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The Startup Guide to Upfront Pricing

You ever notice in the bar someone always says to you, “Hey can I buy you a drink?” Say, “no thanks, but can I have the money instead?” Tell him you’re saving up to buy your own goddamn bar. —George Carlin

There is a lot of great startup advice on pricing. There is almost no startup advice when you need to figure out how to think about upfront pricing.

There are plenty of reasons why you might want to focus on your upfront pricing and packaging, and not just your month-to-month pricing:

  • If I’m a customer, I’m already taking out my wallet to buy something. I’m already squinting at the tiny letters on the back of my card. If I’m already considering buying a thing from you, maybe I’ll consider buying another thing from you. If you’re a company that has an opportunity to offer profitable upfront services—like installation, premium onboarding, or insurance—you may want to find opportunities to take my money.
  • If you’re a company with a high CAC, you may want to find a way to recoup that CAC sooner than later.
  • If you’re a company that has to issue customers hardware, you may want to get customers to pay or deposit money for that hardware. In addition to being good for cash flow, this might make customers take better care of the hardware.
  • The fewer opportunities I have to churn, the better.
  • Money is a nice thing to have, and the more of it you can get now, the better.

Many of these are related to cash flow. When you’re a startup, cash flow problems are acute. If you’re a large and successful company, you have tools that smaller companies don’t have, like:

  • Easy access to working capital. If you’re not a distressed company and have stable cash flows, you can usually get a bank to give you a revolving loan.
  • Collections. If you have a predictable customer base, you can sell of your debt to a third party collections agency, which can h
  • Credit checks and risk modeling tools. If you have enough data and access to credit information—like a cell phone company, for instance—you can understand the right financing terms to offer to people. Suddenly, the $1,200 iPhone is in reach to someone who may not have the spare $1,200.

“But I have a profitable product and it’s growing… That’s enough, right?”

Cash Flow: Or, Don’t Grow to Death

The most unintuitive thing I’ve learned about entrepreneurial finance was that a profitable, high-growth company could grow to death.

Why might this happen? Imagine that you’re an entrepreneur starting a beverage company. After selling at small retailers, you strike gold and sign a huge contract like Walmart. Since you’re a newer, smaller manufacturer, you only get 90 day terms—meaning that Walmart will only pay you 90 days after you fulfill the order. Oh, and if they don’t sell, you don’t get paid.

If you have unlimited cash: where do I sign? (Also, can we be friends?)

If you don’t have unlimited cash: your profitable, high-growth startup will stop growing… unless you can find 90 days of cash to pay your suppliers before Walmart pays you. If you agree to the Walmart deal and aren’t able to secure the working capital to cover your inventory expenses, you’re in trouble. If you order extra inventory and the Walmart deal doesn’t go through, you’re in trouble. If you place the order and for some reason Walmart doesn’t sell your product, you’re in trouble.

So while profitability is paramount and growth is great… cash is king. Cash flow is the lifeblood of any company. While a company have phenomenal accounting profitability and stellar growth, if it runs out of cash, it’s game over. The Ingredients of Cash Flow: Profitability, Growth, and “Asset Intensity” The traditional formula for free cash flow is messy, complicated, and unintuitive:

Earnings Before Interest and Taxes [EBIT]
Less Tax Exposure [corporate tax rate (t) times EBIT]
Plus Depreciation [D]
Less Change in Net Operating Working Capital [NOWC]
Less Capital Expenditures [CX]
Less Change in Net Operating Other Long Term Assets [NOOLTA]

If we make simplifying assuptions that (1) sales drive all other operating variables and (2) growth, profitability, and asset intensity don’t change, then we get this beautiful, simple model of free cash flow:

FCFS=p(ag1+g)\frac{FCF}{S} = p - (a \frac{g} {1+g})

where

p=EBIATSales=Profitabilityp= \frac{EBIAT}{Sales} = \textrm{Profitability}

g=Growthg = \textrm{Growth}

a=Net Operating AssetsSales=Asset Intensity Ratioa = \frac{\textrm{Net Operating Assets}}{Sales} = \textrm{Asset Intensity Ratio}

Most people have heard of profitability and growth.

