A lot of people have asked me about how to determine optimal pricing for a product or service.  This morning I read the following statement from Alex Mehr, the founder/CEO of Zoosk, and thought it was the best explanation I’d ever seen.  It’s a great articulation of the theory behind the process I’ve used for years.

Alex Mehr, the founder/CEO of Zoosk on pricing: “There is a way to think about that. The model that I have in mind is a graph where the X-axis is the price and the Y-axis is the revenue. At a price point of zero, you make zero money. A ridiculous price or a very high price point, again you make zero money because no one buys your product. This curve starts from zero and then goes up and then comes down. There is a peak, the revenue maximizing price point. Theoretically it is there whether you know it or not. It depends on your product and your demographics, etc., but if everything else is fixed, there is a revenue-maximizing price point. If you actually know the revenue-maximizing price point, you can do say, okay, that’s the top of the peak.

However, I prefer to make 10 percent less money but have 20 percent more customers. You want to stay a little bit to the left side of the peak. It is around 90 percent of the revenue maximization point. The way I think about it is a little bit different. I don’t look at it as a continuous thing.

I would try to pinpoint the revenue-maximizing price point and then find the nearest round number right before. If my revenue maximizing price point is somewhere between $20 and $30, I would shoot for $19.95. I can tell you that there is at least 20 to 30 percent additional profit you can get by optimizing your product packaging and your product pricing. If you can figure it out, you can go from a company.”

Shah,Tarang; Shah,Sheetal (2011-11-16). Venture Capitalists at Work: How VCs Identify and Build Billion-Dollar Successes (p. 64). Apress. Kindle Edition.

Great products aren’t anointed by product gurus.  Only customers can decide if a product is great.

Customers will decide your product is great if you can map it to their motivation for changing to your solution.  All customers change from something.  Generally they either switch from a competitive solution or from just tolerating a problem without a solution.  New products should decide on one of these markets.  Trying to serve both markets generally leads to failure.

One way to decide which market to serve is to ask yourself: “when we are generating $100m in revenue, which type of customer do we think will contribute the majority of this revenue?”  Your guess is usually the market you should serve.

Greenfield Customers

If you decide to target “greenfield” people (those without a current solution), then your product roadmap should be focused on simple, effective execution of their desired task.  Simplicity is usually much more important for greenfield users than being feature rich. Dropbox is a great example of a product that has succeeded in a greenfield market with a dead simple solution.   For some categories, features do eventually become important to users, but on a greenfield user’s first experience they should not be emphasized.

Competitive Solution Customers

If you are targeting people who will be switching from another solution, then usually features are an important part of people’s decision to try it.  In this case, you’ll want to make sure that you at least have parity on the key features.  Of course they have no reason to switch if everything you do is the same, so you’ll need to understand their switching motivation.  If you can differentiate on one of the key gripes of the competitive solution, there is a good chance you can be successful.  Common gripes include price, reliability, poor customer service, lack of key features, etc.  You’ll need to both message this differentiation and also deliver on the promise. A “false promise” will cause a high churn rate (people who stop using your product).

Reduce Conversion Hurdles

Either way, switching takes a lot of guts and effort.  Most people are afraid and/or complacent about switching.  Even for those who take the initiative to consider your solution, most will give up before actually trying it.  So it’s also critical to reduce all hurdles that may cause them to abandon the conversion process.

You’ll know you have created a great product when users tell you they can’t live without it.  Unfortunately the “cult of great product” occasionally forgets about these critical components of building an indispensible product.

More importantly, TC Disrupt was very helpful in kick starting our UGC. Users submitted and reviewed hundreds of free apps and services on the first day.  We had identified a critical mass of authentic, non-anonymous reviews as one of the biggest hurdles in the business.  TechCrunch helped us clear this hurdle in a single day.  It didn’t hurt that Dropbox, SpringPad, SurveyMonkey, LogMeIn, Wordpress.com, Xobni, KissInsights, Lookout, Webs, Mavenlink, and many others also recruited their passionate users to support them on CatchFree via Twitter.

The Key Challenge with Freemium

The vision for CatchFree is based on the frustration I faced trying to help grow 15 freemium startups.  Customer acquisition is probably the number one challenge for a freemium company.  You’d think it would be easy giving away free products.  It’s not. To understand why, just try standing on a corner in any big city handing out free apples; you’ll find that people are pretty skeptical. That same skepticism applies when trying to give away free software, services and apps.  Too many people have been burned in the past.

Compounding the issue is that freemium businesses can typically only afford to spend about 5-10% of their “premium only” counterparts acquiring a new user.  This makes it very hard for a freemium company to buy growth in traditional channels, where inventory generally goes to the highest bidder. If the product is good enough, eventually organic growth kicks in, but many freemium companies give up or run out of money before they are able to achieve sufficient growth.  Even when organic growth is reasonably strong, the inability to accelerate it can be frustrating for even the most successful companies.

