The first step is to understand what the solution is worth to your customers. How much does it currently cost them (or what is the opportunity cost)? What have they done to try and solve it before? How much have they spent to date on this? How readily will they spend money to solve it?
The benefits of using a new solution are usually quantified as time, cost or revenue. If the current cost or potential benefit is time, this will be more difficult to quantify and sell. If it is reducing existing costs, the saving potential needs to be worth much more than the perceived effort to change. If it can increase revenue and income potential, then it usually has the greatest perceived value.
In trying to position your brand and solution, think about where the true value or ‘wow factor’ is coming from. Is it the complexity of the issue you are solving a super slick and simple user experience; a really high technical capability; based on the reputation or credibility of your team; or a truly innovative application of a particular type of technology?
The next step is to research the potential competitors in your space, both locally and internationally, as well as substitutes (the different ways this particular problem could be solved). Finally, consider what other tools your target customers use, for different purposes, as this will give a good indicator of what they are willing to pay for and how much.
Research shows that consumers use price as a cue to gauge perceived value. With this understanding of the perceived value of the problem, the ‘wow factor’ of your solution, and what people are willing to pay, you can then consider how you want to position your brand and solution, and how this needs to be reflected in the pricing.
Is your market big enough to generate enough revenue at a certain price point?
When investigating your market size and how much you think you can capture, the TAM SAM SOM model will give you an understanding of the total potential customer pool you could access.
For each of the price points you are considering, you can then determine what the total potential revenue is based on the size of your target customer segment, and whether this stacks up against the investment required to build the product and the effort involved in capturing that market.
If you have a large market to draw from and are therefore aiming for scale, you can afford to start with a low price point as there is more room to make money with volume.
Keep in mind that it is really difficult to capture a large market in the early stages of a business; the more you can focus on a narrow customer segment who inherently knows the pain of the problem you are solving, and therefore has the greatest value to gain from your solution, the more likely you are to find product–market fit and get to a position where you can scale.
If you focusing on a smaller or more niche market, you may need to set a higher price to help cover your costs and make a profit from a smaller set of customers.
For tech businesses that have a highly scalable product, you should also consider what additional customer segments you can or should access beyond your initial customer segment. It may be a case of having a lower price point to get to critical mass within your first customer segment, get the feedback and traction you need to get the product right, and then look to expand into new customer segments or geographies to increase your revenue and profit potential.
It is also critically important as an early stage startup to consider how — as an often poorly funded and poorly resourced team — you are actually going to win your customers, and realistically how many you can sign up in the early stages.
<!– wp:acf/pm-alert {"name":"acf/pm-alert","data":{"title":"Hot tip","_title":"field_63dc5c208a0a7","content":"Please don’t apply a percentage to your total available market and claim this as your market potential — no one will believe you.
“,”_content”:”field_63e3067fb31ae”},”mode”:”preview”} /–>What is your go-to-market strategy?
Your go-to market strategy is, simply put, how you plan to get your product into the hands of your customers.
Think about where your target customers spend time, what interests they have and where they go to learn about interesting and new things. This is where you want them to find you.
But you can’t afford to just sit back and wait for them to find you, you also need to consider how you can access them in a way that will allow you to cut through the noise, get their attention and share a message that they will be receptive to.
There are generally costs associated with these activities. Some channels will be more effective than others at convincing people to try out your product. Some other channels may be better at not only getting people to sign up but also become active, loyal customers and advocates.
If your sales process is lengthy, there are high costs involved in people’s time as well as the risk involved in closing a sale. You also need to effectively onboard those users and provide ongoing customer support. These ‘Costs to Acquire a Customer’ (CAC) need to be recovered by the revenue gained through the sale.
Even if it is a relatively quick sales process with higher volumes, you need to consider the cost to acquire a customer and the amount of revenue you will earn over the length of time they will continue to pay for your product, known as ‘Lifetime Value’ (LTV). If it is a transaction based business such as e-commerce or a marketplace, you need to consider the average basket size and likelihood of repeat purchases.
This ratio, between LTV and CAC should be 3:1 to become a viable business.
What is the industry standard for profit margins in your domain?
In almost any vertical you operate in there will be a rule-of-thumb for pricing models and profit margins. The ATO publishes profit margin benchmarks across all industry types for small businesses in Australia and is a great source for this data.
Long before my catering marketplace startup Caitre’d was acquired, I decided to take 10% of the transaction from only the supply side as my margin. I did this because I wanted to be fair to my suppliers who were small businesses themselves, and I didn’t want to charge different customer segments more in case it would just make them go direct.
It wasn’t long before I realised it was an unsustainable pricing strategy. Out of that percentage, I had to pay for everything in my business including labour and product development costs. After doing more research in which I found similar models charging 15% to the supply side, I did the same, and offered catering “packages” to customers based on a 5% markup to bring the overall profit margin up to 20%.
In a matter of days, I’d doubled my gross profit margin.
What are your current and projected fixed and variable costs?
Working out your costs will be able to give you an understanding of how much you need to charge to cover your costs and start earning profit.
You will have some fixed costs, which you need to pay to operate effectively and can be estimated with reasonable accuracy. Variable costs go up or down with the number of customers or employees.
If you are not yet sure what your costs will be, focus on making informed yet flexible cost estimations. There will be some common and basic costs for your type of business, such as company registration, insurance, hosting, office space, legal costs and software subscriptions.
You need to consider what capabilities you have in your founding team, and therefore what skills you need from your first hires. How much you should be investing in your marketing at each stage of your business can be harder to work out, so chatting with other founders in your space will be a good starting point for this.
A break-even analysis will help you work out how many sales you need to make to cover your fixed and then variable costs — and preferably, with a buffer — and at what point you can afford to bring on more resources to help you out.
With most tech businesses, there is significant investment made in a single product that can then be readily resold to many customers. With an understanding of how many customers you can realistically acquire, this break-even point will also give you an idea of how long you can bootstrap your business or if/when you are likely to need investment, and how much.
When and how much do you plan to pay yourself?
Just today I spoke to a tech startup founder who has an MVP in market. She insisted she was profitable. I asked her if she was paying herself. She was not.
There is a mythical quality in startups about salary sacrifice. And yes — in the early days of your business when money is tight and customer acquisition is everything, prioritise revenue growth, reinvest profits and live off of savings and ramen noodles. But it’s not sustainable.
So how do you price a product that can help you start to pay yourself ASAP? You need to include the cost for your time when calculating your cost base, even if you start small, becaise something is better than nothing.
Set targets for revenue as well as your other important metrics, and when you hit these then you should reward yourself as your business performance improves. This helps create positive momentum and focus on the right things. It also helps avoid burnout and getting to the point where you are wondering why you are even doing this when you hit the trough of sorrow. And it is defensible for investors, who generally don’t like putting money into your business only to have it end up in your own pockets.
It someones get lost in the startup world, but the ultimate goal in business is making money and becoming profitable — not raising capital.
Yes, it is important to continually invest in your business and product, but ultimately as a business owner you want to get rewarded for all the risk, blood, sweat and tears you put in.
