Most IT startups that deliver a differentiated product which creates large value for their customers choose to charge their customers based on their ability to pay rather than a measure of the value that is being delivered. This allows them to extract maximum value from each customer. However, despite the logical sense of this opaque pricing approach, few startups have the negotiating power and relationships with key IT purchasing managers necessary to adopt it. Especially in their initial stages, the majority of startups need to rely on a transparent tiered pricing model to win customers.
The traditional tiered pricing model offers different levels of service at different price points. The different levels of service commonly vary along dimensions such as product features, the number of user licenses granted, and customer support. The final shapes of most pricing models are similar in that there are a number of tiers with each successive tier offering a higher level of service at a higher price point. However, this is where the similarity ends, as startups take very different journeys to determine the specific attributes of their packages.
At one extreme are those startups which arbitrarily assign different service levels and price points to different packages. Although higher service levels are more expensive, there is no method to the madness, or reasoning behind the pricing. An exaggerated example of a common mistake is for the basic package to already offer each of the product features that all of your customers want. The difference between the basic and premium packages may be a product feature which no customer wants. As a result, you won’t sell any premium packages, and will leave money on the table by not further segmenting the service levels of the basic package according to customer needs.
This leads to the right way to determine your pricing strategy. In particular, startups that excel at pricing start by segmenting their customers according to their needs. This can be done by surveying prospective customers or looking at the actual usage of existing customers when available. The goal is to determine the product features, number of user licenses, customer support levels, and other attributes demanded by each customer. The next step is to group these customers into segments based on the similarity of their needs. Since few customers are likely to have identical needs, this grouping is as much an art as a science. A good rule of thumb is to create between three to five customer segments. Any less and you’ll likely be missing out on the opportunity to discriminate between the specific needs of different customer types. Any more and your pricing strategy will confuse your customers.
Once you’ve grouped your customers according to their needs, you need to determine what price to charge different groups. Once again, this is more art than science. However, a good approach is to estimate the value in terms of greater revenue and cost savings which your product generates for different customer segments. You should then charge a price which allows you to capture a chunk of that value. The more differentiated your product relative to that of competition, the greater the share of the value you should try to capture. Some of your customers will be performing the same calculation on their side so this approach will help you keep your customers happy while also generating as much revenue as possible from your product. And when in doubt, err on the side of charging more, not less. You can always lower your price to attract more customers, but an increase in price is much harder to justify. What’s more, a higher fraction of your customers than you’d expect won’t even bother calculating the value delivered by your product!