It’s Price Before Product. Period.

Over the second half of the 1990s, Porsche hatched plans for a new car. Annual sales were a third of what they’d been the decade prior, so the company badly needed a turnaround. The car hit the market in 2003. A decade later, Porsche sold 100,000 of the model in one year — nearly five times as many as it did in its launch year — which accounted for half the company’s total profit. This enabled Porsche to eventually pay down its debt, increase its cash reserves and generate the highest profit per car in the automobile industry. What was this impactful, new product?

It wasn’t a sports car, for which Porsche is famed – not, for example, the sexy Porsche 911 that can effortlessly hit 200mph. Instead, it was the Cayenne: Porsche’s family-friendly SUV. How did the carmaker find this degree of impact with a vehicle so counterintuitive to its brand? In this case, it wasn’t Porsche’s engineering prowess or manufacturing efficiency, but how it designed the car around what customers needed, valued and were willing to pay for – in short, around its price.

Building around price is the best path forward according to Madhavan Ramanujam****, a board member and partner at consultancy Simon-Kucher & Partners. When it comes to this pricing expert, investor Bill Gurley may capture it best: Madhavan Ramanujam is to monetization strategy what Bob Marley is to reggae music. He’s managed over 125 projects for companies ranging from hot startups to the Fortune 500, many of which he writes about in his recently published book Monetizing Innovation. He advises companies on several topics including new product monetization, acquisition and growth strategy, pricing strategy, packaging and bundling strategies, and price implementation. He’s essentially the price whisperer.

Drawing from his talk at First Round’s CEO Summit, Madhavan Ramanujam explains why pricing is so paramount from the get-go and the four ways companies often trip up when trying to monetize. He also shares the three guidelines that startups should follow in order to properly design and price their products. Let’s get started.

Why Pricing is Key From The Get-Go

Porsche knew it was taking a tremendous risk by building an SUV, veering from its traditional wheelhouse of sports cars. So the company focused on benefits customers were willing to pay for. The result was a car perfectly designed around features customers wanted, like larger cup holders, at a price they were willing to pay. All the items customers weren’t willing to pay for, like Porsche’s famous six-speed racing transmission, were thrown out, even if their engineers loved them.

On the other hand, Fiat Chrysler in 2009 badly needed a hit in the compact cars category, and focused its development process on engineering and design, settling on a price for the car at the very end. The company even bragged in advertisements that “it was ‘kicking out the finance guys’ from the development process. They worked to design, build and rethink, and repeated that cycle over and over until engineering thought the product was good to go. Money was not an issue and compromise was not an option. The ad shows the company building prototype after prototype to get it right,” Ramanujam says. “Market performance was a disaster. It performed so poorly it eventually forced the company to issue temporary layoffs. Even though Fiat Chrysler was six times larger than Porsche, the company failed to craft a hit. That’s because the company thought about product first and price last.”

“On the other hand, Porsche’s masterstroke was thinking about monetization long before product development for the SUV was in full speed, then designing a car with the value and features customers wanted the most, around a price that made sense. The result was total corporate alignment: Porsche knew it had a winner, and had the confidence to invest accordingly,” Ramanujam says.

Porsche is not an outlier. The vast majority of companies are under some kind of price pressure, and need to create new products and features — and make money off of them— in order to survive. In a 2014 study conducted by Simon–Kutcher, about 80% of respondents said they were under price pressure. About 60% even said they were in a price war. The top way companies planned to respond to price pressure was to release new products and services in order to survive, according to this study. And yet 72% of these innovations did not meet their revenue or profit targets, or even failed completely. Why?

Why Monetization Often Fails

New products fail for many reasons. “But the root of all innovation evil is the failure to put the customer’s willingness to pay [WTP] for a new product at the very core of product design. Most companies postpone pricing decisions until after the product is developed. They embark on a long, costly journey of hoping they’ll make money rather than knowing they will,” Ramanujam says. “You can ensure your product not only stays alive, but thrives, by talking with customers early in the product development process. If you don’t, you won’t be able to prioritize the product features you develop, or know whether you’re building something customers will pay for until it’s in the marketplace.”

Drill down to see what customers are willing to pay early on. It’ll drastically increase your odds of success.

Missteps with monetization frequently occur when companies try to sell a product that they haven’t price-tested thoroughly in advance. Take the Keurig Kold, a $370 home soda machine, or the “personal transporter” Segway. Mess-ups on monetization usually boil down to misjudgments on price point, features and market. According to Ramanujam, here’s the four ways companies get tripped up, and how to avoid them:

Feature Shock. These happen when a product has been packed with far too many features. “Products fail when they have way too much going on. They’re over-engineered, hard to explain, nothing stands out, and the company puts a price on it and hopes for the best. It’s usually borne of a sincere effort to be ‘all things to all people,’ resulting in a product that pleases few. Due to its multitude of features – none of them a standout – these products are costly to make, over-engineered and usually overpriced,” Ramanujam says.

