A correct pricing strategy is key for a company. Setting your pricing strategy and price levels appropriately can make the difference between profitability, breaking even, or failing. There are many examples of companies that were able to find sustainable business models thanks to specialized pricing strategies, such as eBay’s promoted posts or LinkedIn’s premium package.
Before we define the different pricing strategies that are available, it is first very important for the founder to understand what market they are actually entering and what their clients are demanding. Furthermore, a founder needs to be aware of how their business model could support different pricing levels. There are many ways to reach $100 million dollars in revenue, but keep in mind that the pricing strategy you choose will greatly affect how your business will be run.
In this post, we will outline the main pricing strategies, walk through a process that you can follow to reach your appropriate pricing option, and detail the main pitfalls. To fully understand the pros and cons of each of these variables, you should also tap your network for entrepreneurs with experience in pricing strategy or get help from professional experts such as the pricing finance experts at Toptal.
Define Your Type of Business
Before choosing the pricing strategy, your first must define what type of business you’re pricing for. It is very different to sell to businesses (business to business, or B2B) than it is to sell to final consumers (business to consumer, or B2C). Depending on which type of client a company has, there are different implications that have to be thought out before choosing the pricing strategy.
Although for many readers the difference between both types of companies is clear, it is worth defining them:
B2B: A company with a business-to-business model is a company that sells to other businesses. The ticket size per transaction is usually large, but the sales cycle is also usually longer than selling directly to consumers, depending on the size of the companies involved. Furthermore, a sales process within the B2B sector can usually involve several bidders that compete with each other (request for proposal). Finally, a B2B transaction tends to have recurrent customers that buy frequently from the seller, which helps with cash flow. Some could argue that B2B is a more quantifiable business model to price towards, as business owners largely are drawn to products that either help them sell more and/or spend less.
B2C: A company with a business-to-consumer model is a company that sells directly to the individual consumer. The ticket size per transaction is usually smaller than B2B sales, but the purchaser usually decides to make the transaction immediately. The stickiness of a B2C customer is frequently lower than a B2B client.
Recently, there have been a few additions to this simple classification, such as business to business to consumer (B2B2C) or direct to consumer (D2C). For the purposes of pricing implications, most of these additions can be grouped into B2B or B2C.
Types of Pricing Strategies
Once you have defined what type of clients your business caters toward, you can review the different pricing options available and the implications that they might have on your growth. It is important to note that this is just an overview of each pricing strategy, and the application of different pricing strategies will have different effects depending on the business.
SaaS Pricing: SaaS means software as a service, which is a software distribution model in which another company hosts an application or product for the customer and that the customer can access it through an internet connection. SaaS pricing is usually periodical, where the customer pays for the right to use the software for a specific time period. Unlike traditional software models, where a lump license is bought outright for one version of a product, SaaS business models charge customers into perpetuity for new iterations of the service.
Freemium Pricing: Freemium pricing means offering your customers some product features for free, with the expectation that they get hooked on the service and eventually demand more features that will be charged. Spotify is a great example of freemium pricing: At first, you sign up for free streaming, accepting ads every once in a while. After a few months of this, you get tired of hearing the same ad again and again and you finally pay up the monthly fee. Dropbox is another notorious example: You use the limited free space for your family photos, but once you reach the limit, you are hooked and decide to pay for the premium version.
Tiered or Goldilocks Pricing: Tiered or goldilocks pricing offers several pricing options to the customer, usually going from basic all the way to enterprise. Businesses structure them in ways such that a customer eventually increases their knowledge and use of the service, hits a roadblock in their current service plan, and then upgrades. By way of example, once again look at Dropbox, which as you can see offers three different business plans for customers depending on customer needs.
When considering the goldilocks pricing option, it is important to know what objectives you have for your company. There are two different goals that can be pursued:
Being able to offer different options to different clients (customer segmentation)
Nudging the customer to choose a specific option, which is usually the middle price between the extremes. This strategy is also called the anchoring effect. In the Dropbox example, it seems the company is pushing customers to buy the Advanced model, with unlimited space versus “only” 2TB.
