Disciplined Entrepreneurship Workbook
Page 17
WORKSHEET
Key Considerations in Choosing a Business Model
Identification of Different Units of Product You Can Charge For (if appropriate)
What are the different potential units you could charge for (e.g., individual product, number of users, usage, site license)?
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Summary of Business Model Candidates
# Option Unit Cust. Fit Value Creation Fit Comp. Fit Internal Fit Pros Cons Grade
1
2
3
4
5
Note: Do not forget to consider creative hybrid models if appropriate.
Initial Decision and Rationale Which business model did you choose and why?
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Tests to Validate What hypotheses are you assuming to be true for the business model(s) you have chosen? ________________________________________________________________________
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What experiments will you run to test your hypotheses? ________________________________________________________________________
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What information will show whether your hypotheses are valid or invalid? ________________________________________________________________________
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How long will you give the experiments to run? ________________________________________________________________________
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STEP 16
Set Your Pricing Framework
WHAT IS STEP 16, SET YOUR PRICING FRAMEWORK?
Determine a framework to test pricing for your new product, and make a decision on what the initial price will be.
WHY DO WE DO THIS STEP, AND WHY DO WE DO IT NOW?
Small changes in pricing can have dramatic impact on your profitability, so there is great incentive to get this right. It should also be a price that is acceptable to you and your customer so that you have a sustainable business. You are able to do this step now because you have made your initial decision on business model, and the pricing framework flows from the decisions you made in your business model.
By the Book: See pages 173–179 of Disciplined Entrepreneurship for basic knowledge on this step.
See page 179 of Disciplined Entrepreneurship for an example of how a company addressed this step.
Even though it is impossible to know the right pricing for your new product just yet, you will do some analysis now and make some decisions to get started, but also build a framework to address the pricing decision as you move forward.
PROCESS GUIDE
It is virtually impossible to know your optimal price for your new product until you are able to offer it at scale and see how customers actually respond, as opposed to what they tell you they would hypothetically do. However, pricing is extremely important as even small pricing changes yield large direct effects on your profitability. As such, it is important to spend some good time on pricing now, but not too much, because it is foolhardy to think you can come up with accurate, detailed pricing at this early stage. Like with many other steps, this first pass on pricing is just a good educated guess to keep the process moving so you can continue learning; you will update and refine this step later.
In this step, you will come up with a reasonable pricing range aligned with the business model(s) you chose in Step 15, Design a Business Model. This framework will then be used to estimate the Lifetime Value (LTV) of a new average customer to your startup, and will be the starting point for later market testing (specifically, some form of A/B testing).
There are six major criteria to consider when making the decision, some of which also factored into your decision on business model:
Value Creation
You will base your pricing on the value you create for your customer, and not your costs. While it greatly depends on the strength of your Core, think of 20 percent of the value created as a good starting point for what you can fairly capture.
Customer Acquisition Analysis Revisit Step 12, Determine the Customer’s Decision-Making Unit (DMU), and Step 13, Map the Process to Acquire a Paying Customer. What is the DMU and the process? What does that analysis tell you?
Understand what authorization limits exist for the person who pays you, and try to stay below them so you decrease friction in the sales process. If your economic buyer, who clearly understands your value proposition, can’t make a purchase of $1,000 without running it by a vice president who is removed from the purchase process and will need persuading, then seriously consider pricing at $999 or lower.
Nature of the Customer
Understand how the elasticity of demand, or willingness to pay, depends on the type of customer. Using Geoffrey Moore’s guide from Crossing the Chasm, customers typically fall into one of five groups, each of whom will respond differently to different prices:
Technological enthusiast (this type buys based on technology coolness and as such is price inelastic and buys in low volume)
Early adopter (this type buys based on ego because he or she wants to be first and show off and as such is price inelastic and buys in low volume)
Early majority (this type buys based on compelling return on investment [ROI] and as such is willing to take risk if reward is high enough and will buy in relatively large volume and be influential)
Late majority (this type buys based on ROI but is willing to take less risk, will buy a good volume, and as such is influenced by success of early majority customers, which de-risked the product for the late majority; when this type finally buys, it will buy in relatively large volume)
Laggard (this type buys based on defensive position because to not buy is now risky because everyone else is buying, and seeks to avoid risk above all else; as such, when this type finally buys—which will be late—it will buy in relatively medium volume)
Strength of Your Core
Your Core will be critically important in your ability to command a premium price. As it grows over time, so will your power to command higher prices and give out fewer discounts.
