VC firms should invest in portfolio companies’ pricing excellence
Pricing excellence is a critical success factor for early-stage companies, but one where companies often stumble
Pricing is based on value, and an understanding of value cascades through all product development, segmentation, marketing and sales decisions
You cannot wait until you are in the market to come up with a compelling approach to pricing
There are high-impact ways to help your investees with best practices today
The Impact of Pricing Excellence
Industrial firms have understood the power of the pricing lever for years. A 1% increase in average price drives more additional profit than a 1% increase in revenues or a 1% reduction in costs (see for example Pricing and Profitability Management by Julie Sheehan, Mike Simonetto, Larry Montan and Chris Goodin of Deloitte). Leading firms have invested heavily in developing pricing strategy and improving pricing practices and have consistently generated a high ROI on these investments.
But there has been much less focus on the importance of pricing to early-stage companies. Some people will say that pricing is a secondary issue, one that can be addressed later after market traction has been demonstrated. Or that early-stage companies should concentrate on product-market fit and that if they get that right the rest falls into place. There are even investors who believe ‘the market sets the price.’ All of these people are wrong. Without pricing excellence early-stage companies cannot meaningfully
Segment their markets to focus where they can win
Make effective product investment decisions that will create value
Establish the compelling value stories that they need to have a market impact
And pricing is a critical vector for innovation in its own right. Companies that deliver a new pricing model are much more likely to win high returns for investors than those with a ‘me too’ approach. Google and Pay per Click advertising is a compelling example. And with the advent of cloud computing and the infiltration of software into many new and existing product categories we are entering a golden age of pricing innovation. Investors need to drive their portfolio companies to take advantage of this.
What is Pricing Excellence?
Pricing excellence is about more than just picking a number. For B2B companies it begins with an understanding of differentiated economic value.
What does this mean? Economic value is always for a specific customer (or a well defined market segment) relative to an alternative. And there is always an alternative, whether it is a direct competitor, a substitute, ‘doing what we have always done’, or even ‘doing nothing’. Economic value is the ways in which a solution (i) increases a customer’s revenue (ii) decreases operating costs, (iii) decreases operating capital or (iv) decreases capital investment.
In consumer markets value is often more psychological and social than economic (though there are exceptions in these tough economic times). Here the best practice is to treat price as part of the overall brand concept and to tie pricing into the brand benefit ladder.
Too many companies begin with product development, then look at their costs, come up with a price and finally see if there are any customers willing to buy at that price. They may never understand how the customer gets value relative to the alternatives. A better process is to start by understanding customers and how to create differentiated value for them. This determines product features and price. The customer doesn’t really care about the vendor’s costs. Of course if your investee cannot find customers and then deliver and capture value at a price that is well above cost there will not be a business; but you want to know this before you make an investment and not after.
Companies also need to have pricing discipline. They need to understand and stand behind their pricing and be able to communicate it to the market. Some early-stage companies, desperate for revenues, default to discounting and call this an investment in the market. One should only make an investment in anticipation of a return, so always ask what return is expected on the discount and how this return will be captured. In most cases, price objections reflect a failure to communicate differentiated value (or the absence of differentiated value) and not actual pushback on price. Discounting is the easy way out.
Is based on an understanding of value
(economic in B2B products; psychological and social for B2C)
Uses pricing metrics that align with how the customer gets value
Is tuned for each market segment
Requires discipline and courage or it will be eroded by ad-hoc discounting
Is part of a coherent go-to-market strategy
When does pricing excellence matter?
Defining market segments
Segmentation, even micro segmentation, is emerging as a best practice for early-stage companies. We don’t want to boil the ocean and we need to use capital efficiently. Too many segmentations are based on large-picture demographic variables. The best practice is to use value drivers and the customer buying process as the foundation of a market segmentation. The work done to understand value is a critical input into segmentation. Demographics can then be used as proxies and to estimate the size of an opportunity.
Making product investment decisions
Time is life for start-ups and many choices need to be made on what goes into a solution and what can be left out. Understanding value is a critical lens for making these decisions. One wants to invest in those features that increase differentiation value.
Designing the go-to-market strategy
A good go-to-market strategy is targeted at a small number of market segments and is aligned with the customer buying process. It is critical to get pricing right as a poor pricing structure can kill the best product in the best segment. Ask your investee if the pricing metric (the unit in which the solution is priced) aligns with how the customer is able to buy and how the customer gets value. Make sure the pricing metric does not stand in the way of adoption. For example, the always popular ‘per user’ price can smother a viral adoption model. And the pricing strategy (penetrate, skim, market following) needs to be coherent and aligned with the go-to-market approach.
Building content for inbound marketing
Inbound marketing is another best practice that is drawing a lot of attention. Good inbound marketing depends on providing the right content at the right time so that the customer’s natural buying process is well supported and value is provided each step of the way. Communicating differentiated value, establishing the most relevant alternative in the buyer’s mind, and managing price expectations are all a critical parts of inbound marketing.
If a sales person is not able to communicate the economic differentiation value to a buyer the only fall back is to negotiate on price. And few things destroy an early stage company’s value like early and persistent discounting.
In our next post we will focus in on how early-stage companies can come up with a pricing metric and use it to drive innovation.