This Ted Talk from MIT professor Dan Ariely provides one of the best examples available (starting at 12:25), where he speaks about a specific case. In this real-life example, The Economist provided its readers with three subscription options: online subscription for $59, print-only subscription for $125 and finally a third option of print plus online, also for $125.
Ariely showed his MIT students all three options to see what options they would choose, and the results can be seen in the following table:
|Subscription Option||Yearly Cost||% Chosen|
|Print and online||$125||84%|
As the table shows, 84% of students chose the print and online option. After this first survey, Ariely removed the “print only” option and gave a separate group of MIT students the same survey with the two remaining options. These were the results:
|Subscription Option||Yearly Cost||% Chosen|
|Print and online||$125||32%|
The difference in results is clear: Only 32% of students chose the print and online option. If these were real results for The Economist, offering all three options with the “print only” anchor would have increased revenue by 42.8%. Clearly, anchoring through Goldilocks pricing can be a highly effective strategy for getting the maximum value from your products and services.
One-time Licensing Fee: In a one-time licensing fee, the customer buys the software or product one time and it is owned by the customer without any more payments. One clear disadvantage is that this pricing strategy does not make the customer sticky, as the transaction is made only once. Another disadvantage is that there are no immediate incentives for software updates and maintenance. From a cash flow perspective, this pricing model also results in irregular periods of high cash inflow, around times such as a new release, new budget years, or even Christmas.
This option was popular before the rise of the internet (remember buying Microsoft Encarta every year?) and the resulting ability to upgrade and maintain software online.
Per User/Seat Pricing: Per user/seat pricing means pricing in conjunction with how many users per customer will use the product. This option is also called per license pricing.
Enterprise Pricing: Enterprise pricing is an ad-hoc pricing that a company prepares for a large client that cannot fit into a standard option plan. Usually enterprise contracts are closed for at least a year, as the amount of development and setup work is significant for both parties.
Cost-based Pricing: Cost-based pricing first analyzes what the actual product costs are, and then based on that cost level the business increases the pricing a certain percentage. For example, a physical store retailer can decide that it will sell all items at a 100% markup: Therefore, if it buys a product wholesale for $10, it will sell the product at $20. This option is very common among retail companies.
Value-based Pricing: Value based pricing first looks at what value a specific product provides to the customer and then calculates the pricing as a function of that value. A generally accepted rule of thumb for setting the final price is to set it at 10 times less than the value provided to the customer. For example, if for the customer, the perceived value is $1,000, the retailers would sell it for $100. This pricing strategy can only be sustained if the product sold is unique, without many competitors undercutting the price.
Competitive Positioning: With a strategy that pursues competitive positioning, the company analyzes how it wants to be perceived vis-a-vis other competitors. The company could try to slightly undercut its competitors, with the risk that the competitors would match this pricing and start a downward pricing spiral. Alternatively, the company could try a more premium approach and set its price above competitors.
Razor Blade Model: A razor blade model consists of providing an initial product that hooks the customer and then later selling them a second product that is essential to the use of the first product. There are two clear examples of this strategy: first, the actual razor blade company Gillette, which sells its razor handles relatively cheap and then sells the actual razor blades at a premium. Secondly, printers. While actual printers sell at a low price, continuous purchasing of ink toners will eventually by far exceed the initial hardware cost. You can see further examples of this pricing within the industries of video game consoles and pod-based coffee machines.
Free Products (Revenue Is Earned from Critical Mass and Ads): This pricing is currently very popular with the success of companies such as Facebook and Google—They do not charge their customers for the use of their products, making customers’ data the actual product to sell to third-party businesses. There are clearly some very successful examples of this strategy. However, a founder must be aware that success with this strategy is very difficult to achieve, as the company needs to become very large and reach critical mass while being unable to obtain significant income during the ramp-up phase.
