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The BLUF (Bottom Line Up Front)

1. ROI is almost never the right answer when deciding a price - often the right answer lies in the price architecture, not the price level

2. ROI benchmarks (e.g. 10x ROI) are dangerous, even though they are popular with pricing “gurus”

3. ROI-based pricing doesn’t work because there is always a big gap between the actual value added by your product, and a customer’s willingness-to-pay for that value. We explain why.

What should my ROI be?

A few months ago, a potential client asked me for “ROI benchmarks” in his industry. The company was a vertical SaaS company¹ in a niche industry. His question was well meaning, but ultimately nonsensical.

You would think that your price should be a direct reflection of your ROI; after all, ROI is the way you measure value of your product right? That’s true, but it only tells a part of the story. Here at Crescendo, we rarely focus on the quantified ROI of your product - like costs and competitors, it rarely leads you to the right answer and can distract you along the way.

How many consultants does it take to price a light bulb?

A long time ago, I once recruited for consulting firms. Anyone who has ever gone through the consulting firm recruiting process can recall the dreaded “case study” interview. To prep for case interviews, many college seniors² buy and devour the consulting Bible, Case in Point.

Case in Point helps you to answer those hard hitting consulting questions, like:

• I’m losing money - how do I stop that? Answer: more revenue, less costs.

• How many golf balls fit into a 747? Answer: 26,652,678

• Why do you want to work at this firm? Answer: providing shareholder value is my personal brand

One of “easy” cases at the beginning of the book stuck with me. It was about an everlasting light bulb that never burns out.

Case in Point offers a few solutions, but even their “right” solution misses the point.

• $75 - Constant Margin: Keep gross margin the same to price the bulb (93% gross margin, $5 COGS)

• $37.50 - ROI Based Pricing: 50 years of replacing $0.75 light bulbs annually is $37.50.

• $400 - New Target Market: The “right” answer. Sell to municipalities to save on labor costs. Assumes a 2x ROI on a $200 truck roll to change a bulb.

Every single one of these misses the real answer. You don’t sell the bulb.

You give the bulb away for free and lease a square foot of light.

This isn’t even that weird. When I was going through training at Simon-Kucher & Partners, we used to study a Michelin case where they invented tires that lasted 20% longer. Despite their proven ROI, Michelin couldn’t push a 20% price increase through to customers and instead changed their price metric from “per tire” to “per kilometer driven,” essentially creating a subscription to their tires. 10 years later, Michelin’s profits were 25% higher than Bridgestone’s and more than 3x Goodyear’s.³

Bad Pricing Advice

There are a lot of pricing gurus out there on the internet. We don’t like many of them. My partner Patrick likes to say that bad pricing advice on the internet is about as common and equally dangerous as people selling essential oils for weight loss.

Here is some bad pricing advice from former YC Partner Kevin Hale. In this presentation, Kevin argues that you should set your price at 10% of the value you create, or a 10x ROI.

Let me be very clear. We would never recommend such an approach.

This is the kind of lazy pricing advice that hurts startups and really grinds my gears. Why? Because it’s dangerous. Let’s play this out.

Reason #1: What if Y Combinator is wrong?

I said the 10x rule is dangerous. Why? Let’s do some math for YC.

Pretend that I just raised $500k from YC. To make the math easy, let’s also pretend that I’ll need to raise my Seed Round in 2 years, so my burn rate is $250k / year or ~$21k / month. Let’s also say that I’m doing $1M in ARR right now. [Edit: that means we’re spending $1.25M / year.]

I go to my YC advisor and ask how I should price.

So what if Kevin and the YC team are wrong? What if real willingness-to-pay wasn’t 10x, but 9x or 11x? In case you’re wondering, that’s a price ranging from $9.1k to $11.1k.

If we underpriced, we missed out on an additional 16 months of runway; if we overpriced, we just lost 6 months of runway. In other words…

Reason #2: You can’t price to ROI, even if you wanted to

Let’s go back to my pricing Magic 8 Ball, but this time I have more information:

• The actual ROI on my product (let’s assume I can prove it too)

• The customer’s cost of capital

• The variance on my ROI

• The time it takes to realize the value

• The average price of comparable products and their ROI

You now have enough information to price your product. But what’s that I hear?

YoU sTiLl dOn’T kNoW tHe AnSwEr?!?!?!

It’s ok. It took someone winning a Nobel Prize in Economics to figure it out.⁶ I don’t know the answer either.

What would I do instead? I’d ask 2 customers what their willingness-to-pay was and take it from there. For more on that, see some future blog posts on willingness-to-pay methodologies.

Why ROI-based pricing doesn’t work

I like a good framework.⁴ It’s very rare that I change the frameworks that I teach. You have to really convince me that your framework, especially a pricing framework, is better.

I used to believe that there were only 2 distracting things to look at when pricing your product: costs (the obvious one) and competitors (the controversial one). I have added ROI to my list because of a great pricing book I read and a difficult client.

At the risk of alienating my readers, I must give James Wilton a shoutout for this framework and for his book, Capturing Value. Below is my summary of his framework.

Applying the Ladder to a Difficult Client

We recently had a client who had proven ROI. They could calculate with amazing accuracy the increases in revenue that their software would bring their clients. And yet, customers still weren’t buying. It was our job to figure out why.

The first issue was with our client’s imperfect value communication. While the client was able to calculate their customers’ ROI in sales calls, as the software was running, that calculation aged like room-temperature tuna. Furthermore, customers revealed in interviews that they didn’t believe our client’s calculation, because they couldn’t reproduce it using their own data.

To put it simply, they didn’t believe the ROI.

Even when they did agree to the ROI though, their willingness-to-pay was still low. First off, while the ROI was accurate on average, in any given year it could be off by a meaningful amount. So there was significant variance in their ROI.

Second, the ROI wasn’t immediate, but had a payback period. The customers’ Time Value of Money (TVoM above) forced them to discount that ROI.

Lastly was the customers’ budgets. I have always said that willingness-to-pay is the intersection of utility and wallet size, and on occasion, even when the customers could see the ROI, they simply didn’t have the capital.

Where did we end up?

The client really wanted to price the product as a percentage of value created (ROI). But in the end, we ended where we always do. We priced the product to willingness-to-pay.

Get in touch

Crescendo works with medium-sized software companies to improve their pricing, packaging, and promotion strategies. If you’d like to book a quick consult, reach out at [email protected] or schedule time via the button below.

1  So hot right now

2  And sad MBA 2’s

3  For the full case, read Monetizing Innovation, by Madhavan Ramanujam

4  Surprise surprise

5  My most popular framework

6  I think this would be most akin to option pricing, aka Black-Scholes, but you could make an argument that it’s just the Capital Asset Pricing Model (CAPM)