I’m on the board of a venture-backed startup that sells software-as-a-service. At a board meeting a while ago, the CFO enthusiastically announced that the company’s customer retention rate was 96 percent. I didn’t want to be a killjoy, but commented that, in my opinion, this was actually a bad sign. If customer churn was really that low, we were underpricing. The CFO seemed shocked that such a high retention metric could be bad, but as we dug into things the rest of the board came to agree that we had a pricing problem.
Later, with an insightful new CEO and CFO the company undertook a major overhaul of its pricing to align it with the tremendous value the startup provides to its customers.
I wish I could say the pricing problem with this SaaS startup was an exception, but in my experience of advising, investing in and serving on the boards of more than 20 startups, it seems to be the rule. It’s easy to understand why.
What are the two things startups are desperate for? Customers and revenues. Given that pressure, it’s almost inevitable that many startups underprice their products and services in an attempt to land customers and generate revenues.
What are the two things startups are desperate for? Customers and revenues. Given that pressure, it’s almost inevitable that many startups underprice their products and services in an attempt to land customers and generate revenues.
I also see this phenomenon play out with my entrepreneurship students here at the University of Utah’s David Eccles School of Business: many reflexively go to price as a key means to help their startup compete with incumbent companies.
I think entrepreneurs should generally resist this impulse. Underpricing creates real problems for early-stage companies. Here are a few:
- First, pricing is a signal of quality. Many prospective customers are actually scared off by low prices. The SaaS company I mentioned at the outset was having this problem. Our pricing was substantially lower than our main rival and our low prices were causing prospects to believe we had a less valuable product. This was misleading because our software was genuinely the best in the marketplace. Low prices send the message to prospective customers that the value of your product or service is low.
- Second, low prices send false signals to entrepreneurs. How will you know if you’ve got a product or service valued by the marketplace if you price it at sub-market prices? Pricing a startup’s products or services too low is like running a faulty test. You don’t want to fool yourself into thinking you’ve got a real business when you’re only making sales because you’ve significantly underpriced. Here’s the harsh reality: How good could your product or service be if the only way you can make sales is to offer bargain-basement pricing? Low prices prevent entrepreneurs from accurately evaluating their own startups.
- Third, underpricing is simply not sustainable. Startups are in a desperate race against time and money. Sure, you need to make sales. But while the underpriced sales you’re making feel good in the short run, they may be disastrous in the long run by preventing you from getting to profitability. This problem is reflected in the now well-known questions about “unit economics” that most savvy startup investors ask entrepreneurs. Angels and venture capitalists want to know that the lifetime average value of a customer is greater than the average customer acquisition cost. Low prices are like sugary breakfast cereal. It’s good at first, but you’ll be starving by 10 a.m. A lot of startups starve to death because of underpricing. Low prices won’t ever allow them to have a sustainable business model.
Underpricing won’t get you where you want to go. So how can you know if you’re doing it?
With large established businesses there are lots of metrics and historical data that can be crunched to establish pricing. It’s largely an accounting exercise. With startups, things move more quickly and the tests are a bit more instinctive. Here are some quick and dirty ways to know if you’re underpricing:
- Are your margins within industry norms? Small-scale retailers, for instance, typically have gross profit margins in the range of 25-35 percent. If you’re operating a retail business and yours are lower, you may have a problem. Other industry norms can be applied to your startup as appropriate as a check-and-balance on your pricing.
- When you fail to close a sale with a prospective customer, do they complain about price? If you’re never hearing complaints about prices, you’re probably pricing too low. Remember the example of the SaaS startup we began with — closing nearly every sale (or getting nearly 100 percent of your subscription customers to renew) without complaints about pricing is a strong indication your prices are too low. Having customers complain about prices — at least occasionally — is a decent sign that your pricing strategy is roughly appropriate.
- Develop some quick market intel about your competitors’ pricing. It might feel good if your prices are lower, but you may be harming your startup’s prospects. Resist the temptation to compete on price. Whenever possible, compete on value instead. Have the entrepreneurial guts to tell your prospective customers you aren’t cheap, but you are high-value. Competitor pricing intelligence can tell you if you’re in the ballpark, or if your prices are too low.
- As a general rule, if your lifetime average value of a customer isn’t at least three times greater than your average customer acquisition cost, you may have a pricing problem. The 3X multiple is a good rule of thumb for most companies. An even higher multiple, of course, is better.
- Under the right circumstances, run some pricing tests with certain prospective customers. Try some significantly higher prices while articulating your value proposition more effectively. Do you still make sales (or earn renewals)? Is the reduced volume more than made up by the higher prices? As with all things entrepreneurial, run tests cheaply and quickly and incorporate what you learn.
The SaaS company we began with has successfully revised its pricing strategy. Customers now understand that company’s value proposition well. Those increased prices bring in pure margin. But it would have been better to get pricing right from the outset.
In 2016, author and tech investor Tim Ferris asked world-famous serial entrepreneur and venture capitalist Marc Andreesen what advice he would give to startup entrepreneurs that he could state on a billboard. Andreesen’s answer? “Raise prices.”
I agree with Marc Andreesen. Don’t fall for the trap of low pricing with your startup. Create and sell value as an entrepreneur.