Hub of the Freemium Ecosystem

CatchFree is solving this challenge by helping freemium businesses leverage their most important asset to grow – large passionate user bases.  The CatchFree Network links together the best freemium apps and services, enabling each service to draw off the growth experienced by other leading freemium services.  We will be offering referral credits for each person referred from a freemium business to the network and providing surplus referrals back to a freemium company at a profitable CPA.  Collectively the best freemium businesses have nearly a billion users between them, so they will all benefit when traffic can circulate easily among them.

To be effective, CatchFree must adopt the culture and standards of the best freemium companies.  So we have put it entirely within our community’s control to determine who can and can’t be accepted to the network.  Unethical behavior by freemium businesses will quickly get them banned by the network.  While this may seem anti-commercial, it turns out that a highly ethical approach is a key requirement for a freemium company to succeed anyway.  Companies like Dropbox and Evernote are genuinely loved by their users and it’s their evangelism that propels them forward.  I know some of you are thinking of some unethical companies that are succeeding with freemium, but I would argue that they were likely ethical in the early days and more recently lost their way because of greed.  In those cases, freemium has become a tangential part of their model and is no longer their core.

The Wild Feedback Loop

There will be lots of learning and surprises along the way, but we are very excited to be out in the “wild”.  As Paul Graham suggests: “tame” users can only take you so far.  By working hard and acting on user feedback, we’re confident we’ll be able to give freemium the platform it needs to thrive and change the game in some of the most profitable categories of technology.  As CatchFree gains traction it is going to be very hard to compete against a great freemium app or service.

This article in TechCrunch actually captured our vision pretty well: CatchFree Wants to Become the Hub of the “Freemium” Ecosystem.

We also announced our $5.5m Series A funding by Polaris Ventures, True Ventures, Index Ventures, First Round Capital and 500Startups.

Lessons Learned

I’ll try to share lessons learned for taking a network effect startup to market over the coming months.  It is significantly more difficult to get traction in a network effect business, but post traction they are much easier to grow.  This is part of the reason we raised so much up front.

Here’s our launch demo and a bit more on the vision:

Your marketing spend should be very minimal until you validate that you have created a product that people want or need (an important exception is for network effect products, which I’ll cover later). I would suggest 95/5 ratio between product and marketing. You don’t necessarily need a marketing person on the team to do this early validation.

Once you’ve validated that people want or need the product, you should spend as much as you possibly can on customer acquisition as long as the value of each user exceeds the cost of acquiring them. Often this requires raising additional funding, but if you can present proof of profitable, scalable marketing channels then it should be easy to raise the additional funding. Of course you should complement this paid customer acquisition with free sources if possible (and you can start these early in the validation process). If your product really does a good job solving an important need, you should also have strong organic growth. At this point the spend ratio generally tips toward marketing. I’ve seen it as high as 80% to marketing and 20% to product.

The exception for network effect businesses mentioned earlier is for the following reason… The user experience for a network effect product improves with each additional user. You may need to reach a critical mass of users before you can validate that the product is important for users.

I didn’t really intend to become a founder, but was hit with an epiphany of a huge opportunity that I was perfectly suited to execute. I actually tried to push it out of my find for several days (my consulting practice has been fun/lucrative) but I kept having a nagging feeling that it had to be done. I shared the vision with a few venture capitalist friends and they quickly offered to fund it. I then received strong need validation from potential customers, which wasn’t surprising since the original epiphany had been based on engaging many potential customers.  Momentum has been strong ever since (though surely there will be course corrections along the way).

I’ll be on a blogging vacation for the foreseeable future…

As a successful entrepreneur himself, Andrew did a great job of steering the conversation to the topics most interesting/useful for entrepreneurs. It took me a while to get warmed up (it was a Monday morning after a weekend in Vegas), but there is a lot of new and useful information – particularly in the second half.

Successful startups are only possible with founders who have the guts to go for it so Andrew and I spent a lot of time at the end of the interview trying to analyze the qualities of the best entrepreneurs. Each of the founders I’ve worked with deserve to be on this list, so I regret not mentioning all of them. If the video isn’t loading below, try this link.

But what separates great teams from weak teams? I believe it’s the team’s ability to “figure stuff out.” Founders figure out potential customer problems that are worth solving.  Engineers figure out how to build a well functioning product that meets this need.  Marketers figure out how to reach people who really need the product and how to convert them into customers…

While natural talent is a big part of figuring stuff out, we can all benefit by improving our work environment.  There are two areas in particular that prevent creative problem solving.

1) Too much focus on financial rewards

It is obvious that the effort required to raise VC funds can be a major distraction from executing the business, but few realize that the repetitive discussions about financial outcomes can also shut down your ability to figure stuff out. In my 15 years in startups, I can’t think of a single breakthrough epiphany we experienced while fundraising.

