There is a lot of bad pricing out there. But most of it is not so much the result of a bad decision as it is the result of ad-hoc pricing decisions, ‘me too’ pricing or people inadvertently stumbling into a price war.
A company we recently worked with had priced access to its data as a flat fee. Selling access to the data was a side business and no real thought was given to the pricing. The CEO just sort of made up a price and sales was happy to pick up some extra revenues and commissions. To help them, we went through our typical process, which begins with a value-based market segmentation. A good market segment is a group of customers who get value in the same way and who buy in the same way. We found three distinct segments (well, actually four):
- A group of companies that repackaged and resold the data generating 200-300X what they paid for the data
- A group of companies that used the data internally to support decision making and who were priced approximately at their willingness to pay
- A group of people who also wanted to use the data internally, but for less high value decisions, and who had elected not to purchase
- A group who had no idea why they had bought and would probably not renew
We were able to come up with two different pricing metrics for the two use cases who used the data and to find a scaling metric that allowed both of the groups who got value from internal use to buy. The fourth group, well, they should probably not have been customers in the first place.
In this case, the ad-hoc pricing was recoverable. This was because there were relatively few customers, the company maintained good relationships with its customers, and there was no compelling competitive alternative. Not everyone is so lucky. Sometimes the pricing gets locked in.
Pricing as a frozen accident
Ad-hoc pricing often becomes a frozen accident. This is a term from evolutionary theory. A good definition comes from Mary Bell on Quora:
The genetic code is an “accident” because it was not designed for optimality; there may never even have been a competing alternative. It simply provided a functional system for self-replication, and wound up being used.
The code is now “frozen” because so many parts of an organism would need to change in order to accommodate a new genetic code or mode of inheritance. Even making a single change to the codon-to-amino acid table could disrupt thousands of genes. Other, more efficient systems than our genetic code may exist, but if we can only make one change at a time, we can’t move directly from the current system to a better one: we would have to go through some intermediate with low fitness. And because there are so many existing organisms to compete against, that low fitness would probably not be tolerated.
Pricing is a lot like this, especially for innovations. Someone comes up with a pricing model, it gets coded into all sorts of processes and decisions, and becomes very hard to change, even though there are better alternatives possible.
This is especially relevant in pricing during category creation. Although it is true, as Micah Litow, COO at Kalderos says “The place to start is with the value of the category as a whole.” That does not mean one can ignore pricing. In a new category, the winner will be the company that figures out how to connect the value metric (the unit of consumption by which the buyer gets value) with the pricing metric (the unit of consumption that the buyer pays for).
‘Me too’ pricing
The other common pricing mistake is “me too” pricing. This is where one defaults to the pricing model of dominant competitors, even when that model gives one the competitive advantage. Generally speaking, you do not want to play against stronger more established rivals on their own ground. This was the lesson of Clayton M. Christensen’s work on disruptive innovation. Disruptive innovation works best when one is competing against non-consumption using a new or under-appreciated value driver. As the best practice is to link the value driver and the price, and the value driver is new or under appreciated by the dominant players, a new pricing metric can be a winning move, provided you do the homework to really understand the differentiated value.
We have seen this approach applied with some companies that were moving from on-premise to SaaS and subscription pricing. In this case, there can be concern that the new offer will cannibalize the existing product. (I am of the school that believes that if you can cannibalize yourself one should, because if you don’t do it someone else will do it to you, but that is easy to say, and it is understandable that some companies balk when established businesses with billions of dollars of revenue are on the line.) One can design a pricing metric that makes it difficult to compare the on-premise license and the SaaS subscription and align the offers to different market segments.
Not everyone agrees with this approach. Tom Tunguz, who is one of the smartest venture capitalists writing about pricing strategy, has questioned if early-stage companies should differentiate on the pricing model. The basic point is that innovating on too many things at one time can increase risk and that value innovation is more important than pricing innovation. I disagree, value and pricing innovation are joined at the hip.
Pricing metrics and initial pricing levels frame markets. They act as an anchor point for all future pricing.
- Copy another category’s pricing and your category may never get off the ground.
- Set the price levels too low and the long-term value of the category can be compromised.
Stumbling into a price war
The other all-too-common pricing mistake is to stumble into a price war. Price wars can destroy the long-term value of a market. They can reset prices at new and lower, often much lower, levels and in many cases these prices never recover.
How do you “stumble into a price war”?
- You cut someone a special deal and it gets out (and it always gets out)
- You have a special promotional offer around some new functionality, your competitor sees this and matches or beats your price
- You cut prices in order to fill some open capacity or to clear inventory (this is seldom relevant with SaaS but you still need to be aware of this)
There is a simple way to avoid price wars. Keep your pricing fair. If your customers and competitors all perceive your pricing as fair, you are unlikely to trigger a price war and you will be careful in responding to one.