Product / Pricing fit and how to think about your product pricing

I met with a startup yesterday that we are looking at investing in.

They are early in their entrepreneurial journey but have managed to build a solid product and have early signs of finding product / market fit (if you don’t recall what that is, read here). They spent 1.5 years building a great product and in the past 5 months have managed to sign up 20 clients without much sales and marketing effort and are getting orders for more.

The market they are in is fairly new, very niche but growing rapidly (100%+ a year). There’s recent legislation that has been released that supports what they are doing and in some ways makes a solution like theirs, an absolute necessity for the clients that they serve, and while there are some competitors in the market, none have built a product that does what they do and is being reflected in their close rate for new business (close to 90%). They literally have more orders than they can fulfill with their bootstrapped team.

During our due diligence conversations we got onto the business model and I asked the CEO about the pricing strategy that the startup has chosen.

He said that they spent some time analyzing the market, the typical revenue that their clients generate (between $20m to $45m), the competitors pricing and what they believe they could charge that would be a “no brainer” for their clients. They ended up with a price that wasn’t the cheapest in the market, nor the most expensive: effectively, a middle of the road pricing strategy.

I see founders make this mistake often. Being a new startup you’re worried that your product isn’t as good as you want it to be. There are still features and functionality that you wish you had. In addition to that, you’re desperate for sales and cash. You’re bootstrapping and want to win the business. You don’t have the conviction to price “too high”, as you think you’ll jeopardize the limited opportunity that you have and besides, you tell yourself that you can charge more once you add in that new functionality that will make the product even better. So you choose a price that you feel comfortable with and that you believe the market will accept.

What I can say with almost certainty is that you’ve gotten that pricing wrong. Statistically, the probability of deriving the correct price for the market on your first attempt is close to zero and if my experience is to go by, the founders bias to win business and optimistic notion of how much it will actually cost to scale the business, means that the pricing chosen is generally too cheap.

There’s another element at play though. Using pricing to indicate to the market your strategy and ensuring Pricing / Market fit.

What do I mean by this?

Lets borrow a strategy framework by famous business strategy and Harvard lecturer, Michael Porter. Porter says that a firm can embark on 1 of 4 effective strategies to capture a market.

1. A broad cost leadership strategy.
   By this he means that you are the cheapest in the market. Your business has some kind of cost advantage that allows you to be the cheapest and therefore dominate the market. Think Walmart and Amazon.

2. A broad differentiated strategy.
   Your business builds the most innovative and differentiated product in the market. You spend more on R&D than your competitors and as such create the best products allowing you to charge a premium. Think Apple.

3. A niche-differentiated strategy:
   You are focused on a specific niche that you understand so well that your product is far superior to any generic alternative that exists, allowing you to capture that niche at a significant premium. Think Peloton or Superhuman.

4. A niche-cost leadership strategy:
   You are focused on a specific niche that you understand so well and use technology and systems to leverage a cost advantage over competitors who are more broadly focused. Think Freshbooks.

There is technically a fifth strategy but according to Porter it is ineffective and the worst strategy. This strategy he calls “being stuck in the middle”. You’re not the cheapest in the market, nor the most expensive. You’re pricing doesn’t signal any strategy and you don’t stand out in the minds of your customers because of it. You’ll be squeezed at the bottom by competitors who are focused on cost leadership and have built their systems and processes to do so and you won’t have the margins to compete with the niche/differentiated competitors who will out innovate you.

This is effectively the path our startup has chosen.

I explained this to the CEO and suggested that they go back and experiment with their pricing on their next few proposals. His product is focused on the niche-differentiated strategy but his pricing isn’t. He doesn’t have Product / Pricing fit.

How do I know this ?

He has more orders than he can fulfill, a 90% close rate and every client we spoke to said that his product is the best in the market. The market is invariably telling him that he is too cheap and he himself is not signaling the superiority of his product with his pricing. I recommended that they should experiment with by doubling, tripling and quadrupling their pricing to see how it impacts their close rate.

He asked if he could do that when he’s already signed 20 clients at the current pricing?

Yes you can. One of the advantages of a startup is that you have very few clients and zero brand. It’s a time that allows for massive experimentation with very limited downside risk.

So what difference would seeing at this stage that tripling the price of his product is actually a more accurate price to have VS maybe losing the next 2 to 3 sales?

Invariably, ALL the difference.

Sign up to A Blockchain VC: