April 14, 2020

How To Build a First-Year Pricing Model That Balances Costs & Income

So you’ve got a great idea for a new tech product, say a powerful new SaaS platform or a sleek new mobile app. It’s exciting. It’s innovative. It’s going to change the way people work, play, plan, talk, travel, save, or spend. Few things in life are more thrilling than this moment, when you realize you’re really onto something.

And then you realize you’ve got to figure out how to sell it. (Or maybe you don’t—for some aspiring disruptors, the idea is so compelling that they can’t imagine the market won’t agree. This baby will sell itself!)But for many first-time entrepreneurs—and lots of established ones, too, if we’re honest—putting a price on a new product is a stressful and confusing process, especially because to the person who thinks of it, an idea feels, well, sort of priceless.

This post will give you some broad guidelines for building a pricing model for your first year on the market. Especially in that first year, your primary considerations in pricing your product should be the value you can provide to customers, the dynamic nature of start-up costs relative to your income, and the outsized impact of your initial financial projections on your ability to secure adequate starting capital. And at the end of the day, an effective pricing model can help you evaluate whether your product is commercially viable as currently configured. If you need to go back to the drawing board to find a configuration that can make money, you want to know that before you’ve cashed checks from banks or investors.

Four Keys to Building a First-Year Pricing Model for Your Digital Start-Up

There are more ways to price a new product than we could possibly cover in a single post, which is sort of the point: it depends on the product and the market, so you need a dynamic, customizable model for projecting costs and income in the first year. Typical intuitive models like “absorption,” which is preoccupied with offsetting initial costs, or simple market pricing, which simply benchmarks a price from comparable products already on the market, will not be sensitive enough to your specific product and market. Instead, an effective first-year pricing model will incorporate these key considerations:

1. Base pricing on the value to the customer rather than a short-term view of costs.

Consider how much money your product might save a customer, whether in salaries and subscriptions or as a lower-cost, streamlined alternative to an incumbent product that is priced and scaled for big clients. There are various ways to price your product to maximize value to a target customer profile, or to customize your product and pricing according to a range of customer needs. But these choices have cashflow implications that must be factored into your pricing model.

Value-based pricing can be an entire pricing model in itself, especially in a “blue ocean” environment where your product doesn’t have to contend with well-established incumbents. But it’s also a core business value that cuts across various pricing strategies meant to make your product profitable in an already competitive market:

  • If you use a “penetration” strategy, which sets a price below market value to gain market share, it will be most effective as a way of delivering value to the customer rather than as a blind gambit for acquiring customers. A value-conscious implementation of the penetration strategy asks, “Can I afford to offer comparable value to incumbent products but at a lower cost?” or “Are there customers of incumbent products who would accept less functionality in exchange for lower prices?” The riskiest use of the penetration model is one that gives the least consideration to customer value, banking on a later price hike to recover costs without considering whether the higher price will change the customer’s value calculation.
  • A “freemium” strategy, which offers a free version at a carefully determined level of functionality, with paid features available for subscription or one-time purchase, is already intertwined with considerations of value to the customer. You have to make sure that the features you’re giving away for free are sufficiently in demand to get you market traction, but you also must accurately assess the demand for your paid features relative to the costs of developing and maintaining the free ones. DropBox a good example of a freemium SaaS product that offers a fairly robust free entry level (2 GB of cloud storage) in order to build an ecosystem of individual users that attracts big users to scalable paid plans.

2. Pricing model needs to be compatible with expense model.

It is a truth universally acknowledged that businesses ultimately have to make more money than they spend. But making your pricing model compatible with your cost model doesn’t mean simply adding 10% to your projected costs and calling it a day. It means finding a strategic synergy between costs and income, which demands a more detailed and flexible model.

  • First, consider whether you can provide value to customers at the price point required to recover your costs. Think of Sunrise, a native calendar app that was popular with users but ultimately not viable as a business, because even a nominal charge would have made it impossible to compete with default apps and incumbents like Outlook and Google Calendar. There just wasn’t an opportunity to create enough value to justify a per-unit price, and leadership didn’t have the vision to pursue other pricing strategies before it was too late.
  • Second, consider customer acquisition cost (CAC) relative to income per new customer (customer lifetime value, LTV). Countless digital startups have failed because they were unable to acquire new customers at a lower cost than the income they got from those customers. But this calculation is much different for a one-time purchase than it is for a subscription service, which is different from a transaction- or time-based service, and so on. While not every product can accommodate each one of those models, you may have more flexibility in your configuration than you realize, and it’s vital to understand the implications of each configuration for your CAC/LTV ratio.
  • Finally, consider the scale at which your product can be commercially successful. Some big expenses associated with scale may not be immediately visible to a first-time entrepreneur. For example, the big data required to be successful in some markets (at least at a certain scale) may price out a small entrepreneur.

3. Smart pricing helps you ask for the right amount of start-up capital on the front end.

First-time entrepreneurs sometimes “flatten out” pricing and expense calculations, rather than projecting them into the future with a realistic, dynamic cash-flow model. But the time for building this model is before you finish securing capital. It’s always better to raise more than you need for the initial investment, since investors tend to perceive higher risk when you have to ask for more money in order to stay solvent. They want to catch you on the way up, not save you from bankruptcy.

At Clear Function, we’ve had a lot of success using pro forma analyses, combined with effective coaching, to help clients (and ourselves) project costs in a variety of “what if” scenarios. Pro formas can help you re-scale or re-configure your product to optimize your value proposition for a target customer base, and they can help you game out your CAC/LTV ratios for various product configurations or market conditions. And they can give you a dynamic, time-based view of your start-up income relative to costs, helping you ask for the right amount of capital on the front end.

4. Effective first-year price modeling can show whether your product is viable as currently configured.

It’s important to realize that the worst-case scenario is not that you don’t get to launch your new product, but rather that you do and you’re not prepared. The best thing a good first-year pricing model might do for you is to show you that you’re not quite ready to start your business.

The good news is that the answer is almost never “just give up.” More often, your model will help you find a new configuration for your product that enhances its value to your customer relative to your costs, or perhaps it will show you that you need to secure more start-up capital than you first realized. That’s the virtue of an effective pro forma—it tackles the “what ifs” while they’re still “what ifs,” and before they become “what nows.”

Like we said, there’s more to building an effective first-year pricing model for your digital product than we could cover even in a long-ish blog post. Entire business school courses are devoted to the subject, after all. But there are a few core principles that will help keep you grounded in your market reality: price your product for value to the customer, build a realistic and dynamic model of your expenses, use tools like pro formas early in the process to project costs and incomes for a variety of product configurations and market conditions, and listen to your price models if they tell you your product isn’t quite ready for prime time.

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