Pricing Habits of Successful Entrepreneurs
Should entrepreneurs set low prices to capture market share, or price high and target a few select market segments? That is, should they Price Penetrate, Neutral, or Skim? This question has captured our attention for a century, but do we have an answer yet? What do we know?
Penetration pricing positions prices low relative to its competitors after adjusting for differential benefits in order to gain customer attention, and capture a large market share quickly. It is often defended on the basis of earning future economies of scale, scope, or learning. Yet it must not be overlooked that pricing low implies earning low profits, and cast potential losses in the short term.
Skim pricing positions an offering’s price relatively high compared to its competitors after adjusting for differential benefits, and is often defended as a means to recoup development cost. This defense is nonsensical to any educated business person since all development costs are sunk costs, and sunk costs should have no impact on a forward-thinking decision—such as price.
Skim pricing should more rationally be thought of as targeting a specific market segment which places a high value on the offering. Or as an approach to accomplish a strategic goal (proof-of-concept, stake a position, test-the-waters, set value perceptions, etc.) that forgoes sales volume and short-term profits in expectation of future profits.
Neutral pricing positions an offerings price neither high nor low, but neutral relative to its competitors after adjusting for differential benefits.
A Case for Penetration Pricing
Large established businesses looking for material impacts on their business often choose penetration pricing. Penetration pricing can generate a lot of customer interest quickly, pump up revenues, and capture shareholder attention.
However, we aren’t examining the habits of large established business; we are talking about entrepreneurs. Entrepreneurs are generally entering a business landscape with less information, less skills, less resources than an established business. In fact, one should wonder how any entrepreneur can succeed against large, entrenched corporations they’re forced to share the market with.
And yet, we see it. And every time, there is some level of amazement to their story. Moreover, we can observe entrepreneurs using the exact same price position at launch as large corporations would. For instance, consider Amazon, Tesla, DoorDash, or Blue Apron.
Amazon launched in 1994 as an online bookstore. Overtime, it developed into a broader online retailer. Today, its business includes Amazon Web Services (AWS), streaming, and more. In retail, it has famously pursued a clear penetration strategy. As of Q1 of 2019, Amazon was suspected to have lost $2.5 billion per quarter on its retail sales of approximately $30 billion. Yes, Amazon made money: $1.9 billion on $51 billion in revenue. But its core business in retail is a profit failure subsidized by shareholders and an ancillary business.
Moreover, building the Amazon.com retail business required a decade of quarter-over-quarter losses. Cumulatively, Amazon.com didn’t even break even until 2011, 19 years after its founding and well after AWS came to market in 2002. I am not sure, but I suspect Amazon.com has never made money in retail. Amazingly, investors bought into this growth story, and Jeff Bezos is currently the richest man on earth.
Similarly, Tesla could be said to be using penetration pricing in many senses. Founded in 2003, it took until Q4 of 2018 before Tesla posted back-to-back profitable quarters with $139 million in profit on $7.2 billion in revenue. Cumulatively, as of the end of 2018, Tesla has lost $9 billion since inception. That is 15 years of overall losses. Yes, Tesla jolted the auto industry forward with its all-electric vehicle concept. Fortunately, investors paid into this green growth story and now every Elon Musk tweet is a must follow for the SEC. Elon Musk’s net worth is $21.2 billion. Total capital raised for Tesla: $19 billion.
DoorDash has also used penetration pricing to take share from GrubHub and other delivery services. DoorDash valuation: $4 billion. Profitability: nonexistent.
Blue Apron? In competing with grocery delivery it has used promotions and penetration pricing to capture people’s attention. Blue Apron valuation at IPO: $2 billion. FY 2018 Losses: $138 million. 2018 Valuation: Roughly $200 million.
From the above stories, would one suggest entrepreneurs use penetration pricing? If the purpose of a company is to serve customer’s needs profitably, one would state that these businesses, or at least their core business in Amazon’s case, are failures. If the purpose of an entrepreneurial company is to spin a growth story to take investor’s money and make themselves rich while hoping that some exit plan or more profitable opportunity can be developed in the future, then I suppose so. But that would be a major redefinition of what a good business is.
While on a personal level I am delighted that Jeff Bezos and Elon Musk did the work they did. On a business level I would be pressed to call them unequivocal successes. Jeff Bezos demonstrated that retail e-commerce would attract customers and can be done at scale. Similarly, Elon Musk demonstrate that e-vehicles can be made practical and people would buy them. Established companies did not take those initiatives even though they could have. These entrepreneurs did.
Yet, I question if the future of e-commerce still belongs to Amazon if Amazon retail was held accountable for profitability like its peers Target and Walmart. Similarly, I question if the future of e-vehicles belongs to Tesla if Tesla was held accountable like its peers Volkswagen, Ford, GM, Nissan, Toyota, or a host of other established automotive companies who are now fully into the e-vehicle market. And I question the wisdom of investors to contribute billions of dollars on a long-shot which, in both cases, has not worked out. Do Amazon and Tesla deserve their valuation given their profit earnings in comparison to their competitors?
Let’s try again.
The Case for Skim or Neutral Pricing
Reed et. al 2005 research examined the thought paradigms of highly successful entrepreneurs. They defined highly successful entrepreneurs as individuals that have founded one or more firms, remained with one of them for 10 years, conducted in IPO, and have grown a company to $200 million or more in annual revenue.
Reed’s research demonstrated that highly successful entrepreneurs tend to use skim or neutral pricing, depending on the perspective one takes to their price positioning.
They identified a specific customer segment that placed a higher value on their offering than most, and priced appropriately for that market segment. For most of the market, these highly successful entrepreneurs would be perceived as doing Skim pricing. For their target market segment, they would be perceived as being price neutral.
In effect, these highly successful entrepreneurs forwent the mass market in pricing high. Instead, they targeted and captured a select market segment that value their offering, one that would be willing to pay more to attain their offering. In accordance with the target segment’s willingness to pay, these highly successful entrepreneurs priced their offering appropriately.
Does it work? Yes.
Katrina Lake of Stich Fix uses what I would call a more neutral pricing strategy appropriate for her target market. Also, she makes profits in her core business.
Similarly, Southwest Airlines, Virgin Atlantic, P&G, Nissan, Dollar Shave Club, Rent the Runway, and many others use a more price neutral strategy to attract a specific target segment. They actually serve their customers profitably, and as such would fit what I would recognize as successful. Moreover, Microsoft, Oracle, and many other technology firms have had a long history of profitability.
Pricing low in the expectation of profits at scale isn’t even common for successful technology driven companies, not even among those with a Silicon Valley history.
So, if asked for advice on the original question: should entrepreneurs price penetrate, neutral, or skim, I believe we collectively know the answer: Price neutral for your market segment which most values your offering. It may appear like skim pricing to others, but it is more likely to create a healthy business. As for penetration pricing and entrepreneurs: it works if you are great at publicity and attracting investors.