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In a post from his blog, Dave Parker, Co-Founder and CEO of Bundled.com and mentor for the Seattle Founder Institute, explains how to hypothesize appopriate product pricing. Instead of putting off pricing until the last minute, Founders should begin thinking about and planning their financial model early on.
Below, the article "The Mystery of Product Pricing" has been republished.
"Dealing with startups and financial models is one of the areas of discussion that always comes up in product pricing. What’s generally astounding is the lack of thought or time that has gone into the process. I know, I know, you’re busy building a product and can’t be bothered by such triviality. But, when it’s time to prepare a venture ready financial model, you’re going to need to input your pricing hypothesis into your pro-forma document. So let’s get to that hypothesis. But first:
What pricing isn’t:
- SAAS isn’t a price – software as a service is a delivery model (Compared to shipping boxes of software on disks).
- Freemium isn’t a price – it’s a go-to-market strategy that is designed to acquire customers and convert some percentage of these customers to a paid version of the product.
- In App Purchase isn’t a price – it’s a way to monetize the sale of virtual goods within a game.
- Advertising isn’t a price – it’s a method selling Cost per Impression CPM or Cost per Action CPA
- Sponsorship isn’t a price – like advertising, it’s a payment for your offering based on time vs. quantity or CPMs or CPAs
- Lead Generation isn’t a price – it’s a method of selling data to buyers for completed online forms and prospect data
- Subscriptions aren’t a price, it’s a model of recurring billing for an offering
- Affiliates aren’t a price – it’s a model of paying a network of people with traffic a commission for accessing that traffic
- Licensing isn’t a price – it’s (usually) a one time payment for the use of a product. This can also include:
- Maintenance isn’t a price – it’s an annual renewal amount for a license that generally includes support and product updates. This is generally calculated as a percentage of the original fee (15-25%).
- Services aren’t a price – it’s a delivery tool to get your product installed. Generally services should have a cost+ 35-40% Gross Margin (GM).
- Markup isn’t a price – it’s a method of taking a % of the sale of someone else’s product as a reseller of a physical product
- Commissions or Transaction fees aren’t a price – is a % of total sales, like the fee taken by eBay
Pick which of the above BOLD items you are considering for your company and your model. Now the good news, you’ve just selected the product categories to use in your venture-ready financial model.
Categories are the types of products that you will pricing. You can expect to tier these products and prices – one size will not likely meet all. For example, on Lead Generation you will be getting paid a $$ amount for every lead that you sell to your buyer. An easy example of this is when you fill out a form on the web to get pricing for Auto Insurance:
- If the form only has a name and email, it can expect one price.
- However, if the form has name, email, phone number and additional profile information, it will receive a higher price.
- If that lead is sold as an exclusive lead, it will have an even higher price.
So, in your financial model you can show that as:
Lead Gen A
Lead Gen B
Lead Gen C
Price is a number:
Now that you know some of your categories, it’s time to start putting numbers into the spreadsheet for your startup. Here are some basic ways to think about how to price your product:
- Cost based pricing – this is the easiest, and, like Services or physical commerce above, you take your cost of services and mark up the cost to the desired GM percentage. Keep in mind that you need to base that on the fully burdened cost of the product or service. For example, if you are doing a setup or service for a customer, the cost isn’t just the hourly rate of the employee doing the work, it also includes their cost of benefits, office space, technology, communications, etc. For a product you need to include shipping or delivery.
- Value based pricing – what is the most you can charge for your product? DON’T START BY PRICING TOO LOW. You can always lower your price, but it’s incredibly difficult to raise your prices later. This will require some testing.
- Customer based pricing – Understanding your customer is key to knowing what you can charge for your product. Understand the value that they are getting from its use. Do they save time, save money, acquire more customers? It will give you data for the value pricing.
- Quantity Pricing – how do you tier your pricing based on user quantity of users vs. the volume
- Usage Based Pricing – like video storage or former pricing by the wireless carriers for text messaging – NOTE – pricing that is not predictable for customers is generally a bad idea – unless they have few other competitive choices
- Market Comps- what are your competitors charging for a similar product – some of this data is easy to find by using:
- Quora – is a great Q&A site, you can ask about business models and seek pricing data
- Public Companies Data – available via Free Edgar provides the public company data on both quarterly and annual reports
- Competitor web sites – for the most part, they offer fairly transparent pricing information
- Adjacent Comps – are there any adjacent market competitors or proxies for your product?
- Customer Surveys – asking customers what they will pay is useful, but only a data point.
- Average Revenue per User – or ARPU becomes a factor in calculating the number and frequency of transaction Hopefully, you aren’t selling a customer for a transaction, but building:
- Lifetime Value – or LTV will help you establish what you are willing to pay for customer acquisition.
So pick some numbers! We’ll get to the expense side of your model in a different post. Remember to have a $1M business you need 10,000 customers at $100 or one customer at $1M!
Prices will change over time:
Also, pricing will likely change over time, either up or down based on what you have to offer. Make sure on your assumptions page, you create a grid to accommodate that assumption. For example:
Product Year 1 Year 2 Year 3
Lead Gen A $35 $40 $40
Lead Gen B $50 $70 $70
Lead Gen C $15 $18 $18
This will help you build out your model for some flexibility and will save you a ton of time in editing your model.
Don’t make an Epic Fail presenting dumb numbers: See Benchmark Forecasting Data for your Startup here"
To hear more from Dave check out his blog ForestTreesBark and follow him on Twitter @DaveParkerSEA