Pricing Models Explained

What pricing models are there for startups launching new businesses and products? 

How should you price your product or service? How do you arrive at that number? What might the challenges be?

There are a variety of pricing models and strategies available to entrepreneurs today and how they end up showcasing those on their business plan. We’ll probably see more emerge in the future too. 

Pricing can be everything in business. You can rise or fail on pricing alone. Early initial pricing can seem like the biggest challenge now. Yet, be cautious about plans to change pricing later. It could bring everything crashing down around you.

Here are some of the most common pricing models explained.

Freemium

The freemium model exploded in popularity with LinkedIn and Dropbox. Sometimes it works for a while. It can certainly work long enough for startup founders to get into hyper-growth mode, acquire millions of free users, and then pull off a grand exit through a high priced acquisition or IPO.

We may not yet have seen this model fully tested for sustainability. It will typically require some substantial startup fundraising to cover upfront losses and customer acquisition. You had better really do the math and be accurate on your assumptions on how many users will convert to premium paid pricing. At least if you may need to hunker down and rely on being profitable during a downturn.

It’s no secret that many Google Drive, Dropbox and LinkedIn users will never choose to pay for anything. They will jump ship before paying anything. When COVID-19 hit, we also saw some of these companies which went public performing very poorly.

Dropbox and Upwork are two which saw their stock prices plummet into dangerous territory, despite being some of the few companies which should have been best positioned to thrive with more remote work happening. 

This business model is all about offering the base product for free, with a premium, paid upgrade.

Premium Pricing

Many startups are riding on being cheaper than the competition. This price war mentality rarely works out. It often creates a race to the bottom, with only the largest and best-funded companies able to weather the battle and come out on the other side with a virtual monopoly.

The reverse strategy is to go all the way up on the scale with luxury or premium pricing. Add perceived value and create demand at the high end of the market. This doesn’t just work in the automobile and fashion industry. It can apply to virtually every industry. Not all, but most.

What’s the most you can charge, and still get sales?

Subscription Pricing

Subscription pricing models have exploded over the past few years. Still, not too long ago SaaS was a new phenomenon. If you are in a must-have sector, then a subscription model with recurring revenues can be very beneficial. Especially in an economic downturn, when it is hard to get new business.

There are pros and cons to this model. Recurring revenue is great. Though in many cases startups have to spend several months of income to gain a new user. Many also underestimate consumer resistance to contracts. Then there is the danger of underpricing your subscription.

Whether it is need or greed, many very visible companies have raised their prices over time. From the inside, the raise may seem menial. If you are the CEO of a $1B subscription business, then hiking prices on all of your customers by $1 here and there may not seem like a big deal.

Remember that on the customer side, it isn’t even always about the price and value. It is about the principle. If they feel you are taking advantage of them, providing less value and tricking them into paying more, they might leave in masses, even if you only raised prices by $1.

Licensing and royalties can be similar pricing models to explore as well.

Tiered Pricing 

Many progressive entrepreneurs are seeing more wisdom in tiered pricing models.

This generally means several levels of pricing and product. With higher price points for plans with more features. 

This also means being able to benefit from several levels of customers and a more diversified customer base. Some who will deliver fast growth. Others who will deliver bigger chunks of profit. It creates a more diversified and sustainable business model. You can have average consumers, business accounts and enterprise users.

Just be wary of continuing to raise prices or demanding annual payments for more features to low level plans. These customers may not care about those features. They are driven by the least out of pocket option upfront and the MVP. 

Value Pricing

In 2019 we began to see more startups launching that relied on value pricing models. 

The best way to describe this model is being based on the value you offer your customers. You base your pricing based on how much you can make your customers, or how much you can save them. This is often charged as a percentage. A percentage that can seem small, but can be big dollar figures. It may be 1% of the value, but could be $50,000 or more a year in revenue.

Cost Based Pricing

This model means setting your price based on a desired profit margin above the cost. That may be a flat 35% for example. Now, if your new disruptive technology can slash your and the industry cost base by 50%, you may be able to sustainably price your product at 50% less than the incumbents and still make good industry benchmarked profit margins.

Portfolio Pricing 

You’ll see this pricing model in play at Walmart and local restaurants. They make very thin profits on some popular magnet products, and then make that up in higher profits on other products you buy, just because you are there. This works the same offline as well as with online retail sites like Amazon. 

Loss Leaders

This relies on selling an initial product or anchor device at a loss. Then making it up with ongoing services. For example Uber discounting early rides to buy the market. Or selling printers, and then charging extreme prices for ink or 3D printing filament. 

Before you pick a pricing model, make sure you consult your advisors and an M&A expert for how this may impact you for better or worse later.

Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.