Profitability is how much of a dollar that you sell you get to keep, before interest and after taxes. The higher the profitability, the more of every dollar you get to keep. Low profitability, less cash available to reinvest in the business or distribute to shareholders, bondholders, and needy cousins.

Growth is a percentage measure of your sales tomorrow relative to your sales today. If you’re profitable and growing, then you’ll have more cash available in the long run.

It’s that in the long run that makes this tricky. Suppose you offer a product for $20/month, and it costs you $100 to win the sale. An additional sale today will tie up $80, assuming you’re paid the first $20 at the beginning of the month. If you only have $800 in cash, you can make 10 profitable sales…and immediately be out of business.

That’s where the concept of asset intensity comes in. Asset intensity is the ratio between the net operating assets (NOA)—the assets needed to generate the sale—and sales. To understand it a different way, ask yourself: “how much more in assets do I need to make an additional sale?” Put a different way: “for me to make an additional sale today, does it tie up cash, or does it free up cash?”

If it ties up cash, it has a positive asset intensity. If it frees up cash, it has a negative asset intensity. And if it cash neutral, then it would have an asset intensity of 0.

Asset Intensity Example Business Why
Positive or Neutral Most businesses—retail, hotels, restaurants, manufacturing, etc. Businesses where accounts receivable are larger than or comparable to accounts payable in most periods.
Negative SaaS businesses driven by organic growth, insurance, consulting firms, Blue Nile (they sell inventory without owning it) Services where you pay today and get your product or service tomorrow, or where you have more time to pay your suppliers than your customers have to pay you.

Negative Asset Intensity and Deferred Revenue

You’re probably asking: “tell me more about this ‘freeing up cash’ business.”

Suppose Dropbox wins a customer that comes it organically (that is, without paid marketing). The customer is interested and immediately signs up for a month-to-month plan at $10/month.

At the beginning of the month, Dropbox has recognized $10 in revenue because they have received $10 for services offered. Dropbox can’t actually realize that revenue until they have delivered the service. That means that, instead of booking the full amount as revenue, they book it as deferred revenue—that is, revenue that is deferred until the service is delivered.

So the deal a customer makes with Dropbox: I’ll give you money today, and you don’t have to provide the full service I paid you for until tomorrow. What does that do to Dropbox’s balance sheet? At any given moment, they have a full extra month of cash—for free.

Suppose the same customers was willing to accept 2 months of service for free if they paid for a year in advance—that is, $100 /year upfront, instead of $120 /year month-to-month. In a year, Dropbox is giving up $20 in profit…but gets to defer a full year of revenue, and invest it in whatever they want. If it costs Dropbox $100 to acquire a new customer, the upfront cash from their first customer just bought them a whole second customer. Tying Cash Flow to CAC, LTV, Churn, and Payback Period

A lot of SaaS investors give advice like this:

Investor Metric VC Advice (SaaS) Cash Flow Metric
LTV:CAC 3:1 Good; 5:1 Great Profitability
Payback Period 9 months good; 6 months great Asset Intesity
Growth 10% month-over-month good; 15% month-over-month great Growth

Lo and behold, this advice maps beautifully onto our cash flow metrics!

The Psychology of Upfront Sales

By now, you are hopefully convinced that upfront pricing can have some incredible upsides relative to month-to-month models. All things considered, a customer would rather hold onto their hard-earned money than give it away all at once.

What Prospect Theory Tells Us About Pricing

Prospect theory articulates some of the ways psychology can make people irrational about economic matters.

Ideas in this section borrow liberally from this paper.

Customers work from a “reference price.”

Perceptions of price are relative. A bottle of wine that sells for one price at a high-end restaurant, a different price at a low-end restaurant, and a different price still at a seedy corner store.