Daniel Pink demonstrates the potentially negative effect of financial incentives in his new book Drive, The Surprising Truth About What Motivates Us.  He describes several experiments where people who were offered a financial reward to quickly complete a challenging task actually performed worse than those who simply did it for enjoyment.  An important part of figuring things out is getting into a state of flow (sometimes known as being in “the zone”) and a focus on financial incentives often prevents this state of mind.

The book mostly challenges the effectiveness of typical incentive structures inside more established businesses, but I believe the implications are even stronger in startups where survival is contingent on our ability to figure stuff out and the financial rewards of doing so are potentially enormous.

2) Too much pressure

I’ve also realized that I’m not good at figuring stuff out when I put too much pressure on myself.  A few months ago I had a beer with a friend and successful serial entrepreneur, Antony Brydon, and he zoomed right in on my problem.  I had put myself under so much pressure to help the startup with which I was working, that I had virtually shut down my creative abilities.  He mentioned that he’d been reading Andre Agassi’s autobiography where similar self-induced pressure had destroyed Andre’s ability to play tennis.  His career only recovered when he remembered to loosen up and have fun.   Every time I feel myself getting tense, I now remind myself to loosen up and immediately feel my creative problem solving abilities return.

While self-induced pressure is common in startups, pressure can also be applied externally by the Board (or the CEO to the rest of the team).  Most leaders don’t realize how counterproductive this can be in a startup.  It is OK to apply pressure for better execution of things that have been figured out, but it should be applied very sparingly when trying to encourage the team to figure out the remaining unknowns.

The solution: loosen up and have fun

When breakthrough thinking is needed, a fun, collaborative and supportive environment will generally yield better/faster results than the pressure of sticks and carrots.  This is especially important in the early days of a startup while the team is still figuring out a viable formula for the business.

Also, given the likely negative effects of fundraising, I recommend fewer/bigger rounds of financing (if possible).  Run leanly on your first round while you figure out the key success elements of the startup.  Then raise another round while executing the formula.  This may result in more dilution, but a more valuable company should offset this dilution.

Finally, encourage the team to obsess about solving customer problems rather than their potential financial outcome from success.  The best breakthroughs initially come from immersion in customer problems and then later from understanding the customer experience and benefits of your solution.

Element 1: Gratification engine

Your gratification engine is the repeatable process of turning cold prospects into highly gratified customers. Whether you are aiming big or small, an effective gratification engine is probably the hardest of the four elements for a startup to get right.   Tenacious execution works for a lot of things, but you can’t force customers to want, need or like what you have created.  Building an effective gratification engine is an iterative process driven by a lot of prospective customer feedback.  Once you get the basics right, your process of gratifying users can be optimized with tools like Performable for landing pages and KISSmetrics for full funnel tracking/improvement (I’m an advisor to both).

Element 2: Economic engine

Once you have figured out how to gratify prospects, your next challenge is creating a viable economic engine.  For your business to be sustainable in the long run your average revenue per user will need to exceed your average cost per user.  Beyond business sustainability, the right monetization approach will also be based on the value users get from your solution, the competitive environment and your ultimate growth strategy.

Element 3: Growth engine

Your growth engine is very dependent on your economic engine.  If you have relatively limited revenue per user, you’ll need to pursue tactics with a very low marginal cost such as PR, SEO or viral marketing.  With a higher revenue per user, you’ll also be able to effectively arbitrage growth through paid tactics like display advertising and SEM.  The most valuable companies generally choose an approach that allows them to capture the biggest share of the market in a sustainable way.  This often means a strategy with lower revenue per user.  They don’t invest too much time in one off gimmicks, instead they focus on growth drivers that can be repeatable and scalable.

Element 4: Huge addressable market

The best opportunities generally have the hardest markets to accurately size.  That’s because these are fast growing or whole new markets that are based on potential rather than existing customers.  Perfect accuracy on market sizing isn’t important here.  Instead creative scenarios that show how it will likely be big should generally suffice.  You also want to breakdown potential segments and people that are new to the market or coming from an existing related market.  Again, you just want to have approximations that are believable and big.

Start with a Hypothesis for Each Element

It is important to have a realistic hypothesis for each of these elements before you even get started with the business.  If you are having a hard time creating a realistic hypothesis for one or more of these elements, your vision probably isn’t viable.

I can often look at a business for less than an hour and decide if I believe it is massively scalable opportunity based on my hypothesis for each of these.  If I’m not confident on a specific element, I spend a lot of time vetting this with the CEO before committing to a project

Of course it won’t happen exactly the way you plan.  The best opportunities have multiple contingency plans in case your initial theory doesn’t work.  But if you can’t even creatively come up with a viable theory for each, you’ll likely have a very hard time raising VC funds.  Once you have a theory for each, start with the practical bottoms up execution described in the startup pyramid post.