Startup Pricing: Are You Selling A Giffen Product?

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A version of this article previously appeared in Forbes.

In his premier film appearance in the blaxploitation send-up “I’m Gonna Git You Sucka,” Chris Rock inadvertently addresses a key pricing challenge faced by most entrepreneurs.

Watch this 93-second clip and see if you can identify the pricing pitfall addressed in this humorous snippet. Caution: contains a bit of profanity (it is Chris Rock, after all).

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How Much For A Rib?

A recurring entrepreneurial challenge is to determine the optimal price of a new product, especially absent a directly competitive alternative. This issue is often further complicated by users who request that you unbundle features to reduce the price of your solution.

The questionable “logic” of such requests is, “I only need a fraction of the features offered, so I should only pay for the features I will use.” This is analogous to asking Netflix for a discount because you never use its recommendation engine.

At Citrix, GoToAssist customers would occasionally ask if they could just pay for our screen-sharing functionality because they didn't intend to use the product's other features, such as reporting and session recording. Ironically, similar to Chris Rock’s request to pay for his single rib with a one hundred dollar bill, most of the customers who requested that we unbundled our solution could readily afford, and make use of, our entire product.

Price ≠ Cost

Your pricing strategy should be decoupled from your costs. The underlying costs to deliver your solution are only relevant to the extent they are low enough to generate a sustainable gross margin at scale. Otherwise, costs and pricing should never be uttered in the same breath.

When we launched GoToAssist, we offered our customers the option to brand the customer-facing webpages with their logo and brand colors. The effort to implement this customization was minimal and thus cost us very little. However, the value to our customers was significant.

If we had utilized a “cost-based” pricing model, we would have charged a few hundred dollars for this option. However, using a value-based approach, we charged $10,000, much to the chagrin of our engineers. Yet our customers were satisfied because the value of an integrated support solution far exceeded the price.

According to Albert Oaten, VP Market Development at SecureDocs, "The number of people that negotiate by saying, 'This doesn't look like it costs you very much so I don't know why you don't charge to cover your costs plus a little extra or have a freemium option,' is surprisingly large. Even sales reps will invoke a cost plus logic when negotiating with me on behalf of their customers.  A better criteria for determining whether your pricing is appropriate is, 'do we provide a better value proposition than their next best viable option?'"

Price = Value

Focusing on value sounds straightforward. Yet, the value of your solution will vary by customer, based on the utility each derives from your product. Discriminatory pricing laws aside, you would ideally charge a different price to each of your customers.

When we initially launched GoToMyPC, the price of our annual plan equated to $9.95 per month (i.e., customers paid $119.40 upfront for a year of usage). We based this relatively low price on the thousands of emails we had received during our beta period from would-be customers that indicated they would purchase GoToMyPC, “if the price were lower” than  $19.95 per month.

As I was responsible for driving GoToMyPC’s revenue, I was highly motivated to test the product's price elasticity. To do this, we gathered two key pieces of data: (i) the percentage of our customers who were reimbursed by their employers, and (ii) the average number of hours per month our customers used GoToMyPC.

At the time, our primary customer demographic was white-collar professionals, of which 65% were reimbursed by their employers for the cost of GoToMyPC. We assumed our average customer was paid at the relatively modest rate of $35 dollars an hour, which equated to approximately $140 of “value” delivered by GoToMyPC each month (4 incremental hours of work x $35/hour).

Given GoToMyPC’s significant value and our customers' high reimbursement rate, I felt comfortable championing a 50% price increase, from $9.95 to $14.95. Although there was significant resistance initially from my compatriots to such a large increase, we collectively agreed to test the new pricing, based on the empirical evidence my team had gathered.

Fortunately, our analysis was sound. Despite the relatively large-percentage increase, our conversion rate of trail-to-paid customers rose substantially, from about 35% to around 50%. The price increase also led to a surge of new trials, which increased our overall revenue by over 100%, more than double the impact we expected.

Although we could never conclusively prove it, anecdotally, corporate users told us that the price increase enhanced the legitimacy of GoToMyPC and alleviated their concerns that a $9.95 price was not representative of a professional, secure and reliable service.

The same phenomenon occurred at ProCore, when the company shifted the market focus of its SaaS solution from small contractors to large commercial builders. Despite a tremendous price increase, overall demand jumped substantially while churn dropped dramatically. Anecdotally, it seems that SaaS products often behave as Giffen goods.

Too often, entrepreneurs attempt to widen the appeal of their solutions by dropping their prices to attract more prospects. Although this strategy seems intuitive, it is, in fact, illusory. Value-based pricing that balances gross margin maximization with capturing the largest possible of customers in each market segment will generate more enterprise value over time.

This sentiment is echoed by Craig Harris, CEO at HG Data, "We’ve had success in adjusting upwards two elements of our product pricing. We have raised both the unit price and the minimum order size by over 100% in the past year.  We’ve lost a few of our customers that were habituated to the lower price point, and truth be told, these customers tended to be a disproportionately higher cost to service.  The large increase to the minimum order size has also served as a qualifying tool early in the sales process helping us weed out prospects without budget at the top of our sales funnel.  The net result has been a higher caliber of service to our customers and higher margins that have allowed us to invest back in the business to maintain a premium offering."  <Note: I am an investor in HG Data via Rincon Venture Partners.>

The Customer Is Not Always King

The essence of Chris Rock’s cameo in “I’m Gonna Git You Sucka” became a watchword at Citrix. Whenever we encountered a prospect who attempted to nickel-and-dime us with an unreasonable request, we referred to them as “wanting a rib.”

As Chris Rock runs from the rib joint, actor Bernie Casey enters the scene and admonishes Isaac Hayes’s character, saying, “Don’t do it Hammer. The customer is always king.”

Experienced entrepreneurs know this is simply not true. Some would-be customers, such as those who are unwilling to pay an equitable price for your solutions, should be sent packing. If they are not, it just may be you who is gonna get it, sucka.

Follow my startup-oriented Twitter feed here: @johngreathouse. I promise I will never tweet about that killer burrito I just ate.

Image: Wikimedia Terence Ong

John Greathouse is a Partner at Rincon Venture Partners, a venture capital firm investing in early stage, web-based businesses. Previously, John co-founded RevUpNet, a performance-based online marketing agency sold to Coull. During the prior twenty years, he held senior executive positions with several successful startups, spearheading transactions that generated more than $350 million of shareholder value, including an IPO and a multi-hundred-million-dollar acquisition.

John is a CPA and holds an M.B.A. from the Wharton School. He is a member of the University of California at Santa Barbara's Faculty where he teaches several entrepreneurial courses.

Note: All of my advice in this blog is that of a layman. I am not a lawyer and I never played one on TV. You should always assess the veracity of any third-party advice that might have far-reaching implications (be it legal, accounting, personnel, tax or otherwise) with your trusted professional of choice.

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