Startup 101

The Business of Pricing Your Product

Figuring out how much to charge for your product is surprisingly challenging. Arm yourself with knowledge of basic pricing options, then make your best guess about what price will bring you the most profit.

• By Patrick Foley
• 04/02/2012

Figuring out how much to charge for your product is surprisingly challenging. Arm yourself with knowledge of basic pricing options … and then make your best guess about what price will bring you the most profit.

Admit it: You've thought of an app and made a price*users matrix in your head: "If I charged $1 and found 10,000 users, that's only $10,000; but if I could charge $10 and still get 10,000 users, that's $100,000!"

The most common advice I hear about pricing is simply to charge more, and there's truth in that cliché; it's probably harder to get 10,000 paying users at all than it is to ask those users to pay $10 instead of $1. You might even get a more committed customer when you charge more.

Michael Sliwinski, the founder of Nozbe, put it succinctly: Pricing helps you choose your customers.

• If you charge $.99 in a marketplace, you're choosing customers willing to make an impulse purchase
• If you charge $100,000, you're choosing larger businesses who expect an in-person sales conversation
• If you charge $49 per month, you're choosing customers that place a significant amount of value on your product and will consider the purchase carefully before committing.
• If you charge nothing for your software and support your business through sponsorship, then you're choosing sponsors as your "real" customers, separate from your users

There is not a "right" answer for pricing; like finding a niche, it depends on your goals, as I discussed in last month's column.

As Nozbe has evolved, so has its pricing. A few years ago, they offered $5, $10, and $15 plans, but Michael found that the expectations of $5 users were just as high as the $10 users, so he got rid of the $5 plan and lowered the price of the $10 plan to $7. This resulted in more happy customers, since those willing to pay $10 before were getting it for less. The $5 users were paying a bit more, but they were getting more features, too, so more of their expectations were being met. Those who were unwilling to pay more than $5 were presumably not customers anymore – therefore, price helped Nozbe choose its customers.

If you look at Nozbe's pricing now, you'll see that it encourages users to try the collaboration features. The family plan lets five users collaborate for "only" twice the cost of a personal plan. Because this seems like a good value, the emotional tug of upgrading to a family plan is strong. I know from experience: I was a happy individual user who upgraded to a Nozbe family plan to coordinate podcast scheduling and production with my cohost and our assistant.

You might have noticed that Nozbe offers a counter example to last month's column. Michael followed his passion and built a very successful product in an already competitive space without choosing a targeted niche. I believe that patience has been a key ingredient to his success; it took Michael a couple of years to get Nozbe off the ground, but now he has a dozen people working for him and thousands of customers.

Patience is also key if you're intent on selling a very low-price product. Being the low-price player means you need to acquire a lot of customers (or have modest goals), and acquiring customers takes time.

Even though I usually encourage startups to charge more, it can sometimes be very effective to price yourself lower than established competitors if it helps you reach a completely different kind of customer. I remember being a happy customer of the music software n-Track a decade ago. They charged about $40 selling to "enthusiasts" while the other players in the space charged more than $100 (sometimes much more) selling to "professionals." Rather than undercutting the competition for the same customers (generally a bad idea), n-Track was choosing new, previously un-served customers (generally a good idea). They found a low-price niche that their competitors had ignored.

Key Pricing Questions
There are some fundamental questions to answer before you decide how much to charge. Are you selling to businesses or consumers or both? Subscription or one-time purchase or both? Self-serve or with a sales conversation? Can you leverage a marketplace? Transparent or mysterious pricing?

Selling to businesses is great because people aren't paying with their own money. On the other hand, selling to consumers is great because you don't have red tape. Selling to consumers seems a bit trendy these days, but Joel Spolsky suggests that selling to businesses is usually the better bet. You can do both, but if you're just starting out, it's better to focus on one (you can always grow later).

Twenty years ago, most software involved a one-time purchase (plus yearly "maintenance" fees for most enterprise software). As SaaS has become popular, more and more software is sold as a subscription. This was a big shift for existing software companies; it changed established fundamentals like accounting and sales compensation. Microsoft even had to create a new partner compensation plan to support subscription pricing.