If customers are used to paying $6/month for Google’s G Suite of productivity apps and email, then it might be difficult to sell a related set of products for $16/month. , unless they are exceptionally valuable. Of course, the reference class can vary wildly depending on context. As Harvard Business School’s Bharat Anand has pointed out, a necktie’s competitive space might include power tools… on Father’s Day.

Customers have diminishing sensitivity to changes in price.

Prospect theory suggests that people would rather win $50 twice than $100 once, but that people would rather lose $100 once than $50 twice. Why? Because the pleasure/pain of the 100th dollar you’ve won/lost is smaller than the first

People are loss averse—a dollar loss is more severe than a dollar gained.

Increasing the price of something from $90 to $100 hurts—it is perceived to be a loss, since I know I could have gotten the item at $90. Decreasing it from $110 to $100 is nice, because my reference price is set at $110.

Using Prospect Theory to Increase Upfront Sales

Loss aversion, reference pricing, and diminishing sensitivity make upfront pricing a double-edged sword. The good news is that taking $120 from somebody can cause less pain than $10 12 times because you’re taking that first dollar fewer times. The other good news is that discounting for upfront payment allows you to set a high month-to-month reference price and discount it with your upfront pricing. The very bad news is that $120 is a lot more than $10—12x more—and a customer is going to scrutinize a $120 commitment more than a $10 one.

Semantic Framing matters

Shocker: Discounts make people happy, surcharges make people mad. If we are trying to motivate people to buy something upfront, it is more effective to position the upfront pricing as a gain, rather than month-to-month pricing as a penalty.

Let’s go back to our Dropbox example— $100/year, or $10/month.

You could position this in either of two ways:

  • Pay 20% extra if you buy month-to-month
  • Save 17%—or 2 months free—if you prepay for 1 year

Unsurprisingly, customers are more motivated by the prospect of a discount than the prospect of a surcharge.

If you have a limited-time discounting window, you might want to emphasize a looming increase in price to create urgency. If you are trying to sell earlybird tickets to an event, it may be helpful to position the coming price change as a to create urgency of purchase.

Bundling and Unbundling Services

If you are offering a basket of services—hardware, monthly service, premium support, paid apps, premium platform features, premium onboarding, upfront setup services, etc—there are opportunities to create urgent “closers” for sales and create upsell opportunities for the company. Unbundle Gains Prospect theory suggests that people would rather win $50 twice than $100 once. The value gained from the 99th dollar is less than the gain of the first dollar—so unbundling the benefits gained from discounting can be better than

Suppose you offer a service at the following price points:

  • Upfront cost hardware cost: $100
  • Month-to-month SaaS: $30
  • Add-on monthly service: $30
  • Installation, setup, onboarding, or other upfront charge: $50

Rather than offering one across-the-board discount, it looks more attractive if we discount these individually.

For example:

  • Upfront: $100 $85
  • Monthly service: $30 $25.99
  • Add-on: $30 $13.95 for the first 2 months
  • Installation, design, or other upfront charge: $100 $50
  • Etc

Bundle Losses

If you’re about to buy a very expensive $20k car, it can seem like a no-brainer to add-on the $500 fancy nice-to-have feature. It is, after all, only 2.5% of the base purchase price of the car…right? That same $500 add-on purchased 2 months later might look like a much higher number—and a much tougher sell— without the $20k amount next to it.

This insight creates opportunities for product marketers to sell add-on services at the moment of purchase. For example:

  • If you purchase design services right now, we’ll reduce the cost of design from $150 to $100.
  • If you purchase premium onboarding right now, we’ll reduce the cost from $100 to $75.
  • Etc

Bundling losses this way also creates an urgency of sale.

Integrate smaller losses with larger gains

TODO

Unbundle smaller gains from larger losses

This is the “silver lining effect.” If you are about to take a large loss—for instance, an upfront price, or buying a larger number of devices, etc—it can be helpful to the customer if you find the “spoonful of sugar” to make the medicine go down.

