Value-led Growth: Pricing

What I learned about pricing products over the last 20 years of building 10+ B2B & Consumer products.

I started the Value-led Growth series by talking about Soft & Hard Value Proposition. For the second entry I want to zoom in on one key part of the value proposition — Pricing.

Pricing is often quite misunderstood and gets disproportionately low attention to the value it actually drives. In my own path as a founder of ZeroTurnaround this is the area where I feel I made the most mistakes and hope to help you avoid the same fate.

Fundamentally pricing is a function of three equations¹ representing three main perspectives:

• User
(Value Prop - Competitor Value Prop) -
(Price - Competitor Price) > Switching Cost

• Business (unit economics)²
Price = Costs + 5% Profit + Moat Premium

• Channel³
  (Price/Churn) / CAC > 3

Definitions:

• Switching cost is the physical, mental and monetary effort required from switch from a competing product to your product.

• Moat premium is the unit monetary value of the unfair advantage you have over your competition because of scale, innovation, regulation or early-mover advantage among others.

• Churn is the per cent of users churning per period (same period that they pay the Price for the equation to work). Price / Churn is also known as Lifetime Value or LTV.

• CAC is the cost of customer acquisition or in other words average money paid to acquire a single paying customer.

• Note that in the first formula either the value prop or price difference can be negative. A typical situation in an early product is value proposition worse than competition, but a better pricing.

These are nothing new — these are relatively standard microeconomics concepts translated to the startup lingo and married to the user experience concepts. However they are rarely well understood or evaluated in a structured and consistent fashion in my experience.

In my time as the CEO of ZeroTurnaround we hired consultants to help us price our product correctly. They ran panels and produced a semi-believable price sensitivity curve and some suggestions for user segments. However they looked at the price only from the user perspective and did not understand the implications for the business or the channel, which were severe.

Let’s go through them one at a time and then come back to the overall picture in the end.

User

(Value Prop - Competitor Value Prop) -
(Price - Competitor Price) > Switching Cost

As user you will (eventually) use the service that gives you more value at less cost and you will switch services when the gain in value is higher than the time and effort you need to put into going for the new service.

A few things to note here:

• Switching cost always exists. There’s often a misunderstanding that first movers in the market don’t have a switching cost — in reality most of the time their cost is the highest, as they need to educate the market and convince users to change their habits.

• Switching cost is often underestimated. If you have trouble to convert signups to paid users, price is always suspect.

• Switching cost is upfront. A common way to overcome initial switching cost is to do activation campaigns that decrease price for beginning users. But post-campaign the equation still needs to work. Significant post-campaign churn is a sign that pricing is wrong.

• Switching cost is continuous. Users build habits and business build scale over time, so the switching cost can remain non-zero for a long time. Engagement campaigns help build habits and/or scale and overcome the remainder of the switching cost post activation.

• Freemium creates a competitor. A common approach in SaaS to overcome the switching cost is to create a free tier offering. But you should see that free tier as a new competitor with its own value proposition, but without the switching cost. Oftentimes startups find that they can acquire users (overcome switching cost), but don’t have enough value prop left to convert users to the paid service.

• Users are different. Users differ by price sensitivity, value sensitivity and service promiscuity (i.e. switching cost). Choosing the right segment is crucial for your product to succeed. However you need to be very careful to segment the users by their behaviour and the value you drive for them, not demographics or other generic attributes.

• Churn drives segmentation. Users help you to segment them by churning — churned users are likely not satisfied with value prop and offering them better pricing (even temporarily with churn campaigns) will help you to both retain more revenue and understand your users better, eventually driving deeper segmentation.

Note that campaign incentives do not have to be direct or monetary. B2B companies always have trouble directly incentivising and need to look for workarounds.

At ZeroTurnaround we had a quite interesting situation where we didn't have direct competition for our primary product, but the switching cost was enormous due to educational burden and the adoption complexity. Unfortunately it was a B2B product mostly bought by bigger companies, so it was hard to incentivise users to overcome the switching cost. We had to do it the hard way, by reducing adoption complexity and educating the market.

But we also tried other tricks, like building free tools that we gave away and that drove value for the users, creating a channel and reducing the switching cost.

The key to get user pricing right is having a very good understanding how your value proposition relates to pricing, which is hard & soft and which are threshold-based, linear and non-linear.

Business (unit economics)

Price = Cost + 5% Profit + Moat Premium

This is driven by the basics of capitalism — everything you do can be eventually matched by a competitor. Generally competitors also need to provide a return to their investors, so unless you have an unfair advantage (Moat Premium) profits much over 5% are an invitation to undercut you on pricing by giving up profit.

Note that this also assumes that your costs are under control, because even if your profits are 5%, but your costs are bloated, a competitor can still undercut you on pricing and run a successful business. Controlling your costs is absolutely crucial in a competitive market!

There is much more to explore on the costs side, suffice to say that due to increased competitiveness of the tech companies, the next crop of winners will be attacking the cost base and fake moats that are abundant in the current market that is parroting the early successes.

