Your business model describes how you create, deliver and capture value. Much time and effort are spent defining the value proposition: the added utility you create for your customer by solving their job-to-be-done. If the job is important enough and your solution effectively enhances their gains or alleviates their pains, your customer will say “yes” to investing their money and attention with you.
However, founders flounder when considering how to capture this added value through revenue streams. The primary consideration becomes to enhance recurring revenue metrics through subscriptions, commissions and markups. Pricing seeks to underbid the alternatives or is set arbitrarily, hoping the customer will pay with minimal protest. Strategies are established without understanding how the customer perceives the value you offer. This means that you leave cash on the table by not recognizing the real value you add.
Before setting prices, understand your Profit Proposition
Before considering your pricing structure, you need to understand your Profit Proposition. If your Value Proposition is the benefit you offer your customer, then the Profit Proposition is how your customer assesses the utility of your Value Proposition. Understanding your Profit Proposition provides you with a solid foundation to establish a pricing strategy that supports your margin, or the difference between what you charge for your offer and how much it costs you (fixed, variable and marginal costs).
You cannot price effectively if you do not understand how you will generate profit. SaaS companies often have very weak profit propositions because they price arbitrarily, focusing on quickly gaining a customer base to leverage future funding rounds, even when losing money on each transaction. You cannot lose money on each trade, hoping to earn money at scale.
Don’t leave money on the table
Transit is an app I use daily to give me detailed information on bus and metro times that are much more reliable and easy to understand than the local transit commission’s app. Since its founding about a decade ago, it has been free of charge for me, the end user. Its expenses have been covered by rounds of venture funding and fees paid by the transit agencies.
Recently, Transit announced that it would start charging a premium subscription for the level of service I currently enjoy for free. Their justification was to cover the increasing costs of supporting app development. My first reaction was annoyance, although the subscription rate is low, at $2.50 a month. The app has a high utility for me. Therefore, the cost-benefit is still in my favor. However, I wonder why they took so long to consider charging end-users.
This is a failure to articulate a clear Profit Proposition. I’ve always believed that Transit should have been charging a premium tier from the start because the end-user is the one who benefits most.
Understand who benefits and how they perceive the benefit
To define your Profit Proposition:
- List your stakeholders or all the people in the value creation chain who could benefit from the utility you create;
- What is the specific value proposition you offer to each stakeholder?
- Put yourself in the situation of each stakeholder. How do they perceive the benefit of your offer in terms of money, time saved, and improvement in their life? What are their tangible and intangible Returns on Investment (ROI)?
- Then, for each stakeholder, what kind of pricing scheme can you establish, and what would be the impact on the stakeholder of such a pricing scheme?
Depending on your overall business strategy, you may or may not want to charge each stakeholder or do so at different times. Transit first focused on pricing for the transit agencies (a significant stakeholder) but waited until too late to consider the end-user pricing.
Price according to the utility for your user
Articulating your Profit Proposition means thoroughly researching the value-added you generate for your customers and stakeholders. This information is not easy to collect but can reap huge rewards when you understand how they assess the utility you bring them.
Hubspot is a SaaS CRM in a market saturated with SaaS CRMs. Most charge a dozen or so dollars a month. Hubspot’s fees are in the hundreds, even the thousands. What does this mean? First, the high price signals that the service can generate significant returns for its users. Its Profit Proposition is based on the finding that using its service replaces hiring one or two people ($100K+ a year). It also communicates that its service is for larger SMEs. And finally, their pricing establishes it as a “professional” service, distinguishing itself from the others, which are for “amateurs.” Hubspot’s clear understanding of its Profit Proposition enables it to scale in the number of users and, most importantly, its margins. In fact, Hubspot’s gross profit margin for 2021 was 80%.
Focus on scaling margins
Once you understand and articulate your Profit Proposition, you can then explore how to improve your margins as you scale without increasing costs or pricing:
- What would cause the customer to increase their average cart size or purchase amount?
- How to shorten the return on investment time for the customer acquisition cost?
- What would get the customer to stay longer (increase CLTV)?
- How could you attract Tier 2 or Tier 3 non-customers (Tier 2 – people who know you but don’t recognize your value proposition, Tier 3 – people who don’t know you)
- How can you grow the number of customers while also growing your net margins?
Going back to the previous example with Transit, what if they priced their app at an equivalent to a one-way bus fare each month? In my case, the monthly charge would be $3.50. Being a frequent transit user, I believe it to be a fair price that I would barely notice in my daily use. Using this Profit Proposition, Transit could immediately increase its monthly recurring revenue by 35% with little additional effort.
If your Value Proposition is what you offer your customer, then the Profit Proposition is what you gain from your customer. By understanding your Profit Proposition, you can go beyond rent-seeking pricing strategies (transaction fees, commissions, markups) and capture more of the value you add in an innovative way that scales while keeping your customers happy.