What’s on that Price Tag?
12th July 2012 · 0 Comments
Here’s a subject that seems to be top of mind for a number of local entrepreneurs this week. Pricing is both an art and science, and just creating a price list for a product line is no small challenge. It’s a balancing act between what you think the market will bear and what actually enables you to operate a profitable company.
You will recall the theory of price elasticity from your undergraduate economics course. Peachtree Software was a case study on that in the early 80’s. We had begun selling individual components like general ledger for $1000, so a full suite of accounting could run you $5000 or so. Of course in the very early microcomputer days you could also spend $15,000 on the hardware to run these applications. The competition was the minicomputer industry where turnkey systems could easily run into six figures, so what we had looked like a bargain relative to the norm.
After we sold Peachtree to MSA, and then after I had departed and it was sold again to Intelligent Systems, I returned to the board. The industry had a general slump around 1984, and Peachtree’s momentum had been lost in the face of some price competition by new entrants. I suggested a radical rethinking of the pricing structure, and one of the engineers came up with a way to repackage the product on much less media and therefore lower the costs of disc replication and packaging. The price cut was on the order of 90%, with a whole suite now around $500 as I recall. Whatever the specifics, the theory of elasticity worked as advertised, and total revenues exploded upwards. The brand had already been established, and that re-pricing backed it up with unit volume and market share. But for that pivotal event, the company might never have achieved the sustained success it enjoys even today as part of Sage.
The freemium model has come into vogue in recent years where there is little or no incremental cost per customer and you have a product line that lends itself to conversions from free to pay plans. The best dissection of this model I’ve ever read is Ben Chestnut’s blog from September 2010 on how MailChimp enjoyed extraordinary growth by adopting a freemium model. That propelled them to over a million users by last fall, and there’s no looking back. Of course, as Ben aptly notes in his post, the trick is covering your expenses when you launch a freemium plan. In his case the company had become self-sustaining and was financially prepared; if you’re contemplating this from a standing start, then your investors have to have the patience to hang with you until the model starts to pay off.
The SaaS model is another way of looking at this. Many B2B companies have gone this direction and are making purchasing decisions easy for those who are essentially paying by the drink or via a time-based subscription. If you’ve developed a complex enterprise product, this deprives you of the ability to fund your company with customer dollars with a hefty upfront license fee and the trusty annual 20% maintenance fee to boot. Here again you need to have a foundation of capital to allow the revenues to catch up with the expenses, but your longer-term prospects are probably more market share and that magic potion “recurring revenue” that intoxicates investors.
In the Valley there’s been plenty of success with the just plain “free” model. Just build something, get lots of users, and see if you can find something to charge them for later on. That has worked in spades for companies like Instagram with its $1B exit to Fb. And, it may work for Twitter over time. But, that requires the ultimate in investor patience, and it’s a very difficult sell to investors outside the Valley ecosystem.
And, particularly in the apps world, there’s always the running debate of advertising revenue versus transaction or subscription revenue. Again, investors are more skeptical of purely ad-based plays, and large brands can also be pretty skeptical until you show up with a working product and a bunch of users. If I’m raising money for a deal, I know a quantifiable transaction or subscription model is a much easier sell.
Apart from the various models you may be considering, there’s the fundamental question of just how do you decide what to charge? You can’t hold your finger up and try to sense the wind direction. I’m seeing entrepreneurs doing some interesting surveys on Fb for more consumer oriented products, and I’m seeing enterprise deals being priced based on a projected ROI to the customer. No data is as convincing as making some actual sales, of course, but you’ve got to make the first move and put some number out there.
My preference is to evaluate pricing in the overall context of your business model. You certainly need to look at the competition and do whatever research you can to sense what will work in your chosen market. But, until you feed your pricing strategy into a business model that reflects all your costs and spits out your capital requirements, you won’t be able to make a properly informed decision. Let’s say you’re doing a pure transaction fee model for consumers. You’ve got some variable costs perhaps in charge card or PayPal fees, but you’ve also got to generate enough revenue to cover all your operations from customer service to technology and make an eventual profit. You may be looking at a competitor that is getting 15% and think they are committing robbery, but when you work through all the equations you may realize there’s a good reason for that fee. If you undercut too much, you may gain market share and price yourself right out of business. On that point, if an established player in your market is setting a pretty good price umbrella, don’t think you have a duty to give the customers too much of a break. Take advantage of the headroom and give yourself some margin for error.
<image of Minnie Pearl from Wikipedia>