Tools Used In This Recipe
Pricing is typically a challenge for founders because it's usually not something they've had to focus on before. Founders who come from product development backgrounds in larger companies typically had someone else setting price, and founders with backgrounds in sales might have had leeway to discount but still operated off of a reference price list. Pricing is also not often a core subject in university programs like MBAs. While the factors that influence pricing decisions are different for every startup, in this Recipe we'll list a number of things you should consider when setting price. We'll also cover a number of pricing strategies and identify types of products that should (and should not) consider using them.
B2C products (as opposed to B2B) are typically in competitive markets with many direct and indirect alternatives and relatively high price transparency. Because of this, the first step in pricing a B2C product is to understand your competitors and their pricing. Start by making a list of direct and indirect competitors (for a coffee chain like Starbucks a direct competitor would be Dunkin' Donuts, but an indirect competitor would be an energy drink since both address the same customer need).
You can use search engine keywords to help you find competitors if you are having trouble, but you don't need an exhaustive list of competitors. The five or six most well-known should be enough to understand pricing in your market. Build a matrix of each product, and its price. Take a look at the features of each product. Do any offer features not found in the competition? If so make a note of those.
You are likely to find that prices for your competitors tend to fall in to clusters. After all, these competitors also do price research on their competitors. For B2C goods products tend to cluster in three groups; budget, mid-level, and premium. Often there are feature differences between the tiers, but not always. Some products target the luxury market based only on their visual appeal, and some use their high price as a signal of quality. Your startup's product will need to fit into either the mid-level or premium cluster.
There's no single factor to use when deciding whether to focus on the mid-level or luxury market, but your decision should hinge on your product's differentiating factor. Why would a customer buy your product vs. a competitor? How important is that difference to them? Does it save them time or money? Does it provide emotional value? Also consider whether the competition in one market is weaker than the other.
Picking your initial go-to-market price can seem like throwing a dart at a board. One quick way to set your initial price is simply to identify the market leader in your category and set your price to match theirs. However if you have access to a group of people who are knowledgeable about your market and competitor offerings you can survey them to get an understanding of how they value your product. For a detailed walkthrough of this process, see the related Recipe:
Once you have identified your market segment and initial price, set your price 10-20% higher than your go-to-market price but list it with an initial discount so that it matches your go-to-market price, and make sure your pricing clearly shows both prices; the list price and the discounted price. This has three benefits to you as a startup:
- Showing a discount next to a list price is one of the most common ways to take advantage of pricing psychology to encourage customers to purchase immediately, for fear that the discount will expire.
- An initial discount gives you the ability to experiment with different discount levels to better understand your product's price elasticity. If you obtained your initial price through a survey this process will help you eliminate errors in that process.
- Customers understand that discounts are temporary and are less likely to react negatively if they change.
If you sell online, use your Website's analytics tools to measure conversion rates at each discount level. Once you have enough sales to identify the price point where conversion rates start to fall, you can set your product's price just below that to maximize revenue.
For products that aren't considered commodities there are often multiple features that customers will consider in deciding to make a purchase, and they will often value some of these features more than others. For a TV, screen size is a large component of customer perceived value. But even within TVs of the same screen size, customers may be willing to pay more for a TV that is thinner (because it will sit more flush against the wall). A company that manufactures two TVs with the same screen size may be able to price the thinner one as a luxury item. Tesla famously sold two versions of the same car at different price points, with value-added features like extended driving range per charge being unlocked in software on the higher-priced models.
Having more than one product with different features is especially useful because as your startup grows customers will start to encounter your brand without having made a decision on which product is right for them. Having multiple products will allow them to self-select into markets based on their needs. If/when your funding permits, you should develop at least two versions of your product aimed at different segments. Multiple products also allows you to take advantage of additional pricing psychology tactics.
It seems intuitive that customers' purchase decisions would be entirely rational; given two products of equal capability, customers should always choose the less expensive one. But emotion is a significant component of customers' perception of value. Advertising, marketing, and even the colors you use in your logo or website can all influence the perceived value of your products.