New companies don't have this past to contend with, and most are choosing subscription pricing whenever possible. Rob Walling described the difference at MicroConf last year: with subscription pricing, you start each month with your revenue the same as it was at the end of last month; with one-time pricing, you start each month with your revenue at $0. That makes subscription pricing pretty attractive, especially for a bootstrapper. Again, it's possible to do both, but leave that to bigger companies.

SaaS also implies self-service, meaning your customer doesn't have to speak to a person to buy or deploy your software. People cost money, so self-serve allows you to charge lower prices. If the nature of your product is that it requires a person to explain or deploy, then you probably have to charge more. Being the first self-serve player in a full-serve market can be a powerful advantage, as Salesforce proved. Marketplace apps are inherently self-serve, too, as is most downloadable software for consumers.

Marketplaces make the one-time purchase model attractive for developers again, because they remove obstacles like how to get people to pay for and discover your product. Marketplaces with a careful approval process like the iTunes App Store, the Windows Phone marketplace, and the upcoming Windows Store give customers a baseline sense of trust in your product and help enable impulse purchases.

On the flip side, Andy Brice expressed a concern to me that he'll have to reach more customers with his software or charge more in order to account for the transaction cost of moving to a marketplace like the Windows Store (Microsoft keeps a percentage of marketplace sales). He's also a bit concerned that marketplaces help drive down prices for customers, so while they're clearly a boon for new software developers, marketplaces might be less interesting for companies currently succeeding without them. Ultimately, customers will determine which direction developers are compelled to take.

Marketplaces, SaaS subscriptions, and other self-serve models demand transparent pricing. Customers need to know how much an app costs before buying it. Yet most enterprise software companies move away from price transparency. Why post a price -- and set a low expectation for deal size -- if you're going to be having a sales conversation anyway?

As Joel Spolsky points out in his wonderful post on pricing, there's a big dark area between about $1,000 and $75,000: Anything less than $1,000 can probably be charged on someone's credit card. Anything more than that requires so much hassle that you're going to have to charge enough to pay for a salesperson's time and travel, which can be quite significant. Therefore, if you don't see a price on a Web site, there's a pretty good chance that the company expects a typical deal size to be greater than $75,000, even if the actual starting price is much less.

There are fancier ways to charge customers, like micro-transactions, add-ons, and in-app purchases, but most startups I come across choose a SaaS subscription model, a mysterious-pricing enterprise model, and/or sell apps in a marketplace.

Answering these fundamental questions about your selling model will tell you a lot about the kind of customer you want to choose; but how do you actually determine the price?

Cost-Based Pricing
At a minimum, you have to consider your costs. If you charge less than it costs you to run your business, you'll obviously fail. Development is a fixed cost; you don't spend more on each new customer. That's a big part of the allure of a software business; there's no incremental "cost of goods sold." But you still have to consider the "cost of sale": How are you planning to acquire customers?

Let's say you build an awesome new productivity app called the WidgeMatic, and you plan to use Web advertising to find new customers. You figure out that it costs $20 in advertising to find each paying customer. Charge $29 and you'll make $9 with each sale. That's cost-based pricing.

It seems so obvious; costs are measurable and knowable. The problem is that it's hard to get everything right up front. And even if you do, things change over time; after a few months, your cost of sale could turn out to be closer to $40. Oops! You're going to have to raise prices to stay in business.

Value-based Pricing
Or perhaps you interview your first 100 customers and they all love the WidgeMatic, but they can't believe you only charge $29 for it. You've just discovered that you're leaving money on the table. By talking to your customers, you learn that the WidgeMatic saves them about 20 hours of work and that they value their time at $50/hour. Yes, that means you could reasonably charge $1,000 for the WidgeMatic. Since your customers want a compelling reason to buy, it might be more realistic to charge $99 and convince your customers how much money you're saving them. Your price can be much greater than your cost if you focus on the value your product brings to customers. This is value-based pricing.

As Ben Graham taught Warren Buffet: "Price is what you pay; value is what you get." Lincoln Murphy charges $77 per month for access to his content and community on this very subject of pricing. He charges that much not because the site costs him $77 per month per user to run, but because he's confident that customers will make more than that amount back in their own businesses when they join.

In fact, Lincoln uses and recommends the "10x rule" when determining price: Will your customers perceive the value of using your product to be 10 times what they pay for it? If not, then your prices are probably a bit too high to sustain, or you have to work harder to educate your customers on the value of your product.

