Last week, I shared a presentation with an executive team at a large public SaaS company on everything I've learned about pricing. Here's a summary of the frameworks and theory that I've aggregated over a decade of investing in startups.
Why do we set prices? Setting aside the important reasons of generating revenue and maintaining solvency for a business, there are many other reasons to set price. Price reinforces brand because price telegraphs whether a product is a premium product or a value product. Price differentiates products in the market and can be used as a go-to-market strategy. Underprice the competition to gain share. There are many others too.
There are four components to pricing:
- Strategy: what is the goal of the price?
- Philosophy: how does the company price relative to costs?
- Structure: what is the pricing rubric?
- Positioning: how best to communicate the price?
There are only 3 pricing strategies: Skimming, Maximization, and Penetration. Skimming means charging the first to buy a product more than the later buyers. Maximization is charging the most you can extract in each sale. Penetration is under-pricing to gain share.
There are two pricing philosophies: cost-based pricing and value-based pricing. Cost-based pricing is common in commodity markets. To price based on cost, you take the cost of the product and then add a margin. If you're targeting 50% margins, just double your cost and there you are.
Value based pricing means charging the customer what they are willing to pay. This requires understanding their budget and the value of the product to them.
In software, we typically see three pricing structures. Linear Pricing (LP) - Each analytics event costs $0.10.
2 Part Tariff (2PT) - The analytics software has a base platform fee of $10,000 and each analytics event processed by the system costs $0.10 more.
3 Part Tariff (3PT) - Again, the software has a base platform fee but the fee is $25,000 because it includes the first 150k events are free. Each marginal event costs $0.15.
In academic research and theory, the 3 part tariff is proven to be best. It provides many different ways for the sales team to negotiate on price and captures the most value.
There are three ways to position pricing: per unit of consumption (message, analytics event, telephony minute), per person and ELA (enterprise license agreement), which is a prenegotiated deal for everyone in a business.
To figure out the right pricing strategy, it's critical to determine what the buyer cares about. Do they care about cost or value? What is their core unit of their world: people, dollars, gigabytes? How predictable is the pricing plan? And can the buyer clearly articulate the pricing, advocate on your behalf and champion the purchase?
It's also important to understand the seller's needs. How does the pricing change the market size? The unit economics and cash flows associated with the sale? The competitive positioning?
All of these disciplines fall under product marketing. Well run product marketing teams develop these perspectives before product launch. By combining market research, interviews with prospective customers, conversations with the sales team, the product marketing team can develop a unified pricing strategy that is consistent with the company strategy and the sales tactics.
The challenge with pricing is that it's never a constant. As an industry evolves, competitive pressures change, a vendor's positioning changes and the buyer's needs change, so must pricing.
Thinking through these 4 core parts of pricing is critical to ensuring internal alignment and maximizing success of developing the right pricing plan for your business.