Startup Pricing 101
by Kevin Hale

YC Partner Kevin Hale goes over the fundamentals of pricing and monetization, how it affects your customer acquisition strategy, and how to optimize it through a few rules of thumb.

Watch this if:

  • you aren't sure how to price your product
  • the unit economics of your business aren't working
  • you're worried that your target market is too small

Transcript

This was a highly requested talk from last year where lots of people have questions about pricing are really confused. It's actually was well requested both at YC itself. That's a very, very popular workshop that we run. And so we're gonna go over a lot of basic fundamentals for pricing that hopefully will just help you understand how to approach your pricing and monetization from first principles and then you help you help yourselves, same thing with the landing page. So we're gonna go over first principles for pricing. We're gonna go over why is pricing particularly hard for startups, for people making innovative products and new markets? Like, why is it extra difficult?

How do you do price optimization? Like, how do you actually do it? What does that actually look like? And just kind of demystify that whole process. When we look at the challenges of pricing, you start recognizing why certain types of customer segments that you're going after are difficult, like SMB. And we'll talk a little bit about that. We're gonna talk about how pricing affects your acquisition strategy. It changes what you can do and what you cannot do. And it's extremely important because a lot of companies get caught up doing the wrong acquisition strategy or wasting too much money because their price is incorrect.

And then I'm gonna give you some rules of thumbs, some pricing tricks, just to help make it a lot easier when you're encountering different pricing problems. I call them pricing tricks, sprinkles, okay. There are three levers you can pull to improve growth. So in the last doc, I talked about conversion rate and churn, but monetization is actually the big dog. It's the one that I really like now, there was a survey done with over 500 SaaS companies and they talked about sort of like amount of effort that they put into each one of these strategies and the returns that they got as a result of it. Now, acquisition is really fun and exciting. It's the one that everyone kind of understands simply. It's like I get more customers. I get more logos. Gives me more growth. Retention, of course, it's about keeping customers and monetization is about getting more money per customer.

Now, if you increase just your efforts or resources by 1%, your work on acquisition, usually get a return of about 3.32%. In retention, it's about 6.7%. And when you're optimizing pricing, that gives you your biggest bang for your buck in terms of impact on your business, yet it's the one that is most neglected and I think it's the one that everyone is so afraid to touch because they're so scared that if they get the pricing wrong, that they will lose all their customers.

Now, the first principles, the basic idea about pricing, the thing, the concept that really opened up in my head how to think about pricing, how to understand the problems that people are facing and why startups get it wrong is to use a concept called the pricing thermometer. And so you have to understand that when you price something, there's actually like two other factors at play. And so there's the cost, there's the price, and then there's the value. And the interplay and relationship between these items affects how growth happens inside of your company.

Now, the gap between price and cost, that is your margin, that is your incentive to sell. And so the bigger that gap is, the more you are driven to want to push your product to your customers, better salespeople, etc. This gap here between price and value is incentive to buy. And the larger that gap is, the easier it is to have your customers to wanna sign up or use your product. Now to figure out price, there's really two ways to go about it. You either start with the cost, if you know what it is, and you figure out where your price is based off of that, that is called cost-plus. The other way to do it is figure out what is the value of your company or product or service, and then you figure out your price from that. And that is called value-based pricing.

In startups, and almost pretty consistently across all businesses, everyone will tell you, you should strive for value-based pricing. It allows you to charge a whole lot more. It allows you to manipulate this incentive to buy. The problem is because people do not understand their relationships or even understand what are the costs and what are the value that the customer is gonna think about their product, they put their price in a kind of arbitrary place, and they don't know what are the forces that play it, that drives it. And it results in four different types of mistakes.

The first one is startups will price their products too low. Basically, you consistently undercharge is the number one piece of advice we give to most startups to fix their pricing. And I'll talk a little bit why most companies fall into that trap. You underestimate your costs and the result is you have a problem where your margins aren't enough to cover, sort of, acquisition. You don't understand your value. You don't understand how your company thinks about the problem that you're solving for them or how they value it. And either they don't understand your value, or you don't know how to convince them of the value that you think you offer. And as a result, you can't get the price that you want.

