Value-based pricing for startups

Why do you think Louis Vuitton can charge over $3,000 for a shoulder bag when another high-street brand, Coach, charges $500 for similar items and still makes a profit? Presumably both are made using similar kinds of materials and processes, so while not entirely irrelevant, cost isn’t the determining factor. Instead, the focus is on creating customer value. What allows Louis Vuitton to charge such a premium, in simple terms, is exclusivity: A customer who chooses to buy one believes there is more value in being able to walk around with an LV bag than having $3,000 in their pocket.

While this example is from the apparel industry, the concept of value is critical to getting pricing right for all entrepreneurs. An example closer to home is Salesforce, which charges a small business $75 per month for a licence. The price has little relationship to the actual cost for Salesforce to deliver one user licence; the software is already built, and the process of issuing a licence is fully automated and available to buyers on a self-service basis. Instead of product cost, Salesforce’s main considerations when setting a price is covering their customer acquisition cost within the first 12 months, while keeping the price at such a level that the customer sees enough value to continue to pay $75 per month for years.

As these examples show, the idea behind value-based pricing is not to focus on product cost but on what buyers perceive they are getting when using a product. Employing customer value as a way of determining price means continuously focusing on building your understanding of what is important for customers and the role your product can play in customers’ hands. The underlying belief is that customers are willing to pay anything (reasonably, within their means), as long as they are getting a perceived return on the transaction.

In practical terms, setting prices according to customer value means striving to really understand your customers: how they work, and their objectives and priorities. For example, one venture in the AI and automation space made very detailed customer workflow maps, including which staff member was involved, for how many minutes and seconds, and the corresponding cost—even if some touch points only amounted to cents—before tallying up the cost of the entire process. To be able to create such a detailed understanding of their customers, the company spent hours interviewing and observing how their customers (in this case, banks) worked through a specific process. In addition to understanding the cost of the process, the mapping exercise provided insights into what particular steps of the workflow would be most valuable to automate.

Please note that from a pricing perspective, once you understand the amount you could save your potential customer, you can’t claim the full amount as your price—you have to give a considerable part of it to the customer to motivate them to make the change. This is partly because customers can’t always be certain of realizing the full benefit of what you offer, so they’re taking on risk by implementing your product and therefore will expect a return.

Of course, value is not just about time and cost savings. Here are some examples that illustrate other types of value.

• People buy stocks and mutual funds in the belief that they will yield financial returns.
• We buy insurance products so we don’t have to worry about worst-case scenarios, a.k.a. peace of mind.
• We donate to charity not because we expect anything in return but because we believe in altruism.
• Some people dress fashionably or renovate their homes because they care about aesthetics.
• When learning to speak a new language or play a musical instrument, we’re motivated by the feeling of mastery.

By systematically engaging with your potential customers, will you understand which functional and emotional values are important to them.

Focusing on value is not a one-time process but a continuous effort. One factor that has a considerable influence on perceived customer value over time is your brand: As a startup, your brand initially carries very little weight, but you can develop what is often referred to as a “brand premium” and therefore increase your prices—just like Louis Vuitton.

Actions

• To ensure you understand the value your product offers customers, create a day-in-the-life summary.
• Complete a value proposition design canvas

Read more on pricing:

• Pricing objectives for startups
• Key pricing principles for startups (Coming soon)
• Pricing strategies for startups
• The experiment: Pricing strategies for startups
• Effective pricing tactics: Pricing strategies for startups