Does performance pricing lead to commoditization? No.

Tom Tunguz is one of the best informed and prolific of the venture capitalist bloggers. His blog is generally well researched and thoughtful. Worthy to be on your read regularly list. On May 9, 2017, he published a piece titled "The Challenge of Performance Pricing for SaaS Companies." This time, I think he got it wrong.

Let's start with his definition of performance pricing.

"Performance pricing means explicitly pricing of product in terms of the customers’ revenue gained or cost reduced from its use."

Then go to his conclusion.

"Performance pricing is a challenging go to market strategy for one key reason: it cedes the startup’s pricing power to the customer. This has three key ramifications."

In his view, the three key ramifications are that:

  1. Performance pricing focuses the renewal conversation on the numbers, and if the numbers are not improving, the customer is likely to churn (i.e. not renew).
  2. Performance pricing commoditizes a category.
  3. Sales teams lose leverage and relationships become less valued.

To make sure I have captured the key points you should read the post yourself (link above).

Basically, what is being called performance-based pricing here is a flavor of value-based pricing as introduced by Tom Nagle. (I recommend you read the book, but if you prefer video, here is one from the Professional Pricing Society*). The core idea of value-based pricing is that (i) pricing is most compelling when it is based on differentiated value provided to the customer (and not on costs or the market price), (ii) value is always for a specific customer or for a segment that has been defined in terms of how they get value, and (iii) value is always relative to the alternative. The most powerful pricing models link the value metric (the unit of consumption by which the user or customer gets value) and the pricing metric (the unit in which you price).

The key thing is that price should track the differentiated value. Differentiated means the ways in which an offer provides value that the alternatives do not. The part of the value that is provided by alternatives gets priced by the market and is commoditized. To repeat an image from an earlier post (The value two step), you want to price based on your unique advantage.

Value-based pricing is what prevents commoditization. It does this by shifting the conversation away from price to value, and helps the sales team focus on your unique value and not get trapped in price competitions.

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Here is Tom's conclusion.

"Though performance pricing makes sense theoretically, it changes the power dynamics of a sales conversation, ceding all of the leverage to the customer. A startup will face greater churn rates, stiffer competition, tougher sales management, and ultimately commodification. The pricing mechanism itself reinforces that the product is a commodity. "

This is wrong on each point. Yes, performance-based pricing changes the dynamics of the sales conversation, by moving it away from price to value. It moves the leverage from the customer (especially the procurement function) to the seller, if the seller is equipped to talk about (and demonstrate) differentiated value. The result has been, in my experience, lower churn. Value-based pricing is the way to prevent commodification, and does not make a product a commodity. On the contrary, it is pricing metrics that do not track value, like an underlying cost metric or the number of seats, that leads to commodification.

How did Tom Tunguz get this so wrong? He generally has good instincts and does compelling data collection and analysis (anyone interested in early-stage innovation should subscribe to his blog). I think there are three reasons:

  1. The notion of performance is poorly defined and does not focus on what actually matters, the differentiated value (the value that is unique to the offer relative to the competitive alternatives). It is perfectly true that common functionality is commoditized (the place where the three circles intersect in the above graph). The best pricing metrics will track and communicate the differentiated value.
  2. The suggestion that performance can be reduced to a single number. In most non-trivial software, there are several vectors by which value is delivered. Value communication and pricing need to take these multiple value vectors** into account. This is why designing pricing is part art and part science.
  3. The implication that innovators can get away without having  "a substantially better product, and the ability to continuously maintain that lead." In fact, this is what we must do as innovators. We don't need to win on every value vector (most early-stage companies cannot do this). We do have to find a few ways to create value that matters a great deal to some market segment and then focus in on these. This will often be a market segment that is underserved or even ignored by the incumbents.

Creating differentiated value is not easy. Innovation is hard and it only succeeds when it is based on a real understanding of the customer's business and how to create value for it.

There is some concern that value-based pricing is too reductive and does not put enough weight on the emotional dimension of value and price. There is some truth to this criticism, especially when applied to some of the more doctrinaire approaches to value-based pricing which can focus only on the economic side. Even B2B sales has a strong emotional component and that can be part of the value. Companies that adopt performance-based pricing strategies need to be careful to pay attention to the emotional dimension.

Our recommendations on performance-based pricing?

  1. It is the way to go and it is the best way to avoid commodification.
  2. The way to avoid commodification is to focus on your differentiation. 'Me too' offers get 'me too' prices, but at a discount.
  3. Make sure you understand and communicate all of the value vectors (all the different ways you create value) and design a pricing metric that captures the critical vectors.
  4. Include the emotional aspect of value in your thinking. Your price must be perceived as being fair (see Make your pricing fair) and must resonate with buyers (see B2B Pricing Black Magic: Appealing to Emotional and Economic Needs).

Value-based pricing helps companies focus on what matters: the way in which they create and communicate value for customers relative to the alternative. This helps with market segmentation and customer targeting, as well as the design of revenue and pricing models.

VCs are increasingly paying attention to pricing. Pricing power is an important indicator of company value and can be used as an input to making investment decisions. Investors will also want to coach their portfolio companies to help them implement the most effective pricing strategies. Tom Tunguz has also written about "The Price Anchoring Effects of Distribution Platforms," something we are also concerned with in "Framing Effects of Platforms on Price" and "How to Price Your Product: A Look at Bots and Integrated Applications." 

* Disclosure - the Professional Pricing Society video is sponsored by and references LeveragePoint, a company where I (Steven Forth) was a co-founder and where I still have some equity.

** 'Value vector' is a new term in pricing. It is introduced to get away from more static concepts of value and to convey the idea that value is "a quantity having direction as well as magnitude, especially as determining the position of one point in space relative to another."