And lastly, you focus on the wrong customers that you think, man, man, if I built a better product and I charge half of the competition, I win. The thing is that almost never happens. And the reason is because you, as a startup, you as working on something to create a new market are working on innovative products, you are focused on the wrong customers. They are not the mainstream people who are going to look at the price and make most of the determination based off of that.

So this is the sales and profit over product's life from inception to demise. That's what it's called. All you need to know is that these are five different stages of a company, and this is what sales might look like over different stages, and what profits might look like over those different stages. You who are in startup school, you who are getting seed funding, you are in the first two stages, product development stage, introduction. You are not in the growth phase. And the thing to keep in mind is that the customers in the first two stages, the ones that you're going after, they don't look like mainstream customers that you find in growth and maturity stages. They're not mature customers. They're early adopters and the thing to know about early adopters is you kind of don't really get a lot of momentum and growth until you get past the first 2% to 5% of potential buyers of your market. These people in that 2% to 5%, the called early adopters, and the thing that drives them is very different from mainstream people.

So, there's a couple of things to keep in mind about pricing innovative products. What you are trying to do fundamentally is require users to change their pattern, to stop doing it the old, shitty, spreadsheet way and do it in the new, better, your way. And getting someone to change their pattern is actually difficult, right? Especially if they're a mature person, partly because the average user lacks information needed and the trust in you or whatever it is that you're making to make that change, to take that risk. You are entrepreneurs, you're comfortable taking risks. Your customers are not entrepreneurs for the most part. They're probably less comfortable taking risks.

And so in the beginning, you're going after people who are willing to take a risk, and those are early adopters. Those are people who care about benefits above all else, that the highest value to them is beating their competition, doing something much better and taking a chance, that something new will give them that edge over anybody else. Those early adopters, therefore, are not price-sensitive. If anything, if you've built a better product and you charge less, it looks like you have reputation risk. It's like, why is it too good to be true? What is the catch? And what will end up happening is it makes it takes it much longer to get them to understand.

This is basically all price optimization...this is the most complicated way that you can try to show price optimization. This is a demand-yield curve. And what you have on this side is different prices and on this side, you have sales, unit sales. And basically, what you are trying to figure out when you're optimizing the price that you're charging your customers is like basically, what is the perfect balance between how much I charge and how much sales volume I get? And then your price optimization is basically that, try different prices and then see what the effect is. When I have my companies optimize their prices, they just use a very simple table. You don't need to try to figure that weird-ass graph. Basically, you wanna have a column that says, these are the prices I'm gonna try, and then what is the result in conversion rate? What is the result in sales volume? And then how much revenue did I generate? That's all it is.

And so let's say I have prices at these different price points and I get these different conversion rates and I get this sales volume. I should immediately be able to see who the winner is. Here we go. Now, the one thing to keep in mind, once we have figured out something like this on a simple product, is that these areas at lower prices, if you can afford them in terms of your margin are actually lost opportunities. And what you wanna understand about these are these are what you're going to see if you offer discount pricing or offer tiered pricing at different price points.

Another exercise I like to go with companies when dealing with pricing is help them understand is like, are you in a danger zone? And so what I usually do with my companies is I help have them, sort of, calculate what would their business look like or what is it gonna look like to be a billion-dollar company? And usually, the rule of thumb there is to be doing $100 million a year in sales, in revenue. And so that basically is like at your price that you give, how many customers do you need to have to make $100 million in that year?

So let's have a bunch of different price points then we know, okay, great, I need these number of customers in order to make this formula work. You understand what that looks like. At a $100 price point with a potential of a million users, right? This is consumers. That's what that consumer space looks like. And you know what this down here looks like, $1,000 a year, we call this enterprise. This area here is the part that a lot of companies are in and really, really struggle. They're on the struggle bus and it tends to be SMB. These are people who kind of treat their money like consumers, right, but they kind of look like they might be an enterprise. And the reason why this is such a danger zone is because it will tend to fit in the wrong place on my next diagram.