Take Amazon’s Fire Phone. The company, already the successful maker of gadgets like the Kindle, decided to launch a feature-packed phone that had four cameras, facial recognition technology and 3D effects, as well as Firefly, a shopping feature that let you buy a product by pointing the camera at it. Reviewers panned the phone and sales struggled, leading to a $170 million write-down largely attributed to the unsold inventory.

How to combat feature shock: Beware when your R&D team wants to add a feature but can’t articulate its value to a customer. Instead of cramming tons of features into one product, practice restraint. Separate your customers into buckets depending on their needs, values and WTP. Then tailor your products differently to each segment. Essentially, you want to sort features into different groups and create packages or bundles that appeal to each.

“Curb your instincts to please customers by giving away too much value unless people will pay for it. This will maximize the potential of your new products,” Ramanujam says. “And get comfortable with the idea of giving your price-sensitive segment only basic quality and service levels, rather than giving them everything. Product configuration requires the guts to take away features.”

Take the case of Microsoft. It has different versions of its Office suite, so that different groups of customers – business, home and education – find options best suited to its needs. It’s been a highly successful approach.

Minivations. Sometimes, companies will create the right product for the right market. The only catch: The company or entrepreneur didn’t have the courage to charge the right price, and as a result, the product is under-monetized. If you evaluate the product’s sales versus its potential, and it gets a C+, that’s a minivation.

“Everyone knows that they could have done better, but they just claim it as a success because it still worked. Take the computer manufacturer Asus. It unveiled a mini-notebook in 2008 priced at €299 that sold out in a few days. Demand exceeded supply by 900%. Asus couldn’t make them fast enough and lost significant revenue once its supply ran dry,” Ramanujam says. “The Asus product fell far short of its price potential; it was way underpriced. Asus left lots of profit on the table. They could have priced a lot higher, serviced the market that was willing to pay, and then dropped the price after building far more units to target the mass market.”

How to catch minivations: Look for minivations early. It’s key to watch your team’s attitude before and after the product launches. “Some early warning signs may be that your team seems comfortable checking the box and lowballing on targets. There’s a lack of ambition and a desire not to overprice,” Ramanujam says. “Your sales team is going to be your canary in the coal mine. They will be easily meeting its targets with your new products. Your channel partners will be reaping their maximum margins. Sellouts will be popping up. If the majority of deals are going through the pipeline without any pushback on price, you may have underpriced it. Track the number of price escalations, as well as the length of the sales cycle against historical norms. It will give you more hard evidence that something new is occurring, which you can then address.”

Hidden Gem. Hidden gems are products that a company should have developed, but didn’t because it goes against the grain of what it normally offers. Take Kodak as an example. “The company in 1974 had digital photography technology, but didn’t release it because they were concerned about cannibalizing their existing business. Kodak didn’t introduce its first digital camera until 1995, 21 years after the fact. They declared bankruptcy in 2012,” says Ramanujam. “None of this had to happen. Kodak’s team became complacent about their firm’s successful, pre-existing business model, and the company stagnated.”

How to harness hidden gems: The big miss with hidden gems lies in failing to recognize the value and often disruptive power they represent. “These ideas often never make it to the executive suite. They are stopped by mid-level executives who are either unable to see their potential or are scared of them. A more open culture could save these ideas from being lost too early,” Ramanujam says. “‘Where does the buck stop?’ becomes a tough question to answer in the case of hidden gems. Who was responsible for the big miss? In most organizations, no one is responsible for recognizing the hidden gem’s potential.”

Your company may have hidden gems lying around if you are going through any of these inflection points:

Changes in business model

Disruption in your industry

Differentiation of an existing commodity business

A change from selling a product to a service

A shift from offline to online business

A move from analog to digital

A switch from hardware to software

“The key here is to be very careful and mindful when you’re going through these big organizational changes. You don’t want a great idea to get lost in the shuffle, and you also don’t want to see great ideas killed by middle management. The key is grooming a culture where ideas are heard and taken seriously,” Ramanujam says.

Undead. This category of product should never be released, because it comes back to haunt you, like a ghost or zombie. “They come in two varieties: Either they're the wrong answer to the right question; or an answer to a question no one cares about. Either way, you should never have developed these products. Undead failures teach us that some well-intentioned, marvelously engineered new products should never be brought to life,” says Ramanujam. “One of the most celebrated — and then reviled — was the Segway. It was supposed to change the world. But sales underperformed in a major way, and one of the top problems with the machine was price: At $3,000-$7,000 each, there was little hope for a mass following.”

