Key pricing principles for startups

One of the hardest tasks for entrepreneurs, especially first-time entrepreneurs, is determining the prices of their products. This is especially true of very innovative products for which few or no reference points exist in the market. More often than not, entrepreneurs price their products too low. This article highlights a couple of principles that will help you determine price and avoid critical mistakes in the process.

Pricing and growth

Paul Graham’s famous 2012 essay makes it clear that the main imperative for startups is growth. However, few entrepreneurs seem to make the connection between pricing and growth, and we’ve seen countless examples of entrepreneurs charging too little for their products to fund their growth. In fairness, not many entrepreneurs have built global businesses and therefore fall short in their understanding of the time and cost involved in building a global customer base—the main challenge being the cost of a repeatable and scalable customer acquisition model.

A simple but effective way of thinking about pricing as it relates to growth is based on gross margin. Gross margin is calculated by subtracting the cost of goods sold (COGS) from net sales. (Net sales is sales revenue less any discounts, and COGS is the materials and labour included in the units sold.)

Here are some very simplified examples of a gross margin calculation to help illustrate how it impacts growth.

Example: Medical device

Cost to make: $1,000 per unit
Initial capital: $1,000

  Gross margin: 35% 70% 100%
Month 1 Initial capital $1,000 $1,000 $1,000
Units produced 1 1 1
Net sales $1,350 $1,700 $2,000
Cost of goods sold $1,000 $1,000 $1,000
Gross margin $ 350 $ 700 $1,000
Accumulated capital $1,350 $1,700 $2,000
Month 2 Units produced 1 1 2
Net sales $1,350 $1,700 $4,000
Cost of goods sold $1,000 $1,000 $2,000
Gross margin $ 350 $ 700 $2,000
Accumulated capital $1,700 $2,400 $3,000
Month 3 Units produced 1 2 3
Net sales $1,350 $3,400 $6,000
Cost of goods sold $1,000 $2,000 $3,000
Gross margin $ 350 $1,400 $3,000
Accumulated capital $2,050 $3,800 $6,000
Month 4 Units produced 2 3 6
Net sales $2,700 $4,500 $12,000
Cost of goods sold $2,000 $3,000 $6,000
Gross margin $700 $1,500 $6,000
Accumulated capital $2,750 $5,300 $12,000

The above examples are not based on cost-plus pricing; the price level may have been set using any method. The point of the examples is to illustrate how growth margins impact potential growth rate. In this simplified example:

  • A gross margin of 35% equals very slow growth.
  • A gross margin of 70% equals linear growth.
  • A gross margin of 100% equals exponential growth

For most startups seeking venture capital funding, having the potential for exponential growth is imperative.

If you are unable to collect such gross margins, your typical options are as follows:

1. Revisit your product and value proposition.

  • Are there ways you can increase the value of what you do, for example, by continuing to innovate the product itself or adding services?
  • Can you dramatically lower the cost structure of the product?

2. Consider your go-to-market strategy and messaging.

  • Are you targeting the right customers through your channels?
  • Is your messaging efficient in demonstrating value for customers?

3. Revisit your funding strategy.

Discounting

Early-stage entrepreneurs are often tempted to use price discounts as a way to promote their products. Many startups have not built the costly infrastructure of an established company, and some entrepreneurs feel they can use that to their advantage by competing on price.

However, if your startup has an innovative and therefore differentiated product, customers lack a way of appreciating your discount. They don’t actually know what your product is supposed to cost in the first place. You are probably also too early-stage to have built a desirable brand, so it is hard for you to demonstrate that you are actually offering a bargain. In other words, discounting your price as an early-stage entrepreneur is highly inefficient.

Worse still is the fact that by discounting, you are muddling the market feedback you’re getting. Keep in mind that other than getting product sales and revenue, you are trying to build a business and, in doing so, determining product–market fit and a scalable pricing model is essential.

If you discount the product in your early stage, you essentially don’t know if you have a competitive value proposition. In fact, if you need to discount to get customers, there’s an excellent chance you don’t have a strong value proposition—and that is a serious red flag that potentially warrants revisiting your product and value proposition rather than continuing to use discounts as an approach.

If you discount your product in the growth stage, you are at best slowing down the time it takes to find a scalable pricing and go-to-market model. Throughout the early days of building a business, you are supposed to lose business; if you don’t, you are pricing too low. Understanding your losses—who you lost and why—is critical feedback. We recommend setting your price at a consistent level that allows you to win most of your desired business (with no discounts). Then you can systematically analyze why you win and why you lose.

There are two exceptions to the no-discount rule: In the really early days, as you are trying to understand whether the product is working the way it should in the hands of the customer, you can discount the product on only two conditions.

  • The offer is time-limited for a small, fixed number of users or customers. Even if you discount the product, the price needs to be set to a level that ensures they commit to using it (if you give it away free or close to free, many customers won’t feel the need to use the product).
  • Your expected full price is clearly communicated to the users, but you are providing a discount in return for feedback.

When gross margins don’t apply

There are some business models for which other factors are more relevant than gross margins.

  • Media or content businesses essentially sell eyeballs to their advertisers. For that kind of business, user engagement and network effects are critical because they translate to time spent on a site and user volume—something advertisers like—rather than gross margin.
  • For startups that sell software as a service (SaaS) or subscription-like products, the pricing focus shifts away from gross margins to customer lifetime value and its relationship to the cost of acquiring customers.

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