This is Kristen O'Brien, Managing Editor at NFX, and this is the founder list. Audible versions of essays from technology's most important leaders selected by the founder community. This is 10 years' worth of learnings about pricing, and there are only 3 pricing strategies for your startup. 2 essays written by Thomas Morgan, Managing director at Redpoint. Red by NFX. Last week, I shared a presentation with an executive team at a large public SaaS company on everything I've learned about pricing.
Here's a summary of the frameworks and theory that I've aggregated over a decade of investing in startups. Why do we set prices? Setting aside the important reasons of generating revenue and maintaining solvency for a business, there are many other reasons to set price. Price reinforces brand because price telegraphs Beller a product is a premium product or a value product.
Price differentiates products in the market and can be used as a go to market strategy, under price the competition to gain share. There are many others too. There are 4 components to pricing. 1, strategy. What is the goal of the price? 2, philosophy, how does the company price relative to costs? 3, structure. What is the pricing rubric? And 4, positioning, how best to communicate the price. Strategy, there are only 3 pricing strategies skimming, maximization, and penetration.
Skimming means charging the first to buy a product more than the later buyers. Maximization is charging the most you can extract in each sale. And penetration is under pricing to gain share. Philosophy. There are 2 pricing philosophies. Cost based pricing and value based pricing. Cost based pricing is common in commodity markets. To price based on cost, you take the cost of the product and then add a margin. If you're targeting 50% margins, just double your cost and there you are.
Value based pricing means charging the customer what they are willing to pay. This requires understanding their budget and the value of the product to them. Structure. In software, we typically see 3 pricing structures, linear pricing, each analytics event costs 10¢, 2 part tariff, the analytics software has a base platform fee of $10,000 and each analytics event processed by the system costs 10¢ Morgan. And 3 part tariff.
Again, the software has a base platform fee but the fee is $25,000 because it includes the first 150 k events free. Each marginal event costs 15¢. In academic research and theory, the 3 part tariff is proven to be the best. It provides many different ways for the sales team to negotiate on price and captures the most value. Position. There are three ways to position your pricing.
Per unit of consumption, message, analytics event, telephony minute, per person and ELA enterprise license agreement, which is a pre negotiated deal for everyone in a business. To figure out the right pricing strategy, it's critical to determine what the buyer cares about. Do they care about cost or value? What is their core unit of their world? Pete, dollars, gigabytes? How predictable is the pricing plan?
And can the buyer clearly articulate the pricing, advocate on your behalf, and champion the purchase? It's also important to understand the seller's needs, How does the pricing change the market size? The unit economics and cash flows associated with the sale? The competitive positioning? All of these disciplines fall under product marketing. Well run product marketing teams develop these perspectives before product launch.
By combining market research, interviews with prospective customers, and conversations with the sales team, the product marketing team can develop a unified pricing strategy that is consistent with the company's strategy and the sales tactic. The challenge with pricing is that it's never a constant. As an industry evolves, competitive pressures change, a vendor's positioning changes, and the buyer's needs change, so must pricing.
Thinking through these 4 core parts of pricing is critical to ensuring internal alignment and maximizing success of developing the right pricing plan for your business. There are only 3 pricing strategies for your startup. Pricing. Is there any word that confers some whisper of dark arts other than pricing? Morgan question that instills less confidence than how did you derive your pricing strategy? Many James, startups replicate and tune competitors pricing strategies.
If everyone else prices Pete seat, then so should we? Is this the right thought process? Madivan Ramanujan is a pricing Pete. A partner at Simon Kucher Partners, the preeminent pricing consultancy, he argues in monetizing innovation that there are only 3 pricing strategies startups should pursue. Maximization, penetration, and skimming. They prioritize revenue growth, market share, and profit maximization differently These were also mentioned earlier in this recording.
Maximization, revenue growth. Maximize revenue growth in the short term. Startups should pursue maximization when there are no clear differences in customer's segment's willingness to pay. And when the optimal short term and long term prices are equal, Many mid market software companies price with the goal of revenue maximization negotiating for the highest possible price in each sale.
Penetration, market share, price the product of a low price to win dominant market share, a bottoms up strategy lends itself to penetration pricing. Price low to minimize adoption friction, grow quickly, and then move up market after developing broad adoption. Penetration pricing leads to land and expand sales tactics. Expensify NetSuite, New Relic, slack, follow this model. Penetration prioritizes market share. Skimming, profit maximization.
Start with a high price and systematically broaden the product offering to address more of the customer base at lower prices. Skimming is widespread in consumer hardware. Apple sells the latest Iphones at the highest prices and repackages older models at lower prices to address different customer segments. As Motivan tells it, Steve Jobs was both a product genius and a pricing genius. By pairing the 2 skills, he led Apple to record breaking profits quarter after quarter.
Skimming is less common in the software world because few startups develop a product at launch that will be accepted by the most sophisticated customers and those willing to pay prices that generate the greatest Morgan. There are exceptions, Oracle's database, Tanium's security product, Workday's human capital management software, Startups pricing strategies should be explicit.
They should decide which strategy to pursue and align sales, marketing, product, and engineering efforts along those lines. Mativan recommends pulling your executive team to prioritize revenue growth, volume growth, profit generation, and market share to ensure the company's pricing strategy is consistent with the goals of the team.
For more audio essays from the people who've Beller companies like Instacart, Facebook, Trello, HubSpot, and Dropbox, visit the founder list at nfx.com Omri subscribe to the NFX podcast at podcast.nfx.com Omri wherever you get your podcasts.