Welcome to the last of three in-depth blogs on startup pricing strategy. If this is the third article you are reading…. thanks & well done! (If you missed the previous ones, they are here; is your startup pricing strategy right? And here: dynamic, pandemic and special pricing strategies).
This piece though, is probably the most important of the trio – because I want to show how your pricing strategy directly relates to your brand power and the potential valuation of your startup.
So how? Answer: Margin!
Have you ever asked why investors love to put their money behind a Service as a Software (SaaS) business? Answer: margin!
A typical SaaS business, if it raises finance, should project a future 85% gross margin.
As you know, 85% is an exception margin. It basically means that your base product, delivery and servicing costs are very low. Every extra sale is (nearly) pure profit (albeit, you’ll be reinvesting it).
An 85% margin also requires that you are able to sustain a price which is both high enough to maintain this margin but low enough to keep out competitors and copy cats.
And of course, your costs are relatively fixed – but your price can fluctuate – which is why the focus on pricing is so important and brand power is directly linked to the ability to sustain a higher price (and therefore bigger margin).
(Actually, the accounting term is “Gross Margin” which is the margin between the sale price less the cost of the goods (or providing the service), before any of your cost of sale or organisation running costs are included – so it’s not profit, but it directly affects profits!)
In essence then, once you’ve met the ‘sunk costs’ of building and developing your MVP and then refined v1.0 versions, you should expect that the service/ product essentially sells itself and that people keep renewing (ie. you have low or near zero churn) because:
- Your product keeps getting better and competitors can’t out-compete, and
- The more they use your service, the more valuable it becomes, and
- It is priced right.
For instance, think of a CRM – I began buying one as a monthly SaaS 10 years ago – and I’m still buying it! The longer I use it, the more value (richer data, more insights, greater familiarity etc) it gives me.
So, that’s the ultimate goal – to build businesses that have low marketing costs and low churn and strong pricing power.
Okay, you ask, what about other businesses? Say, an ecommerce business – because they build or buy a product, can they expect / aim for an 85% margin?
No, probably not – but there is strong evidence that the best companies in the world – regardless of what they do – health care products, energy, drinks, makeup, clothes, data, hotels – can achieve a 65% gross margin.
How do we know this? Terry Smith!
Terry who? Terry Smith is a kinda UK Warren Buffett – who has built a fund which delivered a 521% increase over 11 years.
In his recent video to investors Smith described why his fund has been so successful (his fund beat the index by 300% over that period). In his view, the different between his stock portfolio and that of the (poorer performing) index is essentially a difference in pricing power.
Ah! So, we’re back to pricing? Yes.
But what is pricing power?
It’s what you need to maintain margins without losing sales volume. And it is the hardest evidence of a high quality and high value business.
Terry Smith explains the difference between 65% and 40% gross margin as the power and value of a strong brand, IP or embedded customers (eg. when you bought an HP LaserJet printer, you used to have to buy HP ink cartridges).
So, Smith’s selected stocks have a 65% margin – that is, if their product cost £1 or €1 to make, then they sell for £3 or €3.
The rest of the index only has a 40% mark-up. That means, if they sell for £3 or €3 then they cost £1.8 or €1.8 to make.
One company makes €2 per sale, the other makes €1.2. So guess which business has more money to reinvest or ride out a short term collapse in demand?
And, the difference between the pricing power of these two sets of companies has resulted in a 300% difference in valuation over 11 years based on Terry Smith’s fund.
So, what’s our price goal?
That means we now have a goal – buy for €1 and sell for €3 – with large sales volumes!
And, if we are in SaaS, then our goal is to buy for €1 and sell for €6.66!
(If you want to follow the piece where Terry Smith talks about gross margin, it starts here: – although I’d recommend watching from the beginning.
Okay, let’s just remember, startups don’t begin with large gross margins. However, to raise funds and ultimately, to be successful, we need to layout and follow a path to big margins on large sales volumes. That’s what Microsoft et all have done so successfully.
Equally, because this is difficult to do, the valuation of these kind of companies is huge. After all, they are in high demand and there aren’t that many of them.
The lesson here is that ‘future margin’ is what makes your young / startup business valuable. It’s what makes it investable.
So, when you think about the value of your business – look at
a) what is our current margin
b) what is our future margin (and how can we tell a credible story about how we get there).
At least now, you’ll know that to raise finance, you’ll need to tell a story of how you will build pricing power.
Don’t Forget Volume
One last point. As your business adds volume, so individual product costs will fall. And, because margin is sales revenue less cost of the product / service – then your margin widens.
The challenge then is this; do you price high at the beginning (low sales volume, high price, premium product) or do you start with a price based on future sales revenues?
Well, this depends on
- Can you raise enough money to cashflow the loses? And,
- How quickly can you reach volume?
For product-based businesses, you might begin as a ‘Handmade in Britain / Spain’ premium priced product, and then, bring in an Asia / Africa manufactured product – in high volume, with a mid-market price.
For software / service business, it often begins with three pricing options – free (of course), standard and then enterprise! A smart strategy here is that ‘enterprise’ is the future service ‘coming soon’ as it requires lots of extra software developments (integrations, stability, control, reporting etc) that larger organisations value – but for a premium price, of course!
And, by focusing on the ‘standard’ price option at the outset, it allows ‘easier’ sales to smaller companies who are taking less risk in buying / using your less known product (and they make purchase decisions faster, too).
How to put this into action: ask this question:
What is your gross margin strategy?
When you and your team can answer this question clearly and persuasively, you’ll be on the path to success. Oh, and don’t forget, it takes years to build brand power – so, allow yourself the time.
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