So let's imagine that this vertical axis represents price. You can charge either a high price or a low price for your product. And this represents complexity of your sales process, low complexity to high complexity. If you are having a product that is $2,000 or less and is basically self-serve, then you have something in this quadrant here. And this affects completely what you can do in terms of what drives your business, what you can spend on to get that sort of growth. That price point here at $2,000, it needs to have almost all marketing be inbound. You can't spend a lot of money outbound or ads, etc. Your support has to be completely self-serve or very, very minimal. You have no sales team at this price point. You can't afford it, right? But conversions can happen on the same day, must be in a self-serve model.

Transactional, so between $2,000 and $10,000, when you're able to charge this, you're able to have a few new toys up your sleeves. And so marketing now can be focused on generating qualified leads. Your customer support can now offer like SLAs, or you could start paying for training to help people get onboarded. And for sales, you can't hire a dedicated salesperson, but maybe you can have an inside sales rep to sell within companies or within your customers. You could maybe have an SDR and you can maybe have someone dedicated to giving product demos. Sales cycle here should not be longer than one to three months.

Enterprise, so over $25,000. Now, for marketing, you can start spending things on branding, on building up trust with customers. Your support is very, very high-touch that you can afford. You can do phone support. You can have a customer success person dedicated to the client. And for sales, you're gonna start thinking about sales managers, dividing stuff into territories, and having sales engineers that participate in terms of conversion and the sales calls. These will have a sales cycle of about six to 12 months.

This is the garbage zone, right? And you know, if you're potentially in this, and this is the big wake up call for you, if it's taking you months and months and months to close someone but you're not making a lot of money to cover it, you have a process where your acquisition costs are just too high for you to be sustainable. And you have to get yourself out of that problem. All of your work should be towards increasing the perceived value of your product or service.

I'm gonna end on a good rule of thumb. So if you are starting with some kind of price, but you don't know how to, sort of, optimize it or figure it out, then here's a good place to get going. The first thing is, I like to have things where the value is 10X the price of whatever it is I'm charging, and I want to have it so that the value is easily understood to be 10X. So for example, if I charge for a product that is $10, then it should be in terms of perceived value by my customer that it's worth $100 to them. If they do not immediately understand the 10X value of the price, it's gonna be hard to get them to move, their incentive to buy might be too low.

Once you have any kind of price, and this is particularly important for people who are doing B2B or enterprise sale, you should start practicing raising prices. And I like to just start by raising prices by 5%. If you feel really confident, jump it up by bigger numbers if you want, but this is a pretty safe way to do it so that you can feel comfortable with it. And you wanna keep raising prices until you're losing 20% of your customers. That's about a good balance to have in terms of understanding that like I have a good price here. I'm losing 20% of my deals. It's not too high. It's not too low.

In summary for pricing, pricing gives the most bang for your buck. You should work on pricing. If you've never touched the pricing of your product, then you're losing out on lots of potential growth. Understand the variables. Do you really understand your costs? Do you understand why you've played the price where it is? And do you understand the value? When you go into a sales meeting or a call, do you talk to people and you basically say, it's like, "I know exactly what this is going to be worth to you. So when I tell you what the price is going to be, you're going to be like, 'Damn, that's totally worth it.'"

Go after early adopters. Remember, as a startup, that is who you're going after. So when you are talking to customers and they are taking a really long time to make a decision, or they're wanting to have a lot more proof that other people are using it, you are not talking to an early adopter. You're wasting a lot of time on non-believers. Go after them first. Don't take it personally when these people who are much more mature aren't ready for your product. They were never going to be. Your job is to get through that first 2% to 5% of the market. Those early adopters care more about benefits than price. So don't undercharge your products when you have something that is of value and easily understood to have value.

Get organized. When you're doing price optimization, it's really, really easy. Don't overcomplicate things. Figure out a bunch of different price points you wanna check. Understand sales volume, conversion rate, and the revenue that's involved, and that will help you make the best pricing decision. Your price will determine your acquisition strategy. If you realize that your sales cycle or all the things that you're spending on is way too much for the amount of money that you're charging, you either need to increase the price or completely reduce your acquisition strategy costs. Use the 10/5/20 rule. Set a price that is 10X, that is a 10th of the value, increase prices by 5% until you're losing 20% of the deals. Thank you very much, guys.