How to Set Up Your Pricing Strategy
After having gone through all of the different options and creating a shortlist of feasible routes for your company, you must do the hard work of executing and setting the final pricing strategy.
The first thing you should know is that whatever pricing strategy you choose, this option will define the business entirely, from how revenue will grow to how the actual business and team will be built. It is very different to set up a company that sells through a SaaS model compared to one that sells through a one-time purchase strategy.
The second thing to keep in mind is that the choice of a pricing strategy and pricing level is actually a process, and this process must be repeated periodically during the lifetime of the business, as we will see in the last section of this article.
During the process of selecting a strategy, you must first conduct deep customer research. However, be very careful when gathering feedback from non-paying customers. The only feedback that is worthwhile comes from customers that have actually bought your product. Anyone else will probably not have thought through the problem as much as a real customer that has a real need and has paid money for the service.
To obtain these first customers in this beta phase, try to tell a story through your pricing. For example, if you go with the option of value-based pricing, make it clear how valuable your product is and why your initial pricing really makes buying your product worth it. To increase the chances of obtaining these first customers, the founder should hit the road and help to tell the story.
Also, keep it very simple for these first customers. Do not overcomplicate the options. If you want to test different price points, you should create different subsets of clients that will each see a different price point. You can then test the rate of adoption at each price point. For example, it might not be a good idea at this stage to try goldilocks pricing, or at least to show it to the customers.
In addition to all of the above, make sure to research your main competitors, both direct and indirect, and understand why they chose their price levels and strategies. Use this information as another reference point for your decision making process while keeping in mind that your competitors could actually be wrong with the pricing that they chose. Always test out pricing for yourself.
After the initial pricing is set, the iteration process starts. Increase the price slightly and see where the limit is, depending on the level of pushback the customers start to give. Do this with different pricing levels with different customers, and you will have great insight into different customer segments.
Common Pitfalls in Pricing Strategies
There are a few common pitfalls that entrepreneurs make regarding their pricing strategy:
Not Changing Your Price: Even after full launch, a company should periodically review its pricing. At least once a year is good practice. This exercise will allow you not only to stay abreast of what your customers demand, but also what the competition is doing, and be able to adjust accordingly.
Underselling Your Company: Some entrepreneurs, when facing initial resistance from potential customers, tend to reduce their pricing to close sales. This can lead to a situation where they are selling themselves and their product short. Also, thinking that this client resistance is only due to high pricing can be a distraction from other key problems that are the real reason, such as a flawed product-market fit.
Thinking That Non-paying Customers Have Value: As said in the previous section, a founder should be wary of incorporating feedback from non-paying customers. This applies for both initial pricing testing and ongoing sales to a customer, where sometimes a client demands specific changes to your product before buying it.
Providing Too Much Choice: When customers have to choose between too many options, it makes the decision harder for them. Psychologist Barry Schwartz proved in his book the Paradox of Choice that customers can defer decisions for a long time or never actually make the decision. A company should avoid putting their potential clients in a similar situation.
Making Negative Connotations: When selling a product or service, an entrepreneur should avoid using arguments that are negative. For example, it is preferable to not mention that your product will reduce the number of employees your customer needs. It is better to be positive—say, for instance, that your employees will be significantly more productive.
Not Giving Special Treatment to Loyal Customers: For subscription-based businesses, you can push customers toward annual or quarterly payments instead of monthly payments by offering a better price if you pay annually or quarterly. This will will help you with cash flow and the customer will perceive a direct benefit thanks to his loyalty to your product.
Clearly a significant amount of analysis, customer research, and iterative testing is required for proper pricing strategy. There is no one-size-fits-all approach: Each company within each market is different. The key is to fine-tune your pricing until you reach the sweet spot that you are looking for, testing different strategies and price points until you find the perfect combination for your product or service