Lessons Learned: Pricing

By Frank Demmler

Some of the themes throughout this series of articles have been:

Š      Cash is king. Absence of cash is death.

Š      Gross margin is good. More gross margin is better.

Š      Gross margin is the best source of growth capital.

Perhaps not explicitly stated, but implied, the value of your company is heavily influenced by:

Š      The quality of your earnings.

Š      The rate of growth of your earnings.

All of this leads us to focus on one particular aspect of your business – pricing. Considering how important it is, you might anticipate that I have sage advice for you. Surely with over twenty years in this arena, and having participated in hundreds of pricing decisions, I must know the answer. 

I only wish that were so. What follow are some pricing decisions that didn’t quite work out as intended.

Case Study #1: The Inconsequential Add-On

An engineering software company developed and sold a package that added utility to the workstation for which it was intended.  At the time, that fully loaded workstation cost about $35,000. We priced our product at $3,400.

The rationale for this was two fold.

First, we sold the product through value-added resellers (VARs), and we gave them a 60% margin on our product compared to the industry-standard at the time of 40%. An extra 20% of $3,400 was thought to be a pretty enticing incentive.

Second, by pricing the product at less than 10% of the system’s price, we believed that the VARS would be able to tack it on to a workstation order, with an “Oh, by the way, we suggest that you [the customer] add this product to the order. It doesn’t cost much compared to the system price, and you will get more than your money’s worth from its added functionality.”

Compelling logic. Severely flawed in the real world.

VARs want to close deals. VARs do not want to jeopardize a deal that can close, by trying to “nibble” a few more dollars from a customer. If a VAR can close on a $35,000 order, he will do so.

Also, VARs rarely (never?) do missionary sales. This is when something “new” is introduced to the market that requires nurturing and educating customers, with the time to close a sale measured in multiple months, if not years.  At the risk of oversimplification (and the wrath of VARs everywhere), VARs like to take orders from existing customers. That immediately puts money in their pockets.

Case Study #2: When Is a Sale not a Sale?

Same company. Same conundrum. How do we motivate VARs to sell our product? Since there had been pushback on the price of $3,400, we decided we needed to increase the financial incentives for the VAR without actually lowering our MSRP, since we had deals in the pipeline at the stated price.

The answer? A limited-time six-for-five sale. We would give the VAR six products for the price of five, effectively a 17% discount. Also, we believed that if the VARs carried an inventory of our product, they would have additional incentive to sell it.

Again, compelling logic, and this time product began to move.  Our sales were increasing on a month-to-month basis for four consecutive months. There were notable sighs of relief in the boardroom.

Then we started to notice an alarming trend.  Our sales were growing, but our cash was declining, and upon inspection, accounts receivable (money our customers owed us) were increasing at an alarming rate.

What had happened was that the VARs saw a discount and took it, but had no intention of paying the invoices until they had sold the product to their customer (and in some cases, gotten paid by their customers). What we had counted as sales, the VARS looked at as consignments. In effect, we had created a rather expensive field-based inventory.

When this was all unraveled (and write-offs taken), less than 10% of the orders received during that time period were “real” orders. The remaining orders had been solely for the discount. While we were in the right legally, since the VARs were in clear violation of the terms of the sale, what were we to do? Sue our only customers? Not going to happen.

Case Study#3: Leaving Money on the Table

As you’ve seen, it’s pretty amazing how a bunch of relatively bright people, who have quite a bit at stake, can convince themselves of their collective brilliance, and be so wrong.  I could continue along this path of self-flagellation, but I think you get the point, and dredging up these memories is starting to get painful for me.

I will now share a case study with you that started the same way, but had a much better outcome.

Establishing the initial price

In past articles I’ve talked about Automated Healthcare (now McKesson Automation), founded by Sean McDonald. The company was the pioneer in selling barcode-reading robots to hospital pharmacies. Since this was a new product in this space with few meaningful comparables from which to glean a reasonable pricing strategy, the management team had to make it up as it went along.

With that in mind, we had several objectives that at least helped us frame out thoughts.  First, we would never sell a robot for less than what it cost us to make it.  That meant that our alpha customers were going to have to agree to pay over $200,000 for something they’d never seen before, and that they knew was going to be a work-in-process, but I digress.

We also knew that the tipping point at which capital spending decisions in hospitals received intense scrutiny, and thus even longer selling cycles, was $500,000.

Further, we wanted to get $1 million of cash flow from each robot transaction over five years, and that provided guidance for pricing our maintenance contracts.

With those boundary conditions, we priced the two alpha products at $240,000 each.  The initial beta product was priced at $320,000 and the last one, $430,000. The list price of the robot was established at $472,900.

Customers were willing to pay that (often with great reluctance, but pay they did, nonetheless). Our boundary conditions were met.  We were happy and confident campers.

Changing the pricing strategy

About this time, we raised a significant amount of institutional venture capital in a round led by two out-of-town investors. They were much savvier about the ways of Wall Street than we (or so they claimed and we believed, at the time). They insisted that the large dollar value of our sales would likely make our quarter-to-quarter results relatively unpredictable, and that that profile would depress the valuation that the financial markets would give us at exit. 

Therefore, Automated Healthcare shifted its entire pricing strategy to doing leases exclusively. While revenue would ramp up more slowly, and profitability on a GAAP accounting basis would be pushed back, this created a recurring revenue model that would have predictability and could support higher exit valuations.

Not wanting to get too far off track, the only way this could work is if a financial company were willing to buy our leases, so that we could get cash up front, even though we were recognizing the revenue over five years. Don’t let these details distract you.

We found such a finance company and we learned the art of crafting leasing deals that qualified for being purchased.  How did we price the leases, you may ask? We took the $472,500 that we were getting from the sale of a robot, applied the various leasing company discounts, etc., and reverse-engineered a lease price that would yield us $494,000 in cash from the leasing company!

Note several things. We didn’t really pay much attention to our customers in doing all of this.  We used the few data points of purchases at $472,500 to assume that an “equivalent” lease would be accepted.  Second, we got more upfront cash out of the leases than we did when we sold the robots! [There were some short-term cash flow consequences of this abrupt shift in strategy, but that is another story for another time.]

Setting a new sales price

In fact the leasing program was well received and we began taking orders on that basis.  What we found, though, was that some hospitals needed a purchase option so that they could prove that the lease was the way to go. We pulled out our handy-dandy calculator, took our lease and calculated a sale price that clearly made the lease the preferred option.  That price was $612,000, but we didn’t really care since we weren’t going to sell the robot anyway.

The revelation!

As many of you know, one of the appeals of the leasing option to a customer is that its expense can go through the normal operating budget and avoid the scrutiny of the capital spending approval process, staying below the radar screen so-to-speak. We found that some hospitals had found this practice running rampant and had prohibited leases.

When we approached these clients, we explained that we only did leases.  They explained that they were only allowed to make capital equipment purchases.  They asked for the price of our robot, and all we had to provide was that fictitious, reverse-engineered, ridiculous selling price of $612,000, since we “knew” that the sensible and supportable sales price was $472,900, based upon what we had been doing only months ago.

They bought the robot without batting an eye!

Where had we gone wrong? We had accepted the conventional wisdom that we needed to keep the price under $500,000 in order to get through the hospital’s purchase approval process. We never challenged that assumption. Shame on us! We were leaving at least $140,000 on the table!

With that insight and the superior execution of the Automated Healthcare team, the quality of our earnings made a significant contribution in justifying a $65 million price when the company was sold to McKesson in 1996.

Advice to entrepreneurs

Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund, general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of this series of articles can be found at my website.