Pricing drives enterprise value: five questions investors should be asking
By Steven Forth
Private equity (PE) firms invest in companies so that they can increase their value and sell them on. If a company is perfect, in an attractive market with a clear and differentiated strategy that is being effectively executed, then it is not a good investment for most PE firms. It may be a good venture capital investment, if it is early stage, or a good place to lend money, if it is more mature, but this is not where PE generates value. PE generates value by improving business basics. So the questions is what basics.
Given the famous quote by legendary investor Warren Buffet on pricing power, it is surprising that this is not the first thing that investors look at.
We have written on what pricing power is, and how to increase it, elsewhere (see What shapes willingness to pay) so the main question is that given the power of the pricing lever, why isn’t it the first one that PE firms pull?
There is some recent research from consulting firm Mckinsey & Co. that helps to answer this question. In Pricing: The next frontier of value creation in private equity, recent research on pricing and private equity is summarized. Many PE firms try to improve business performance by cutting costs. Many are famous for this. Private companies, especially those run by founders or their families, are thought to build up layers of unnecessary spending over the years, and the PE firm can come in with a scalpel (or a cleaver) and cut out costs. This is seen as low risk (but if it destroys the ability to create differentiated value for customers it is a false economy). The next thing in the play book is generally revenue growth. Top line growth is an important metric and it seems to many that if you can cut costs and grow revenues then profits will naturally follow (see our interview with pricing guru Tom Nagle for his thoughts on this). It is well known that pricing is one of the most direct ways to increase profit and that a one percent increase in price will generally drive a bigger increase in profit than a one percent increase in revenues or a one percent cut to costs. Given the importance of pricing, why are so many reluctant to pull the pricing lever? The Mckinsey research provides some answers.
Let’s work through each of these.
Risk of competitive response
One assumes that this means competitors will take advantage of price increases to steal away customers. Is price the only, or even the main reason that your customers stay with you? If so, you have no pricing power and were not a good investment to begin with. The first thing you need to do is to increase your pricing power (and there are only three ways to do this) or move into a market and develop offers where you have differentiated value.
What you should really be afraid of is price cuts. If you cut your prices, what will your competitors do? If they will respond by cutting prices then you are in big trouble. Pricing wars can destroy the value of entire industries.
Price increases generally build value. Price cuts are more likely to destroy value.
Risk of customers deciding not to purchase
We have coached companies through many price increases. If you have a legitimate reason for the increase, communicate it clearly and treat customers fairly, they will generally go along with the increase. Of course you will probably lose some customers. You probably should lose some customers. For some customers you simply do not provide enough value and they should go elsewhere. Other customers are not and will not generate enough customer lifetime value to be worth the investment needed to keep them.
The three ways to increase pricing power mentioned above are …
Increase positive differentiation (economic, emotional and community)
Decrease negative differentiation (those things the next best competitive alternative does better than you, or the unique costs of your own solution)
Increase your pricing power by strengthening your brand, reducing risk for your buyer or restructuring the value chain in your favor.
Organization face these typical obstacles when trying to increase pricing power
Lack of visibility into the opportunity
This seems like a weak excuse. There are many ways to explore the impact of pricing actions. Start by interviewing customers, prospects and losses about value (not about price) and get a real understanding of how different parts of your markets, and different stakeholders in the business, actually get value. Use this to segment your customers and design packaging and pricing. Will there be uncertainty? Of course, we live in an uncertain world. But not acting also has risks. The real risks can be explored by building Monte Carlo models of the range of outcomes and exploring what information might actually reduce uncertainty.
Weak supporting systems
We do have some clients where making a price change is almost impossible because of how their accounting, billing or delivery systems are structured. Remember the old joke, “in an ERP implementation you take your business processes and pour concrete over them.” Well pricing can get set in that concrete. One thing that PE investors can do is break through this inability to act and put the right systems in place. Even when the systems are getting in the way, there are usually ways to implement at least some pricing actions while the systems are reconfigured or replaced.
Limited management team bandwidth
If management is not looking at pricing, one of the most important levers of profitability, then what are they spending their time on? Pricing should be on the agenda of every leadership meeting and every board meeting. If necessary, reach out to consultants. At the same time, build internal pricing muscles.
Misaligned frontline incentives
This most likely refers to the fact that most salesforces are compensated on the topline. Sales people do what they are paid to do, they are coin operated, and that is how it should be. Redesign of sales compensation should be part of pricing strategy execution. Compensation should reflect the company’s strategic goals. If the only goal is to grow revenues, and metrics like profit, customer lifetime value, category share are unimportant, carry on. Show your salesforce that pricing increases are very often an effective way to increase revenues, even if one loses a few customers. There is even a metric for this, the Selling Price Index (see below).
What questions should investors ask about pricing?
Ask when the last time a pricing action was taken.
Why was it taken? How was it implemented? What was the outcome? Keep on asking this question. Look for changes over time.
Require that the company produce a quarterly Sales Price Index.
This is a metric used by pricing leaders like Dick Braun at Parker Hannifin to measure the impact of pricing on revenue. The equation for this is simple: (Average Price This Year – Average Price Last Year) x Volume for the Quarter. Price changes can contribute or take away from revenue. As an investor, or potential investor, you need to understand this at a granular level.
Consider how much is being invested to increase positive differentiation, decrease negative differentiation or increase pricing power.
These investments should be balanced (none of them should be zero) and reflect the overall strategy.
Get alignment on the goals of pricing strategy.
Is pricing meant to optimize topline revenue, to grow profit margins, to build a new category or claim market share? How does pricing impact overall customer lifetime value? Is pricing being used to manage utilization? There is no effective pricing without alignment on intended outcomes.
Segment the market by value.
Good pricing is based on a foundation of value-based market segmentation. A meaningful market segment is one that gets value in the same way and that buys in the same way. Pricing should be designed for the most important target segments and not be broad brush. One size does not fit all.
Investors and their representatives on the board of directors have a responsibility to make sure that companies are executing on pricing. It is one of the most effective ways to increase shareholder value. Put pressure on management to make sure they are executing.
