Profit 101 #7: Pricing and Unit Economics
Jul 24, 2023
If Your Unit Economics Don't Work Now...
Figuring out pricing (how much to charge your customers) is challenging for any business - but it's even more challenging when you're a startup and don't yet have a sense for your product's value in the market. Recently I've seen some interesting examples in startup land - examples of some founders underpricing and risking insolvency even as others founders are overpricing and risking lost deals. How do you tell which side of the equation you're on, and when you've got your price set just right? Let's start with underpricing, then look at overpricing, and finish with the sweet spot.
Underpricing: If the Unit Economics Don't Work Now...
In some ways pricing is actually easier when you are selling a product or service with unit costs, because your price has to be greater than those costs. To take a simple example, at Fraction we can't charge less than we pay our fractional developers, or we'd be out of business in a hurry! Gross margin targets vary by industry, but in an ideal world (for non-software) you'd love to be at or near 50% - this means that 50% of your price actually comes back to your business after paying for the cost of goods + services provided.
With a SaaS business, you'd like that gross margin to be over 90% because you have almost no unit costs - which gives you a lot more flexibility in pricing. But in either case, it's a good idea to start with low (but profitable) prices and build up from there. Why? This enables you to eliminate a variable when reaching out to customers. Price can't be the reason you are failing, because you've already gone as low as you can go! The ugly truth this may uncover is that no one wants your product yet, but that's a valuable truth, and it's equally likely that you're just selling to the wrong audience.
One thing not to do: don't pretend to be Uber/Doordash/etc and price with negative margins, with the hope of fixing this later. I've met multiple founders trying this, and it almost always meets with misery, because you need hundreds of millions (or billions) in capital to keep giving away product for less than it's worth! Remember, as exits go, the WeWork/Uber/DoorDash crowd didn't even do particularly well relative to startups with better economics. Does anyone remember MoviePass? It's easy to get customers when you are giving stuff away for free - but it's not a business model.
I've actually seen multiple startups near death, and with excess demand, but afraid to raise prices because it would chase customers away. Let me be honest - it's better to fail for lack of customers (with positive unit economics) than to thrill yourself with a lie, and just close up shop later. Don't do it.
Overpricing: If it's Cheaper to Just Build it Myself...
At the other extreme, some startups end up overpricing their product. This could happen for a myriad of reasons, but the result is the same - profitable business is left on the table because rational buyers have a better option.
When considering your solution, buyers will always consider how they do things today, and they'll likely also consider the cost of just hiring people to provide the same service for them (in a b2b context). Whatever product or service you're providing, ask yourself: how much would it cost for my client to provide this for themselves, or via the next best alternative?
Startups that compete against human services should be particularly wary. A few startups I've observed recently priced their offerings for more than it would cost to hire skilled professionals to provide the same service. There's no easier way to get yourself eliminated from competition - if your offering has a human component, and your gross margin is 80%, you're probably going to get laughed out of the room.
Instead of overpricing, start with the lowest profitable price you can establish, and raise from there as you get traction.
Finding the Sweet Spot on Price
Here's a relatively simple approach to searching your way to an optimal price:
Start low, at a price that clears a profit, but at the lowest non-zero margin that you can stomach.
If you can't find any customers at that price, focus on everything else, because you've eliminated price as the key variable. Find different buyers, tweak your product, etc - but rest easy knowing that price wasn't the failing.
Once customers start to buy, start raising prices. Older customers will actually feel good because they got a better deal, and as you raise prices you can watch for declines in close rates.
Keep raising prices as long as close rates remain the same. Once they start to falter, it's decision time: are you optimizing for revenue or for growth? You can likely maximize revenue by raising a bit more - but you kght maximize business success by capturing more market share first.
At HiddenLevers we started at $30/month and told users that this was an 85% discount to the long-term price. We also told those OG customers we'd let them keep half off the long-term price for life (after a super-discounted first year). This rewarded the original customers for sticking with us, while raising their long-term price to a viable level. From Jan 2010, when we first started to get B2B sales, to late 2010, we raised prices from 30, to 50, to 100, to 150, to 200, to 250 - finally stopping at 300. $100/month turned out to be growth maximizing in terms of new sales, but $300/month was revenue maximizing given that one sale at this level was equal to 3 $100 sales. As bootstrappers we chose to maximize revenue immediately, and so we stuck with higher prices - but your approach may need to vary based on your short and long-term goals.
Remember that pricing is a dynamic game, and the right price fluctuates with market demand, your competitors' offerings, and other external factors, not to mention how much value you are bringing to the table. But try to find that sweet spot from the bottom up, and it's one less problem to worry about!
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