All startups eventually confront the challenge of optimally pricing their product or service. Do you give it away, like Twitter, and hope to find a way to monetize later? Do you price at a multiple of your cost like a wholesale consumer product? Or should you simply charge whatever price premium the market will bear? Your decision can have tremendous implications because your price point defines your brand image and market position; cash and funding needs; and, ultimately, your long-term survival.
Your pricing model, revenue model, and business model are all intertwined elements of your overall strategy and business plan; getting them right is essential to attaining your financial objectives. Your pricing model must be appropriate for the markets and customers you target, and you are constrained by the tactics used by your direct and indirect competitors.
What revenue models are commonly used by startups? Here are ten that come to mind, along with some advantages, disadvantages, and special considerations:
Give it away for free, and make money on advertising. Most social apps, both web and mobile, including Facebook, Twitter, and Pinterest follow this model. It’s a very difficult model to follow successfully. Many publishers like The New York Times are putting most of their content behind a paywall because the ad dollars just aren’t there. It either takes a lot of luck (say, being a huge hit at SXSW) or deep pockets for a startup to achieve critical mass with this model. You also need to remember that the user IS your product, and you’re selling access to them to advertisers, who are your real customer.
Free product, bundled with paid services. This pricing model is common for open source software, such as Red Hat linux, where the product is available for free download, but customers pay subscription fees if they want support. Other companies can also charge for installation, maintenance, training, customization, and consulting services. This pricing model is essentially a service business that uses free software as a marketing tool. Note that most investors aren’t interested in service businesses; fortunately, service businesses are good at generating cash flow on their own.
The “Freemium” model. Many software companies like LinkedIn and Dropbox offer a free, limited-functionality version of their product, hoping that some users will pay a premium for advanced features. The trick with this model is to offer just enough value in the free version so you attract (and hopefully lock in) regular users, and incrementally more value in the premium version so that you entice conversion and maximize cash flow. Your pricing must be a function of the incremental perceived value you offer: Can you convert 1,000 users at $100 per year? Or 10,000 users at $10 per year?
Cost-based model. Many consumer products sold through conventional distribution channels are priced at two to five times the production cost, depending on the industry. Margins are much thinner for commodities, of course. Multiples are used because the middlemen in the distribution channel, as well as the end retailer, all have standard markups. If you are selling into existing retail channels, this is a common pricing strategy.
Value model. If you can make a clear case for the value your product offers to the customer, then you can price in proportion to the value. In some cases, the value could be monetary, as in savings: perhaps you have a SaaS solution that takes the place of traditional desktop software, and the end user saves on installation, ongoing maintenance and upgrade costs, and local storage requirements. Or perhaps the value is in terms of health benefits – maybe a new drug that can treat a disease faster, with fewer side effects. The key to value-based pricing is to demonstrate that you deliver considerably more value than available alternatives.
Portfolio pricing. If you offer a suite of products and services, each with a different cost and value to the customer, then you have an opportunity to offer a customized solution that maximizes the benefit to the customer at maximum profit to you. This strategy can become very complex very fast.
Tiered or volume pricing. If your product is purchased in different quantities by different types of buyers, you can offer tiered pricing. This is very common for B2B sales of printed matter or for apparel. Depending on the industry, it might be something like a 10% price break for ordering 100+ units, and a 15% price break for ordering 500+ units. This can also apply, directly or indirectly, to certain consumer products and services: for example, the “buy 9 and get the 10th one free” punch card is volume pricing in disguise.
Market pricing. In highly competitive and minimally differentiated markets where competitors’ prices are visible to all market participants (like most products sold online), prices are set primarily by supply and demand. This takes into account shipping costs and sales taxes. You can earn a slight premium if you have a strong reputation (like Amazon), or if you can promise faster delivery, or if you offer a more liberal return policy. If you can’t justify pricing at a slight premium to the market, then you need to be the low-cost manufacturer or importer, or else you’ll compete yourself out of business. In highly liquid markets such as stocks and commodities, supply and demand will cause prices to fluctuate by the millisecond. But even less liquid markets will adjust pricing in response to spikes in demand – for example, consider Uber’s “surge pricing” strategy.
Feature pricing. If your product or service can be configured to have a “base” model with a variety of optional upgrades, you can attract interested buyers with a low price on the bare-bones version and then upsell on the features. Anybody who has purchased a car or new home is very familiar with this technique. While this approach can be very profitable, you need to be careful not to alienate your customers by making them feel like they’ve been tricked. Consumer protection agencies are flooded with complaints against car sellers!
Razor and blade model. This pricing model involves a reusable “base” component that you sell cheaply (or even give away) and a consumable component that must be replaced regularly. This is why ink jet printers are so cheap: they make their money on the ink. This can also be used with medical devices where a fresh, sterilized component must be used with each application. If you are selling the base unit at below cost, you obviously need a deep balance sheet.
If you are a startup, it’s probably best to keep your pricing model as simple as possible. It’s far too easy to scare off customers with a complex pricing scheme. Start by researching what’s conventional in your industry and build from there.
Finally, study pricing models from the customer’s perspective. Try to interview as many potential customers as possible. Maybe you’ll discover that many of them are frustrated by the pricing conventions that are “standard in the industry” and they’ll be receptive to a different way of doing business.
For additional perspectives on pricing strategies, see the The Science and Art of Pricing slide deck.