You Can’t Price Software Without Focus
Pricing matters at early-stage growth companies because it brings into focus all the work you are doing to a) understand your customers; and b) define the value you’re creating for them. In fact, you should really have a firm grasp on how you can do both — by implementing customer segmentation and developing differentiated value propositions — in order to set a solid foundation for discussing and establishing price in the first place.
4 Steps to Proper Customer Segmentation — Which Have You Completed?
Step 1: You’ve identified a segment as a group of customers who get value in the same way
This basic definition of a customer segment is not enough. To develop real focus you have to go one step further and understand not just why your customer will buy (because you provide differentiated value relative to their alternatives), but how they buy. You have to understand the buying process.
Step 2: You’ve identified a segment as a group of customers who get value in the same way and who buy in the same way
There are many different buying processes, even within the same industry. In some companies procurement rules the roost while in others it is the CFO who makes the critical decisions. Other companies will let business unit leaders make many buying decisions. This is sometimes scale dependent, but not completely.
The reason you need to drill down is that the buying process will have a big impact on your customer acquisition costs. You need to make sure that your unit economics (the cost of acquiring and serving a customer relative to the value of that customer to you) make sense. That is a critical part of growing a company, and it is largely dependent on targeting the right segments.
Step 3: You’ve identified a segment as a group of customers who get value in the same way, buy in the same way, and who will act as references for each other
For early-stage companies, word-of-mouth and recommendations are key to getting market traction. So there is one more thing to take into account in choosing a segment: Do people in that segment talk to each other and act as references for each other? If Jill climbs up that hill will Jack follow her?
Step 4: You’ve identified a segment as a group of customers who get value in the same way, buy in the same way, who will act as references for each other, and who see your differentiated value is high relative to their customer acquisition and service costs.
Notice that we haven’t yet talked about cost. Generally speaking, costs are your problem and not your customers problem and they do not come into setting prices. They do impact segment selection though. And the absolute best segment, especially for an early-stage company, is one where your differentiated value is high and your customer acquisition costs and customer service costs are low.
All this has to be clearly understood before you start worrying about price. Your price will be based on — and ideally should track — your differentiated value. And your differentiated value is likely to be segment specific.
Defining Value: Developing Differentiated Value Propositions
‘Value’ can be one of those Humpty Dumpty words. “’When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’” We have to get concrete about what we mean by value. To do that, there are two dimensions to consider: economic value and emotional value. Both are important in B2B, but let’s focus on economic value, saving emotional value for another day.
Economic value is often thought of in terms of return on investment (ROI), which is in turn dependent on the total cost of ownership (TCO). The problem is that ROI measures are mostly designed for CFOs who need to make decisions between dissimilar alternatives. Ex: Should we invest in this new CRM or increase the marketing budget? In other words, looking at ROI is typically for apples to oranges comparisons. It doesn’t generally help you when it comes to segmenting a market or setting a price. For that you need a different framework — Economic Value Estimation, or EVE™ as it is known.
Economic Value Estimation is a technique developed by pricing gurus Tomas Nagle and John Holden in their book The Strategy and Tactics of Pricing. The two key insights they cover are:
- Value is always relative to an alternative (may be a competitor, or the current solution, or doing nothing — there is always an alternative)
- Economic value is the impact you have on your customer’s business
The fact that value is relative to a competitor is a critical insight. It’s what makes the EVE™ approach so different from ROI and other generalizing formulas. Unless you are a pure commodity offer (and if you plan to create value through innovation you had better not be) there will be some value that you provide that alternatives do not and some value that alternatives provide that you do not. And then there is the overlap. The price of the value that you and your competitors both provide is set by the market. You do not control it. Some very large companies can influence it, but they’re companies with billions in revenues who also control value chains — Walmart, Ikea, Apple (on a good day), or, in search advertising on the web, Google.
Your economic value proposition is the sum of your positive impacts on your customer’s business model less your shortcomings relative to a competitor and any unique costs of doing business with you.
Ex: You can help your customers to grow revenues (increase market share, enter new markets, win in specific situations, increase their own prices), or you can lower operating costs, operating capital, or capital expenditures. In a few industries, like finance and energy, you can also use risk reduction as an economic value driver (in most industries there are no formalized approaches to managing risk, so it is difficult to quantify your value in terms of risk reduction).
Most companies will have several different value drivers (if you have more than seven you are probably over thinking it), and only two or three will resonate with any one particular buyer. You can use these value drivers — both positive and negative — to further segment your market.
Once you have achieved granular customer segmentation and developed a firm understanding of your differentiated value propositions, then you will have the foundation in place to develop your pricing model.
Photo by: Ellie