How to avoid the undead: Undead products happen when proponents wildly overstate customer appeal and don’t segment the customer base effectively. “Had these firms asked customers whether and what they’d be willing to pay for their inventions before drafting the engineering plans, and had they identified the market size by segment and who would be willing to pay the most and the least for it, they would have reformulated their products to meet an acceptable price. Or, finding there is no acceptable price, or that the market size is too small, they would have scrapped the product altogether before they incurred too much financial damage,” Ramanujam says. “A critical step in your new product development process will be making a business case for it – by getting external input. Specifically, you need to know your target customer’s WTP. Your business case document should be an up-to-the-moment reflection of your product’s monetization potential.”

Slapping on a price just before going to market is a recipe for failure. But many commit this crime.

Three Key Rules For Monetizing New Products

The most successful innovators start by understanding their customers needs and developing products around what they are willing to pay to address those needs. It’s not enough just to think about price beforehand – you have to iterate and test your assumptions and talk to buyers at length to truly understand whether your product has a shot. There are several different monetization strategies, and one key thing Ramanujam stresses is that all customers are not the same: Every situation requires a different strategy. Below, he lays out three ways to price your products properly.

Have the Willingness-to-Pay talk early.

Talk about price early in the product development process. About 80% of companies don’t do this — and instead wait until the last minute — according to Simon-Kucher’s study.

“Ask at the onset whether or not people would pay for the product you intend to develop. This is the Willingness-to-Pay talk,” Ramanujam argues. “Frontloading this question is powerful because customers won’t be in the mindset of negotiating price. Instead, they’ll give you objective feedback that you can use to prioritize what you’re building.”

Ask someone if they like a product. Then ask them if they like it at a price point, say $20. The whole conversation changes.

Ramanujam often sees teams put an intense amount of effort into new product features without considering whether customers will be willing to pay for them. “I remember one time when a CEO asked his team to figure out what they could monetize. It ended up that the features lower on their list were what customers were actually interested in paying for. If they hadn't done this sort of exercise, they would have focused their time and attention on all the features, and probably produced a mediocre product. What they were actually able to do was take the ones that really mattered and do a kickass job,” says Ramanujam.

Here’s how to get started: Before investing in your product, directly ask your customer what they’re willing to pay — but do it in a smart way. Present the item and ask:

What do you think is an acceptable price for this innovation?

What is an expensive price for this innovation?

What is a prohibitively expensive price for this innovation?

“After you ask the first question, they’ll give you a low-ball price. Then they’ll give you the ceiling and the cut-off point. These are three very powerful data points,” says Ramanujam. Here’s what each data point tells you:

The acceptable price: “Based on working with hundreds of companies, here’s what we’ve learned: An acceptable price is the price that people are super comfortable paying. No friction, they just love your pricing because it's a steal. If you're pricing for growth, maybe you can price in the acceptable area.”

The expensive price: “Expensive is the price that they would actually pay you, but they don't like it. Neither do they hate it, but it's the price usually that's aligned with value.”

The prohibitive price: “The prohibitively expensive is the price that they'll pretty much be laughing you out of the room. Asking that question gives you some sense of where you can actually be someday, but not at the moment.”

Consider doing a large-scale study with these questions. Plotting out what customers find acceptable, expensive and prohibitively expensive gives you a graphical view of their willingness-to-pay, and allows you to identify “price cliffs”, where demand drops off due to price. “There are psychological thresholds that people have when they think about your product. If you price at $51 as opposed to $49.99, suddenly there's a huge portion of people who think that price is not acceptable. This is how psychological behavioral price points are determined, with these simple questions, which you can do tomorrow,” Ramanujam says. “Knowing the answers to these questions is critical. If you didn’t know this you wouldn’t be able to really price your products the right way. It’ll give you a range of the WTP for your product, far before it’s commercialized and released in the market. And you will know that you have a monetizing potential and you will not be hoping”

Investigate How You Charge As Much as What You Charge

Ramanujam stresses the importance of charging in a way that makes sense and is appealing to the customer — and it’s not just about the price point. For example Michelin in the early 2000s came up with an innovation that made truck tires last 20% longer. “But the head of sales predicted Michelin could only charge a few percentage points more for the new tires. And given that the new tires would last longer, they would reduce customer demand by 20%. So Michelin’s executives revisited the company’s long-established monetization model,” Ramanujam says. “The new model they came up with turned out to be as big a breakthrough as its longer-lasting tires: Charging trucking fleets by the mileage they drove their Michelin tires, not by the number of tires bought. The result was a model that allowed fleet managers to pay for performance and flexibly manage costs. For example, they would pay less for the tires in the event of an economic slowdown, when there would be less demand for trucking. And Michelin could generate 20% more revenue more per tire if they lasted 20% longer. The company wound up having the biggest profits in the industry.”