The ROM exercise machine is $14,000. They sell it based on the value of your time. A four-minute workout in your home saves a lot of time and hassle. If you're part of their target market (the very wealthy), that time might actually be worth $140,000 or more to you, so a $14,000 exercise machine is "reasonable." Value pricing is a powerful concept.

Market-based Pricing
Competition is another part of the equation. My friends at Tweetmatic are working to create a super-simple Twitter solution for businesses that want to tweet but don't have time. How much should they charge? Similar apps include Pluggio, which starts at $9 per month, and buffer, which starts at $10 per month, so $9.95 per month seems like a reasonable place for Tweetmatic to start, too. This is called competitive or market-based pricing.

Pricing sends a signal. If Tweetmatic started at $4 per month, $40 per month or $400 per month, what would it say about their product? Sometimes you want to compete on price: For example, a Hyper-V implementation tends to be at least a third cheaper than a similar VMWare implementation. Sometimes you don't want to let your competitors drive your own prices down; for example, we at Microsoft think Office365 is a lot better than Google Apps, so we focus on the value of our product rather than matching any competitor's price.

Pricing higher, lower or about the same as your competitors are all viable strategies; just recognize that your price says something to your market.

If your product is truly new, pricing can be particularly difficult, precisely because it's hard to find a reference point amongst competitors. I recently attended a Startup Weekend in Lansing, and the winning startup, ClassyWork, came up with a truly innovative idea for turning real-world business problems into classwork for students. Since they have no competitors, they'll have to do some experimentation to figure out what the right pricing model will be.

There's More to Learn
Pricing is an incredibly complex topic, and I've fudged over some important details for brevity. I urge you to study and learn more on the topic as you get more serious about your startup. In particular, if you decide on a subscription model, learn more about Lifetime Value (LTV) before setting your price.

Also, you may be tempted to choose more than one kind of customer through tiered pricing. This is a tried-and-true technique, but I don't recommend starting with a bunch of tiers. Keep it simple and choose one kind of paying customer before you make things more complicated with tiers.

Free!

Finally, let's talk about free. There are many different kinds of free. Free that's not a business. Free supported by ads. Free supported by add-ins and in-app purchases. Freemium. Free Trial.

Free is very powerful, but it can be complicated, too. If you're considering an ad-supported business model, recognize that huge services like Hotmail, gmail, and Yahoo Mail make about 50 cents per user per year on advertising. Facebook is making $4-$5 per user per year, but they have abnormally high engagement. You typically need a lot of engaged users to make noticeable money with an ad-supported model. On the other hand, if you're building something on the side and don't need the money to eat this month, it can be a great way to measure your slowly growing success.

Freemium is alluring, but it's hard to get right. Ash Maurya explained to me that it's more of a marketing strategy than a pricing strategy, so you should figure out your paid product first and then consider offering a free version to help reach more users. The costs you incur to support free users (including support costs) should literally be accounted as marketing expenses (Ash also pointed out that you should ask for product feedback from paying customers, not free ones). If you look closely, you'll notice that a lot of freemium proponents are starting to underemphasize or even eliminate their free plans.

That leaves the all-important free trial. Free trials are often a key part of marketing your product. They help reduce friction, earn trust, and get customers ready to buy. To understand free trials, you have to learn about things like A/B testing and conversion funnels. I'll cover those topics next month.

Pricing is tricky. There's a great deal of valuable material on the topic, but at a certain point, you have to make an educated guess about what price will bring you the most profit and then adjust up or down as you learn more in the real world.

But wait … there's more! Be cautious about offering temporary pricing. Customers get addicted to sales pretty quickly, so before long your discounted price becomes your everyday price. On the other hand, if you offer a monthly subscription, consider offering a yearly discount. This will increase your up-front cash flow and give your users the feeling of getting a bargain, and everybody loves a bargain.

For more on pricing, be sure to read Joel Spolsky, Eric Sink, Neil Davidson (free version), Lincoln Murphy, and Ash Maurya … all were helpful in creating this article.

Let me know about your adventures in pricing at [email protected], on twitter, or in the comments.

(Note: I've interviewed Michael Sliwinski, Joel Spolsky, Andy Brice, Rob Walling, and Ash Maurya on the Startup Success Podcast with Bob Walsh)