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How To Price Software Without Just Rolling The Dice

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I’m going to open this article with a short (and true) story.  I officially kicked off my marketing software company, HubSpot, about 17 months ago.  If you’ve read my blog for any period of time, you likely know that I’m a big beliver in the “charge early, charge often” mantra.  As it turns out, in order to “charge early”, you have to figure out what you’re going to charge people.  That is, you have to have a price for your product.  Thankfully, both my co-founder (Brian Halligan) and I had recently graduated from a top 5 MBA program.  And, it wasn’t just any top 5 program — it was MIT.  You know, that place where science and math and uber-geeky analytical stuff happens.  So, you’d think that when it came time to figure out a price for our product, we’d really dig in, do some heavy-duty analysis, some really hard thinking and come up with a relatively well thought-out price.  That’s not what happened.

When it came to deciding on the price for our software, we basically just rolled the dice.

I’d love to for the statement above to be an exaggeration.  Surely, we spent some time pondering that oh-so-important factor in our business sucess.  Nope.  We didn’t.  One of us (I think it was me) suggested “how about $250/month”, and that’s what we went with.  And, that’s where the price remained for about 2 years. 

Things turned out fine for me and HubSpot.  But, you still shouldn’t do this.  Don’t just roll the dice when it comes to pricing your product.  Give it some thought, consideration and (gasp!) some analysis.  Your first step towards this path should be to run over, right now, and get the book “Don’t Just Roll The Dice: A usefully short guide to software pricing” by Neil Davidson.  Even if Neil weren’t such a nice guy (he is) and even if he doesn’t run my favorite conference (he does) and even if he didn’t build a really successful software company himself (he did), I’d still implore you to read the book.  It’s got the highest value-to-length ratio I’ve seen in a business book in a long time.  Go get it, right now.  And, if you’re still not convinced, Neil’s even been nice enough to give it away for free in convenient PDF form.  Yes, that’s right, you don’t even have to buy the freakin’ book on Amazon for $9.95 (though you could). 

Just on the off-chance that I caught you at a particularly skeptical time and you’re still not convinced, here are some of my notes from the book.

Insights On Software Pricing From “Don’t Just Roll The Dice”

1.  Your product is more than just your product.  You might think that your software product is just the bits and bytes that your customers download (or access online), but you’d be wrong.  What customers are actually paying you for is the entire experience of doing business with you.  Everything from how you market and sell the product, to how you help people use it and how you maintain it going forward.  All of it.  Your pricing should be based on this reality.

2.  There’s a difference between perceived and objective value.  It doesn’t matter how much “real” (objective) value you have baked into your product if your customers don’t perceive that value, they are not going to pay as much for it.  Hopefully, their perceived value is a function, to some degree, of the objective value.  If not, you’re screwing something up. 

3.  Community matters.  The group that your customers belong to, or want to belong to will impact the price they’re willing to pay.  For example, some people buy hybrid cars not just because of the environmental benefit or the higher mileage but because they want to be part of that community.  The same reason some people buy a BMW.  Determine what kind of community you can build (or tap into) around your offering.  Help people belong to the community they want to belong to.

4. As it turns out, people do buy drills (not holes).  There’s the reasonably famous adage around “people buy holes, not drills”.  The point is to focus on the benefit to the customer (not the product itself).  I generally agree with that notion.  But, it’s useful to keep in mind that holes can be a commodity, but people still sometimes pay $400 for a drill.  Benefits are important, but the direct benefiit is not the only one that customers value.

5. The more differentiated you are, the more you control price.  This one should be obvious.  If you have a product that’s about the same as all of your competitors, then you don’t really set your price — the market does.  Of course, nobody thinks of themselves as being identical to their competition (especially software companies).  But, what we often forget is that it’s difficult — and very risky, to try and create a completely new category and be totally differentiated.  Decide which dimension you’re going to differentiate on and make sure it’s reasonable given your particular constraints (like cash).

6. No battle plan survives contact with the enemy.  This quote is not actually in the book, but I think it still fits the theme.  When setting pricing, it’s important to consider what the “market response” is going to be — particularly if you’re in a well-defined category.  Just because it doesn’t make economic sense for a competitor to get in to a price war with you, it doesn’t mean they won’t do it.  Particularly if they’re big or well-funded. If you’re thinking about competing on price, keep that in mind.  Better yet, don’t do it at all.

7. Remember to be fair.  As humans, we often have a sense of what we think “fair” pricing is.  Even though a particular pricing model is “theoretically optimal”, it might not be wise in practice.  As software entrepreneurs, we often think we can get away with certain types of price segmenting simply because it’s enforceable in the software.  Just because you can keep customers from doing certain kinds of things (unless they pay up), doesn’t necessarily mean it’s the right (optimal) thing to do.  In the long term, it could actually hurt.  Try to put yourself in the customer’s shoes and envision if they think the way you price things is fair.  [Note: I’m not suggesting you be all rainbows and cupcakes and suggest that you price based on being “nice”.  I’m just saying that you might actually make more money by being empathetic]

8. Pricing complexity has a cost.  One of the things you learn in micro economics (and is discussed in the beginning of the book) is the concept of supply and demand curves and how you can segment your pricing in order to capture the maximum value (i.e. optimize revenues).  This can be a wonderful thing.  But, it’s critical to remember that this segmentation has a price — it’s not free revenue.  For example, when HubSpot went from a single price ($250/month) to two prices (still pretty simple), life got a lot harder.  All of a sudden, our marketing, sales and even our operational efforts got more complicated.  The product got more complicated.  All of our pretty charts that we used to talk about the business and measure success got more complicated.  The reality is that when you add a new dimension to your pricing structure, you’re adding a new dimension of complexity.  Oh, and by the way, the *second* price that you add to your product is the most expensive.  After that (third, fourth, etc.) things get a tad easier because you’ve already built some of the infrastructure to support multiple prices.  And by that point, your brain is already used to the pain.

Phew!  I typed this entire article in one sitting while simultaneously reading a majority of the book for a second time.  If I haven’t convinced you yet that you should go read it then I think I’m hopelessly inadequate at conveying the importance of this topic and the usefulness of the book.  Or, maybe you’ve already got it all figured out.  If so, may the wind be in your sails and may you go forth and prosper.  For the rest of you, just download the book.

And, on a more selfish note, what are your biggest insights when it comes to software pricing?  What challenges have you dealt with?  What questions do you have about pricing your software?  If you’re looking for some great answers, you can post a question on Answers.OnStartups.com where a bunch of smart folks like Neil Davidson (the guy that wrote the book) hang out.  Hope to see you there.

By the way, you can follow me on twitter @dharmesh.

Posted by Dharmesh Shah on Mon, Nov 23, 2009