This article dos a great job of looking at the many factors of pricing...and I agree with George...pricing is an art not a science.
BY GEORGE DEEB · JANUARY 28, 2015
This article was originally published on Red Rocket VC, a consulting and financial advisory firm with expertise in serving the startup, digital and venture community.
Oftentimes, tech startups are so focused on building their technology, that once it is built, they have no idea how to price it. This lesson will provide some high-level guidance on how to do that.
HOW MUCH DID IT COST TO BUILD?
The first thing you need to do, is quantify how much investment went into to building the technology in the first place. How many developers were working on the project, at what hourly rate, etc. And, since you are most typically competing with a “buy vs. build” decision for your prospective clients, it is OK to use market prices for the costs of your tech team (e.g., $150 per hour, even if you are investing sweat equity and it really didn’t cost you that much in cash out of pocket). So, for an example, let’s say you had a team of four developers working full time (40 hours per week) for three months. Your cost would be $312,000 (13 weeks x 40 hours per week x 4 people x $150 per hour).
DETERMINE AN APPROPRIATE ROI AND TIMEFRAME
Just like a venture investor shoots for 10x ROI on their investments, businesses need to shoot for a reasonable ROI on their investments. And, since we are talking about technology that may have a limited useful life before it becomes obsolete, you need to have a reasonable timeframe that you want that ROI to be realized. My rule of thumb, where you can, is to shoot for a 10x ROI on your technology investment within a three year period of time. Continuing our example, that means you need to recover $3,120,000 in revenues in the coming three years, or around $1MM per year, on average.
DETERMINE YOUR SALES ASSUMPTIONS
Next, you need to reasonably estimate how many sales of the technology you will have during the three year ROI period. You need to take into consideration: (i) how big of a market are you serving; (ii) how many potential buyers are there; and (iii) how much sales and marketing investment are you making to drive leads and close sales. In our example, let’s say you have one salesperson calling on prospective clients and one salesperson can close one transaction a month. In order to close $1MM in sales a year, the salesperson would need to be selling the software license at around $80,000 per sale.
SANITY CHECK YOUR ASSUMPTIONS VS. MARKET
The above assumed there were 36 prospective clients that would be closed in a three year period. And, with a 20% conversion rate in B2B sales, that means your sales person needs to have identified 180 prospective customers. When you sized the market above, how many potential customers did you reasonably think you were out there? If not at least 900 customers (assuming most business have a hard time growing beyond 20% market share), then your sales assumptions may be too aggressive, and you may need to adjust your projections (e.g., shoot for fewer customers at a higher average price–maybe 18 transactions in three years at $160,000 price).
SANITY CHECK YOUR ASSUMPTIONS VS. COMPETITORS
So, let’s say the $80,000 price held up based on your market analysis. But, how does it compare to your competitors? Where are they priced? If you are materially more expensive for a similar product, then you need to lower your price to get competitive (hence, lowering your ROI expectations at the same time). Or, are you materially cheaper than your competitors? If so, now you can afford to actually raise your prices (and grow your ROI expectations beyond 10x, which is a really terrific situation to be in). But, if the ROI starts to dip below 5x, you really need to question doing the project in the first place, given all the risks you will be taking in launching this new product. So, make sure you do your revenue projections before you start building one line of code.
SANITY CHECK YOUR ASSUMPTIONS VS. CLIENTS
Lastly, you need to ask yourself two questions, as it relates to your prospective clients: (1) is the price affordably within their budgets (e.g., enterprise clients can easily afford a $80,000 software licence, but SMB’s would not); and (2) how much would it take for them to build the software themselves, in a buy vs. build decision. In this example, they are getting a $3MM technology investment for $80,000 (that feels like a steal for them, and could argue raising your prices). If you were trying to sell $80,000 software that would only cost them $160,000 to build themselves, then they would start to think about the merits of doing it themselves to “own it”. I like to pitch “we are only 10% of the cost of building this yourself”, which suggests we could raise our prices to $300,000 in this example, and still be a big value to clients.
Anyway, pricing is more of an art than a science. Play with it, test it out on a few clients and adjust accordingly based on how fast or slow they are to act on your offer. Hope this helps point you in the right direction.
Image credit: CC by Cat Branchman
ABOUT THE AUTHOR: GEORGE DEEB
George Deeb is a managing partner at Red Rocket Ventures, a Chicago-based startup consulting and fundraising firm with expertise in advising Internet-related businesses. More of George’s startup lessons can be read at “101 Startup Lessons — An Entrepreneur’s Handbook.”