Thursday, June 12, 2008

Bootstrap Mantra: "How are we different?" not "how are we cheaper?"

Most new businesses fail. They typically fail not because they can't deliver value, but because they can't capture enough of that value to turn a profit and grow. Capturing value requires a clear value message and an appropriate pricing policy.

Unfortunately, most entrepreneurs do not create a detailed value message and pricing plan. They start with a product (or service, I'll use the word "product" to refer to either), or even a technology and then they seek customers for the product. Then they try to sell those potential customers on the benefits of the product. Often, this involves a comparison with a better known competitor: "It's like ACME's offering, but better, and it's cheaper."

Small companies often feel they need to be cheaper than established companies because they lack the brand value. However, something that's better and cheaper is suspicious. It may sound too good to be true. If there is a risk in going with a small company, how much cheaper does it have to be to mitigate that risk? How much cheaper would a car made by your college buddy in his garage have to be before you'd buy it to save money and use it to transport your kids? Lowering price is not an effective way to reduce risk in many situations, particularly when unknown firms try to compete with established companies.

If you have a good product, though, people will buy it and they will be happy that you made it cheaper than alternatives. They may also negotiate with you to get discounts and other concessions. Unfortunately for you, small price reductions can have a big impact on your financial and personal bottom line. If your business is running at 30% margins, a 10% price reduction means you need to sell 50% more volume just to break even. But at 50% more volume, you may need to hire more personnel, boost inventory, and make other costly investments.

Entrepreneurs tend to be driven people. They want to go the extra mile for their customers. So they make the product better, cheaper, and they throw in better service. This often means the owner spending more and more time supporting customers. Customer service is important, right? But the more service you provide, the more some customers will demand it. Before you know it, you're exhausted, frustrated, and you're having trouble growing the business. (For entrepreneurs who have not experienced this phenomenon, you can read about it in Michael Gerber's popular small business book, The E-Myth Revisited.)

Instead of starting your business with the idea of being cheaper, ask how you can be different. Differentiation is what provides the means to create and capture value. For example, for companies offering website design and support, it's hard to be cheaper than the global marketplace. But if you can offer turnkey solutions for specific industries that boost sales and use automation to send emails, saving time for your customers, you can charge more than commodity rates. Starbucks took a commodity offering and transformed it into a $4 per cup experience.

Not everyone wants $4 coffee, and not everyone is willing to pay a premium for website design. So even for small companies, having a range of offerings like "good/better/best" can be helpful. The important thing is that the different offerings cost you different amounts so even if you sell "good" you can still make money. For example, your low end product may not include personal support. Or you may have to buy in larger quantities to get a discount. The different offerings and price points allow you to capture more value under the demand curve than any single product and price point ever could. Appropriate "fences" prevent customers from downgrading. A common example is the Saturday night stay requirement for cheaper airline tickets. While nobody likes the airlines, we don't complain that movies are more expensive in the evening than the afternoon. We expect that if we want a higher level of service, we might pay more (or we might get a discount for accepting a lower level of service). Those customers who eat up all your time on "free" service might behave differently if they had to pay for the service. You might also be able to hire someone to do the service. Companies don't have supply problems, they have pricing problems.

You don't have to be different or better to everyone, just enough of a market for you to be successful. In fact, neglected parts of larger markets are great spaces for startups. Siebel Systems made a lot of money selling customer relationship management software to big companies, but they couldn't effectively sell to smaller businesses. didn't start by competing with Siebel, they went where Siebel wasn't and created a more compelling offering for smaller customers.

By determining "how we're different" we differentiate ourselves from other market players, improve the value we capture, and increase the profitability of the business.

Reuben Swartz is the founder and president of Mimiran and author of Dollars and Sense: The Pricing Blog.

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