Competition
Awareness of competitive options (from the eyes of the customer, not you) is an important data point to consider in this process.
Maturity of Your Product Is your product new to the market, or is it a mature product that may have even been proven in other markets?
The former is high risk and hence harder to command a pricing premium; there is less risk in the latter, which affects not only list pricing but your ability to avoid having to discount.1
Flexibility early on, especially to get those key lighthouse customers or influential customers, is critical, and you should be willing to decrease your price in such scenarios. In such cases, customize the offering and include a confidentiality clause in the agreement with the customer with regard to the pricing so you don’t set a dangerous precedent and have to provide discounts to other customers, too.
When you start going after follow-on markets, your success in other markets will allow you to price with fewer discounts than with your beachhead.
Remember it is easier to drop the price than to raise it, but that does not mean you should always start high and drop the price over time. In some cases, exactly the opposite is the better strategy, partic
ularly with companies that have a short time window to achieve a Core of network effects.
There is also a tremendous amount of behavioral economics involved in pricing, especially for consumers. It is worth reading books and blogs on this topic. One of my favorites is Predictably Irrational by Dan Ariely. You should also learn more about A/B testing so that you have a fundamental skill needed to optimize pricing going forward.
After you complete your pricing analysis, you will probably be even less comfortable with the pricing decision than the business model decision. However, pricing is easier to change than business model, and you almost undoubtedly will change your pricing. Your goal for now is to make a first guess so you can analyze the unit economics for your product and see if they are viable to develop a scalable business. You’ll start that analysis with the next step, Step 17, Estimate the Lifetime Value (LTV) of an Acquired Customer.
GENERAL EXERCISES TO UNDERSTAND CONCEPT
See the back of the book for answers to these questions.
Responsibility for Setting Pricing: While input should unquestionably come from all parties to analyze and ultimately determine prices, who should ultimately decide on pricing? Why and why not for the others?
Sales
Finance
Product Management
Engineering
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The Love of Nines: Why do gas prices almost always end with as many 9’s as possible?
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The Power of Pricing and Not Discounting: If you increase your price by 1 percent, how much effect do you think that will have on your bottom-line profit?
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WORKSHEET
Considerations in Setting an Initial Pricing Framework
Initial Decision and Rationale What unit of product are you using for pricing (carried forward from Step 15, Design a Business Model)? ______________________________________________________________________________
Based on your analysis, what is the price range that is most appropriate and why? ______________________________________________________________________________
In the first year, what do you believe your initial listed price will be, and what will be the effective price to the market and why? (The effective price is the actual price your customer pays after discounts.) ______________________________________________________________________________
Sanity Check: What is your expected estimated marginal cost (cost to produce a unit of product, excluding one-time setup costs)? Does your price per unit significantly exceed your estimated marginal cost in the long term? ______________________________________________________________________________
Test to Validate In setting your pricing framework, what hypotheses are you assuming to be true? ______________________________________________________________________________
What experiments will you run to test your hypotheses? ______________________________________________________________________________
What information will show that your hypotheses are valid or invalid? ______________________________________________________________________________
How long will you give the experiments to run? ______________________________________________________________________________
NOTE
1 Discounting is effectively decreasing the price, but it is less transparent to the market. This is in general a practice to be discouraged, but it can be a valuable tool to use in certain situations, especially early in the product’s introduction to the market.
STEP 17
Estimate the Lifetime Value (LTV) of an Acquired Customer
WHAT IS STEP 17, ESTIMATE THE LIFETIME VALUE OF AN ACQUIRED CUSTOMER?
Estimate the total profit you will get from a new customer, on average, over the time period that the customer would stay with you.