Economists have done extensive research on factors that influence peoples' perceptions of price, especially prices that are shown as a set. The below link is a comprehensive list of pricing psychology strategies. Each one includes a review of the study that supports it.
Pricing Psychology: A List of Tactics
You see a carton of eggs for $3. Is $3 a good deal? How can you tell? What's happening in your brain? Answer: Reference prices. You compare $3 to a "standard" price that you derive from: Previous Prices. How much were eggs last time? Advertised Prices. What price were you promised?
Special considerations for software startups
The unique nature of software, where high initial cost of development is offset by near-zero incremental costs per unit sold, unlock some unique options for pricing. If your B2C startup is Software-as-a-Service (SaaS) based or is offered through a mobile app, this section is worth reading.
Zero is a unique price because it removes the friction of the transaction. Whether your product costs a penny or a thousand dollars there is overhead associated with the customer providing payment. Because software has near-zero cost of delivery it's possible to allow the customer to start to use your product without paying at all. This allows them to better understand its value to them before deciding to purchase. Free trials are by their nature limited, and how you decide to limit them should be based on how it will be used.
Time-based trials are common for software. For a product that is used daily a seven-day trial may be enough time to demonstrate value to the customer. Products that are used less frequently may require longer trial periods. We don't recommend trials lasting longer than 30-days, since you want to push for the customer to make a decision on whether to proceed, and with a longer trial period they may simply forget about your product. Products that charge on a monthly or annual basis should use time-based trials.
Another popular mechanism is usage-based trials. In this model you allow the customer to use your product a certain number of times before deciding to pay. Products that are used sporadically or in bursts work well with this model, and products that offer usage-based pricing should use the same model for their free trials.
Because the incremental cost of each customer is so low with software products, many companies offer a 'free forever' version of their platform with usage-based limits. The goal of a freemium offering is to acquire a lot of customers and to convert as many as possible to paid plans. Dropbox is an example of a successful company that grew using this model. If you plan on adopting this strategy you should consider two things:
- Your upfront capital requirements will likely be higher and it will take longer to reach profitability because customers on free plans may not decide to convert to paid for months or even years.
- Your hiring plans over time will look different than other companies. Instead of hiring a sales force you will hire more product design and copy staff to design upgrade paths and incentives into the product.
You will almost certainly not be able to afford to invest in both sales and product, so once you decide to focus on a product-led growth strategy using freemium, switching will be extremely difficult.
One-time vs. recurring revenue
While plenty of businesses have been based on recurring revenue even before the rise of SaaS business models (for example daycares and lawn care companies with monthly fee structures), software-based businesses are well-positioned to take advantage of recurring revenue models because users receive the same level of value from software over time. Additionally, while it may be difficult to convince a customer to make an initial purchase, unless the product fails to meet expectations customers will generally accept subsequent charges (and in fact may not even review them, especially in the case of credit card charges where customers may not even be notified.
A few considerations for setting up recurring revenue models:
- You can combine recurring revenue with a free trial and/or freemium pricing technique.
- One positive aspect of recurring revenue is that companies generally charge in advance. Compared to more traditional software sales where a company will send an invoice to a customer, who may them have up to 90 days to send payment, getting cash upfront is a huge benefit especially for an early-stage startup. It does create some obligations from an accounting perspective however.
- Given the benefit of receiving revenue upfront you should absolutely provide incentives for customers to purchase longer-term subscriptions. Offering a free month for customers who purchase an annual plan vs the month-to-month plan is a good way to incentivize customers to purchase a longer-term plan. If it makes sense for your product you can offer additional discounts for multi-year purchases.
For B2C startups price is a topic that you'll revisit frequently as you grow. When you start to gain traction, expect competitors to take notice and potentially adjust their prices and product offerings to better compete against you. You'll want to build a mechanism to periodically survey your competitor pricing and offerings and be prepared to adjust pricing over time in order to maximize your startup's growth.