The single most important business decision in evaluating a business is pricing power. And if you need a prayer session before raising price, then you’ve got a terrible business –Warren Buffett
I read this quote in Confessions of the Pricing Man: How Price Affects Everything, written by Hermann Simon. Simon is a former academic, an ex-professor at INSEAD Stanford, Harvard, and London business schools, who extensively researched and taught pricing theory. As Simon writes in the book, he left academia in 1985 to found Simon-Kucher & Partners, the preeminent pricing consultancy that generates several hundred million dollars a year in revenue and employs more than 300 people.
Pricing power, or market power, is the ability of a startup to raise prices over time. As Simon writes later in his book, “People have asked me thousands of times to name the most important aspect of pricing. I answer with one word: value.” A startup gains pricing power when it creates tremendous value for its users and defend its products from the threat of substitutes and new entrants. The second component is equally critical to sustaining pricing power as the first.
In Zero to One, Peter Thiel professes the same concept: founders should aim to create monopolies. Monopolistic companies have ultimate pricing power.
Simon-Kucher Partners surveyed companies across 50 countries for their Global Pricing Study. Only 1/3 of respondents believed their companies had a high level of pricing power. Does your business?
All of these concepts of pricing, pricing power, value, and defensibility contribute to finding product/market fit. True product market fit should be lasting and enduring product market fit. That means creating disproportionate value for users and buyers of software over time. So the startup can charge more and more for its product as the product improves, broadens and is used by increasingly notable customers.
Transient product market fit, often can manifest as first-mover advantage. The first company to create a category, define a new product, bring a new technology to a market, or exploit a novel distribution strategy does have short-term pricing power. But without a strong defense, it may be the last mover that wins the race. Quoting Thiel again, “Microsoft was the last operating system, and Google was the last search engine.” Startups need the 1-2 punch of first mover and a competitive defense
Pricing evolves as the market changes with the entry of substitutes and threats. Pricing evolves as a startup’s product matures, its brand solidifies and its team coheres. Because of all these conflating factors, pricing discovery is a challenging, ongoing process. The optimal price to charge is a function of the value the product creates and the leverage the business has within the ecosystem.
When experimenting with price, two questions matter. First, the relative pricing question: how much are you willing to pay relative to a comparable product? Second, what do our customers' reactions to our pricing changes imply about our business' defensibility and pricing power? Consequently, what are the implications for our startup’s strategy?