WHY DO WE DO THIS STEP, AND WHY DO WE DO IT NOW?
The LTV is an important number because you will compare it against your Cost of Customer Acquisition (COCA) to see if your startup will make more money from a customer than it costs to advertise and otherwise convince a customer to buy your product. As a rule of thumb, LTV should be at least three times greater than the COCA in order for you to be profitable, though this factor varies wildly from industry to industry. Knowing what drives LTV will help you make smart decisions about your product. The LTV can now be estimated because of the work you’ve done in Step 15, Design a Business Model, and Step 16, Set Your Pricing Framework.
By the Book: See pages 181–190 of Disciplined Entrepreneurship for basic knowledge on this step.
See page 190–193 of Disciplined Entrepreneurship for examples of how different companies and teams have addressed this step.
It may seem complicated, but COCA is just an estimate that will help you understand the critical drivers behind your company’s financial success.
PROCESS GUIDE
Now that you have chosen a business model (at least an initial one) and a pricing range in the previous two steps, you can develop an estimate of approximately how much a new average customer is worth to you. You will not know this number to great precision, but it is essential to understand the general order of magnitude and what drives the profitability of a new customer. Is it the initial sale? Consumables? Retention rates? Gross margin? Volume? Repurchases? Timing of purchases?
Common inputs to estimate the LTV include:
One-time revenue (the initial purchase price of a product)
Recurring revenue (maintenance contracts, etc.)
Other revenue (e.g., upselling)
Gross margin for each revenue stream (price of your product, minus production costs—do not include sales, R&D, or administrative expenses in this number)
Retention rate
Life of product
Repurchase rate
Cost of capital for your business1 (not for you personally, but for your business)
Once you know these numbers, you can build the five-year profit stream for your product. There is one last important step that you need to do. You will need to convert this revenue stream into one number with a consistent unit. That consistent unit will be “today’s dollars.” Today’s dollars means the time at which you start your sales process and have to spend money to acquire the customers. As such you will then be comparing like for like when you compare LTV with COCA.
To do this conversion you will utilize a well know concept to people in finance called “Net Present Value” (NPV). Doing the calculation for NPV means that you discount future cash flows by the cost of capital based on how far into the future the cash flow happens. Cash today is better than cash a year from now. Cash a year from now is likewise better than cash two years from now.
What makes this especially important for you is that the cost of capital for your startup is so high. The reason for this is that your new venture is very risky and has few hard assets. Banks are very unlikely to lend money to your business, so you have to get it from other channels that will charge a premium for taking on this risk and extra work they will have to do to monitor their investment. These investors (usually equity investors as opposed to debt stakeholders) demand a return well beyond the banks or more traditional investment opportunities like public stocks or even venture capitalists (who will enter at a lat
er stage but still expect a substantial return). The good news is that as you succeed, you will reduce the risk in your business and the cost of capital will come down, but at the beginning it is very high—50 percent is the number I suggest you use. In the worksheet in this chapter, I have helped you with a row that gives you a NPV discount factor for each year to take all of this into consideration.
Depending on your industry, you may find that a time period other than five years is more appropriate for your product. For instance, the LTV for customers purchasing a new power plant or pharmaceutical may not be comprehensive enough if you only look at the first five years. When determining whether to change this time period, consider first the length of the sales cycle, and second the amount of time it takes to develop your product. If you choose a different time period, you will still only make estimations based on five time periods—for instance, if you choose 10 years as your time period, then each interval will become two years, so that “t=1” on the worksheet becomes two years, “t=2” becomes four years, and so on.
The LTV tells you the unit profitability of how much you will make by acquiring one additional customer, minus the marginal costs—that is, the parts and labor—of making the product(s) that customer will buy. The LTV does not include marketing or sales costs, which you will estimate in Step 19, Estimate the Cost of Customer Acquisition (COCA); nor does it include research and development costs to develop the product. It also does not include the general and administrative costs (things like executive team, real estate, legal, human resources, and other overhead functions, most of which are fixed costs) required to have a company to support the overall operations.