  • Upfront discounting. Is there a way to add a “silver lining” to a high upfront cost?
  • For devices: if we offer financing for the hardware, what if you prepay for the whole device, get $X off?
  • For the plan: prepay for 6 months, get 1 month free?
  • The discounts mentioned above to design services and onboarding when you purchase the device?
  • Volume discounting. Volume discounting is discussed elsewhere. What if we give you 1 device free after the purchase of 3 or 4 devices?
  • Bundle discounting. If you choose enough add-on services, we may choose to bundle them for a discounted rate. For instance, if you get Visit, Music, and enterprise features, do we bundle those together for less money?

The “What does this dollar do for me?” Effect

Bundling and unbundling losses doesn’t come for free. By bundling and unbundling features, you need to actually assign value—and set new reference prices— for each component of your product. This is risky, but also creates opportunities.

Dropbox has had to sustain a price base despite rapidly falling cloud storage costs. As of this writing, Dropbox doesn’t offer add-on pure storage, and this may have to do with them not wanting to create references prices for their storage costs.

By contrast, Everlane uses price transparency to these ends. By showing customers how much they pay in cost and how much they take in markup for each product,

If a customer is contributing money towards each component, . A dollar going toward your local park is likely a more welcome contribution than a dollar generally allocated toward the government treasury—even if that dollar goes right back to the park.

Imagine that you are a startup offering early 5G Internet service to homes. Since your service is early, you need to distribute a $200 piece of 5G hardware to the home. Since you are cash-constrained, you want to find a way to get the customer to pay you upfront for the hardware.

Rather than an opaque upfront price, customers might be more willing to pay an upfront price if they understand that it’s a kind of passthrough price for the hardware. If customers understand why certain items are priced that way—especially upfront line-items—they’ll be better able to justify paying.

Hyperbolic Discounting - Get Started Today, Don’t Pay Until Tomorrow

Many people will take $100 today over $110 tomorrow. Those same people will take $110 in 6 months over $100 in 5 months. When 5 months go buy, they’ll take $100 immediately over $110 in a month. Aren’t people strange?

Hyperbolic discounting is driven by immediate gratification, procrastination, and delusional optimism. All of these are failures of self-regulation.

Immediate gratification is the phenomenon in which people want the benefits now, and are willing to delay the costs needed to pay for these benefits until later. Tying upfront payments to immediate benefits—either in the form of discounts or added products—can help motivate upfront payment.

Procrastination is the phenomenon in which short-term costs are given undue saliency over long-term costs. If immediate gratification is “get it today,” procrastination is “pay tomorrow.” You can use procrastination by positioning

Delusional optimism is the phenomenon in which decisions are made based on overconfidence, or a virtuous conscience. You buy a gym membership in January thinking you’ll go to the gym a lot. You buy a boat thinking you’ll be out on the water a lot.

Focusing on the benefits of commitment, or the virtuous aspects of your product (“think of how it will change your life, and be good for your community, and save money, and help the environment!”) can help trigger the overconfidence you need to make an upfront sale.

Tying It All Together

  1. Cash is king. Startup equity isn’t accepted at grocery stores. Maybe in SoMa.
  2. You can grow to death. You can sell a product that is profitable and high-growth.
  3. Asset intensity. The cheapest dollar of working capital you’ll ever get is the one you earn from an upfront customer.
  4. To get customers to pay upfront over month-to-month, you usually have to discount. Customers need a reason to give you more money upfront.
  5. Semantic framing matters. Customers love discounts and hate surcharges.
  6. How you bundle and unbundle products can lead to big impacts on how those products are perceived. You can a. Unbundle gains. For instance, by giving many line-item discounts instead of a top-line discount. b. Bundle losses. For instance, by loading additional expenses onto the biggest bill c. Bundle small losses into larger gains. d. Bundle small gains into larger losses.
  7. If you unbundle, be prepared to answer “what does this dollar do for me?” Where possible, explain what each dollar does for the customer.
  8. Inspire overconfidence and offer something extra immediately. Immediate gratification, procrastination, and delusional optimism cause people to value benefits today and costs tomorrow.