The Moat Premium is the most interesting part of the equation that needs to be well understood to set the pricing right. The Moat is the unfair advantage that the company enjoys ahead of competition and usually is related to one⁴ of the following:

• Economy of scale. That’s the most classic one — both fixed and variable costs can be reduced with scale. This means that the company can have higher profits, but still can be hard to undercut on pricing by smaller competitors.

• Network effects. Some businesses have value proposition to each user increasing with each user added to the network. This can be hard to match by smaller competitors and indeed such markets tend to be effective monopolies or duopolies. Very typical for social networks like Facebook.

• Marketplace critical mass. Marketplaces bring the supply and demand together and need a critical mass of both to be successful. Matching that for a newcomer can be very costly. Moreover as in network effect incremental supply and demand add value for the whole marketplace. E.g. very hard to compete with Booking.com as you need a critical mass of hotels globally (or at least in hot holidays destinations).

• User Data. The very data on user behaviour can create a hard-to-match advantage in value proposition. Famously Google search is very hard to compete with, because they have much better insights into search due to their very scale. Facebook is very hard to compete with in ad targeting, as they have more data on user behaviour than anyone.

• Vendor lock-in. This remains a huge source of advantage for B2B companies, though more and more it moves from deep systems integration, to data migration issues.

• Long-term contracts. Another typical B2B fodder, though it’s not a very strong advantage as it has a natural time limit and a crafty competitor will eat at the customer base piece by piece.

• IP portfolio. Brought up a lot, but actually surprisingly weak as far as moats go. Would be interesting to hear of genuine cases where it works well.

• Brand equity. If you’ve been around for a long time and treated your users well, they’ll be willing to pay a premium, just don’t abuse it ;)

Note that the moat is always a temporary advantage. In the long term technology changes, market changes or just a persistent competitor with a lot of capital can and will overcome the moat. But this may take years or even decades, during which you can use the proceeds to improve your business.

Channel

(Price/Churn) / CAC > 3

Outside of the unit economics we have the customer acquisition cost. This one is crucial as the channel you use and the price you set are intimately connected. Generally the channels come in the following flavours (from least expensive to most expensive):

1. Organic. Organic channels usually have a fixed cost that grows slower than business with scale. It can start with the higher CAC than other channels, but end up much cheaper as the channel ramps up.

2. Direct marketing. Buying users or leads through paid channels, like advertisement or events.

3. Inside sales. Call-center based high volume and high frequency sales.

4. Outside sales. Enterprise guys in suits with golf bags.

Unfortunately channels very much define your pricing. Especially if you go for sales (but also choosing direct marketing over organic growth). The more expensive channels are also more predictable, so make it much easier for the management to deliver consistent results.

It is very important to understand the unintended consequences of choosing a channel.

At ZeroTurnaround we did both a great move and a terrible move on pricing. The great move was being one of the first (in 2009) to move to a subscription for a downloadable desktop software, which allowed us to have a reliable revenue stream with comparable little friction in the market. The bad move was spinning up an inside sales team.

Before that we had very strong organic growth driven by content marketing and community work at a very affordable price that didn’t give people much thought. However, that price point wasn’t sustainable for the sales model so after initial traction with sales we ended up raising the price 3x in a few years. Not only did that make us less attractive for the market at large, but it also damaged the value proposition. People in the developer market really hated getting called by sales, and this reverberated as drying up of word of mouth making us invest even more into inorganic channel. We ended up going from a quickly growing and highly profitable company to a slowly growing company that was burning cash.

So channel can define more than just your pricing — it can also indirectly affect your value proposition, by changing the way people experience your products. Famously, Atlassian refused to build a sales team and instead focused on affordable pricing, resulting in a really robust business that is almost unassailable today.

Often when looking at yet another company adding expensive enterprise sales I wonder if they wouldn’t do better in the long term by just reducing price significantly and waiting for the customers to react to value proposition.

Putting it all together

• User
(Value Prop - Competitor Value Prop) -
(Price - Competitor Price) > Switching Cost

• Business (unit economics)
Price = Costs + 5% Profit + Moat Premium

• Channel
  (Price/Churn) / CAC > 3

Let’s recap:

• Pricing is a trade off between the differentiation from competitors, the unit economics and the available channels.

• Pricing is neither singular (due to segmenting) nor static (due to campaigns).

• Differentiation is generally not long lived, so pricing is driven in the long term by the cost base and moat premium, which is itself driven by scale.

To set the right price you need a deep understanding of your users, your user economics and your go-to-market channels. Time spend on learning and refining that understanding will have incredibly high ROI and setting the right price is key to winning markets and building a sustainable business.

I would be very happy to hear about your experience with pricing as well as your questions and comments on my experience — this is a very deep topic and I just scratched the surface so far.

1. Technically one equation and two inequalities, you win!

2. To be perfectly fair it’s not actually about the fixed profit, but a floor yield on capital. Generally investors expect 15%+ yield on capital in private equity, so this assumes about 1:3 ROI on dollars to revenue.

3. Opinions vary on where a good return on CAC is. Clearly it has to be more than 1, and typically 5 is considered a great return, so I chose 3 as a conservative threshold. Really it depends on other attributes of your business like gross profit and is too complex topic on its own to include in the scope of this post.

4. That’s all I could think of in any case, ideas what else could constitute a moat are very welcome!