Isn’t everything on the internet supposed to be free? It turns out the answer is — not if you’d like to build a business. Here’s why you may be underpricing your product and four concepts that I’ve found useful when setting prices for new products.
When I started my entrepreneurship journey 10 years ago, I wanted to give my product away for free.
At the time, taking payments online was difficult. VCs cared more about capturing user’s eyeballs than their money; business plans consisted of growing a free product and monetizing it later — usually by hiring a chief monetization officer, building more features, or plastering its website with adverts.
A lot has changed since then. Payments are easier, making money with adverts is much harder, and VCs aren’t funding eyeballs anymore. Yet I still felt a certain resistance to charging for my latest online service.
Why was this?
Intellectually, I understood that people don’t value free products as much as paid ones, and that charging for my product would force the issue: is this product valuable or not?
But my resistance wasn’t intellectual, it was emotional. What if the answer was, ‘No, this isn’t valuable enough to pay for.’ It was safer to defer this possibility, giving me time to build more features. Of course, more features make little difference if the core proposition doesn’t resonate with customers.
In the end, I spent so much time thinking about future features that I failed to truly appreciate the features I’d already built.
Reid Hoffman said, ’If you aren’t embarrassed by your first version of the product, you’ve launched too late.’ Well, if you hold off from charging for your product because you’re worried no one will buy, it’s probably time to build that paywall.
But how do you find a price for your product? This can be extremely difficult, especially if there aren’t many comparable products in the market to benchmark against.
Here are four concepts that can help in determining the price of your software product.
Rather than starting with your product, start with your customer. How much will your client spend to solve their problem?
It’s worth ‘pricing the need’ before starting product development. This will help you quickly eliminate high-touch products that would be too expensive to operate, and identify cheaper product ideas that clients can afford.
How do you know how much a client can pay? As tempting as it may seem, asking them directly is likely to lead you astray. Instead, your goal is to understand your client’s existing purchasing behaviours.
Useful questions include:
If your product has no competitors, dig into other products that your target customer has bought recently to hunt for insights:
If you’re planning to sell into companies, you might ask additional questions, like:
If your customers already achieve their goal without spending anything, or they don’t buy anything online, you’re in for an uphill struggle.
A common strategy for SaaS products is to have multiple pricing plans and to use ‘decoy pricing’ to nudge a customer’s choice in their favour.
Consider the price of popcorn at the cinema. A small carton costs £6 and a large one costs £6.50. But here’s the catch — the large carton is twice as big as the small one. For just 50p extra, it’s clearly the better choice. Right?
This is a classic decoy pricing. It’s so obvious that the large popcorn is great value when compared to the small popcorn that we stop asking ourselves whether no popcorn at all might be an even better deal.
Think of it this way. Imagine that the basic plan for an online service is $99 per month. Sounds expensive, right? But when you find out that the premium plan costs $699 . . . well, that $99 option suddenly doesn’t seem so expensive after all.
Decoy pricing makes use of an asymmetry between the relative value and the relative price to nudge us into choosing one option over the other.
We have a natural bias towards giving things away for free, which means that we’re more likely to underprice our products than overprice them. Luckily, setting your initial offer price doesn’t have to be the endpoint for an online service.
Consider tracking the conversion rates for weekly cohorts and increasing your price every few weeks. You might be surprised by how much you can increase prices without affecting purchasing behaviour.
In some markets, such as high-end services and consulting, raising prices may even increase demand by increasing the perceived value of the service.
To turn a profit, you’ll need to charge more than it costs to deliver the service. For many online services, the largest unit cost is the cost of acquiring customers.
Figuring out your CAC (Cost of Acquisition) early is helpful when pricing your product, especially since the cost of paid advertising typically increases over time, as the market becomes more competitive.
The rule of thumb is that your LTV (Life-Time Value) should be three to five times greater than your CAC. If the ratio is too low, you’re probably charging too little, and if it’s too high, there is an opportunity to grow more aggressively.
Low-priced online services can be sold to businesses using paid ads, email marketing, and content marketing. However, higher-value services require a salesperson and account representative to close the deal. Sales cycles are long and frequently blocked by things outside your control, such as the availability of your customer, or internal decision-making processes.
In Zero to One, Peter Thiel describes a ‘dead zone’ in which the software is too cheap to be sold by salespeople and too expensive to be sold online.
So, enterprise software companies are faced with a dilemma — either they drop their prices or increase them to align with their preferred distribution strategy.
Part of building a successful business is finding customers who are happy to pay you because you’re making a real difference in their lives. Confirming that these customers exist — and are willing to pay — is best done before it’s too late.
Embrace early feedback and resist the urge to give everything away for free. There’s nothing like profits to align everybody’s interests.
Thoughtful essays on growing teams, building products and raising money by Serial Entrepreneur and Investor, David Bailey.