Two things came together last week to frame this post. First, Tomasz Tunguz (one of the best of the VC bloggers, if you don’t already subscribe to his blog we recommend it) published a provocative post asking ‘Should Your Startup Differentiate on Pricing?’ The general conclusion seemed to be ‘No’ (see the rationale below). Second, we have had a lot of responses to our recent value report on Pricing Innovation. One of the key findings from that report was that organizations pursuing disruptive innovation tend to use market following pricing, while those engaged in sustaining innovation are more likely to apply value-based pricing. As strong advocates of value-based pricing, this was a bit of a surprise for us.

This is where the Tom Tunguz post came in. In a conversation with Brad Birnbaum, founder and CEO of Kustomer, the following comment was made:

We wanted to be innovative. We thought innovator pricing would be very important to us. We quickly learned as we started talking to customers that they didn’t want innovative pricing. They wanted repeatable, consistent pricing that mapped to the budget they already had in place.

Go to the Tom Tunguz post to read the complete quote, which is worth reading. The summary is …

Prioritizing how to differentiate in the market is a key aspect of product management … Before changing pricing models, listen to customer perspectives on budget.

When there is a clear budget line into which you fit, and buyers have a well established buying process with clear expectations on pricing, introducing a new pricing model can hurt more than it helps.

That is not the whole story. To really understand the interactions between pricing and innovation, we need to better understand the type of innovation we are delivering to the market. As Rashaqa Rahman, who led this research, noted in her blog post Pricing Disruptive Innovations - market-following or value-based pricing? …

Sustaining innovations are innovating on existing value drivers that are already well understood by the market. This makes it easier to map value creation to value-based pricing. Disruptive innovations can create differentiation through new value drivers (economic and/or emotional) or through new ways of delivering on existing value drivers that the customer cares about.

Let’s unpack this a bit. There are three ways to create value through innovation: one can improve on an existing value driver, find a new way to deliver an existing value driver or uncover and deliver a completely new value driver. One can do each of these for an existing market or for a currently underserved market. Putting these together gives the following two by six matrix.

The three approaches to innovation are framed here in terms of value drivers. Value drivers are the basic building blocks of pricing (and product) strategy. They come in two flavours, emotional and economic, and they can be organized and combined in many different ways. One or two of the economic value drivers generally emerge as critical and are used to build pricing metrics. There are three ways to think about value metrics and innovation. In most cases, at least for B2B, it is the economic value metrics that are used in framing pricing metrics.

1. Improving on an existing value driver. Basically this means tweaking the parameters of the value equation for a specific market segment. This is classic sustaining innovation.

2. Finding a new way to deliver on an existing value driver. This is an important form of innovation as it is often a first step towards disruptive innovation, but it does not become disruptive so long as it is based on existing value drivers.

3. Finding a new value driver, always for a specific segment, ideally a segment that is underserved or not served at all.

Value drivers are the impact your offer has on the business of your customer. The six types are set out below. If your customers are SaaS companies, it can also be useful to define value drivers in terms of their impact on unit economics.

So how does this connect to the choice of pricing method? Restricting ourselves to just two methods, value-based pricing and market following (competitive) pricing, the choices map as follows.

Looking at each of these scenarios:

Existing Market x Improve an Existing Value Driver — Value-Based Sustaining

This is the classic sustaining innovation scenario. To win you need to communicate the incremental value and claim part of this in price. The only way to do this is with value-based pricing.

Existing Market x New Way to Deliver an Existing Value Driver — Value-Based Disruptive

This may or may not be a meaningful innovation. At the end of the day, customers care about what value is delivered and not how it is delivered. The only way to know is with value-based pricing.

Existing Market x New Value Driver — Market Following Disruptive

This is the most difficult scenario, but it is also one of the most common. This is the only case in which one may want to adopt a market following pricing approach. One would do this to focus ones early energies on explaining the new value driver and how it works and keeping the pricing conversation as simple as possible.

Unserved Market x Improve an Existing Value Driver — Value-Based Sustaining:

Entering an unserved market always requires value-based pricing. You have to convince the market of the value of your new (to them) solution.

Unserved Market x New Way to Deliver an Existing Value Driver — Value-Based Disruptive

As far as the market is concerned, this is the same as the preceding scenario as the solution is new to them and the value has to be demonstrated.

Unserved Market x New Value Driver — Value-Based Blue Ocean

These are the most compelling, and the rarest forms of innovation. This is when an innovation creates a whole new market that it can dominate. It is not for the faint of heart. It requires a compelling value proposition, time and determination, and a few early believers. But these believers will still need to understand and be able to sell the value. Value-based pricing is essential.

So, before you choose a pricing methodology, think hard about the kind of innovation you are proposing and ask if you are bringing this to an existing market or if you are creating a new market. Don’t default to market-following pricing just because it seems like the easiest route or you are afraid that you don’t understand your customers. If you want to win at innovation you have to invest in understanding your customers. Value-based pricing gives you a framework to differentiate on pricing.