Here’s how to get started: There are several ways to charge – whether that’s a subscription model, dynamic pricing that fluctuates based on factors such as season and weather or a freemium pricing. To figure out what’s best, consider how likely your customers are to accept the model.

“Is your model predictable, flexible, fair and transparent enough for your particular customer base? Customers almost always have preferences, so make sure you’re serving them. Also make sure you do scenario planning to understand how future developments would impact the model, and factor in what your competitors are doing. The reason to ask this question is not to mimic your rivals’ monetization approaches but to set yourself apart,” Ramanujam says. “Assess factors like feasibility, difficulty of customer adoption and scalability. You absolutely must be able to communicate the model easily to customers and partners. And don’t count out technology – the rapid evolution of the Internet and other tech has created tons of opportunity for creating monetization models that are new to your industry.”

Sometimes the best product innovation is the monetization model itself.

Don’t settle for a one-size-fits-all solution.

Your customers are not homogenous, so your product shouldn’t be, either. Instead, create different versions of your product to match your major customer segments. This principle even applies to a staple like water, Ramanujam says. “If it's in a fountain it's free, if you put it in a bottle it's $2, if you put gas in it’s $2.50, if you put in a minibar it's $5. It's the same water,” he says. “Your customers are different. They have different needs, they have different values, and they have different WTP. The only way to cope with this is to embrace customer segmentation.”

Rather than build one product for the entire market, package and bundle different products for specific segments. For example:

People who want the best product

People who want it now

People who just want the normal version

People who are very price sensitive

Here’s how to get started: “When it comes to innovation, there’s only one right way to segment: by customers’ needs, what they value and their WTP for a product or service that delivers that value. Use segmentation as a guiding influence, starting in the R&D stage – be constantly exploring customer needs, values and WTP,” Ramanujam says. He cites GPS device maker Garmin, which created different products for drivers, golfers, runners, hikers and bikers. Drivers, for example, got traffic updates in their device, while golfers got data on their distance from the hole and tips on sand and water bodies to avoid.

These are the principles Ramanujam says are key to segmentation:

Start with customer WTP data. Cluster individuals according to their WTP, value and needs data. You’ll discover your segments this way.

Don’t be beholden to stats. “The most statistically significant outcome might not give you a segment strategy that will work in practice. Ask yourself: Are there clear fences between segments — features one segment strongly wants but others don’t? Have you defined a customer group? The acid test is asking your salespeople whether they can sort their clients into the segments you’ve come up with,” Ramanujam says.

Fewer is more. Start with 3-4 segments, then expand gradually until you reach the optimal number. “The fewer segments you have, the less homogeneous and distinct they will be; the more segments, the higher the complexity. Do not underestimate the latter. Serving each new segment adds significant complexity for sales, marketing and other functions,” Ramanujam says.

Don’t try to serve every segment. Use what’s called market sizing to make sure a segment will deliver you enough money to make it worth it. Estimate how many customers you can acquire and keep, and at what prices, then separate out the attractive segments from the ones that don’t make business sense. “You’re not obligated to serve every possible customer. The products and services you develop should match your company’s overall financial and commercial goals,” Ramanujam says.

Describe the segments so you can address them. Make sure each segment has observable criteria for customizing your sales and marketing messages. “This is critical. In writing TV commercials, Internet banner ads, or any other marketing and sales messages, companies must describe their target segments as precisely as possible,” Ramanujam says.

There’s not a single market where customer needs are homogeneous. Yet again and again, companies design products for the ‘average’ customer.

A Final Word on Pricing

At the end of the day, designing around price will get you the furthest of any strategy. That’s because it forces you to think early and often about what your customers value, and what features — or tiers of features — will maximize your success. Without a price, you don’t have a product. Be careful not to overload your products with features customers don’t want, or build services people don’t actually care about. Designing around price also means you need to talk about it early and often with customers. Find out what their psychological cliffs are at different levels of pricing, be inventive around how you charge and segment customers into different buckets depending on their wants, needs and WTPs. This is the only way you can bulletproof the success of your new product.

“You can build products, slap on a price and hope to monetize, or you can design your products around the price, and craft a thoughtful, successful launch. Provide your customers with products that meet their needs, their values and their WTP. Otherwise, you risk launching duds loaded with features customers don’t want or aren’t willing to pay for,” Ramanujam says. “If your company’s innovation process is built on hope – a gut instinct before you bring your products to market that they will pay off – you’ve made the wrong choice. Even if this process has worked before, you’re building products on a tenuous foundation. If you want to transition from hoping to knowing your product will be successful, make price your core focus.”