The Right Price
People have a natural tendency to undercharge when they're first starting out in business. But they can set their prices closer to market value if they take the time to think
My friend Sam has a son, Philip, who started a software-development company a couple of years ago. After he'd had it up and running for a while, Philip came to me looking for advice. He said he didn't really know how to go about setting prices, and he thought he might be undercharging his customers, perhaps by a substantial amount. Maybe he should raise his rates. What did I think?
I told him that he probably was undercharging and that he ought to try increasing his prices, although I had no idea by how much. I did have a suggestion to offer, however. "Before you send out your next bill to a customer, leave it sitting on your desk for two or three weeks," I told him.
"What will happen then?" he asked.
"You'll think about it," I said, "and the answer will come to you."
The truth is, most people tend to charge too little when they first go into business. It's not always clear, after all, what customers are willing to pay or how much they value what they're getting. So there's uncertainty, and there's also fear. First-time entrepreneurs usually feel as though they need every customer that they can get just to survive. They're afraid that if they ask too much, they might lose a customer's business. Or they worry about setting their rates so high that they'll price themselves out of the market, even if a particular customer does go along with the price they're asking for. As a result, new business owners tend to undervalue whatever they're providing. By that I mean they charge less than their customers would willingly pay.
I almost fell victim to that syndrome in one of my first experiences in business, but circumstances helped me out. I was in my midtwenties at the time, just out of law school, and I'd opened a practice in Manhattan. My first client was a guy named Arthur, who later became a good friend of mine. He'd come to me through a mutual friend who owned a business that Arthur was planning to invest in. Arthur wanted me to draw up the papers. I said, "Fine."
I did the legal work and sent it off. Arthur was happy with it and told me to send him a bill. The trouble was, I didn't know what to charge. I'd never billed anyone before. All I knew was that Arthur was my only paying customer, and I didn't want to lose him. I timidly settled on $2,000 as my fee. My secretary typed up the invoice and gave it to me. But something bothered me about it, so I put it aside, figuring I would send it out in a few days.
As the bill sat on my desk I began to have second thoughts. Business wasn't going so well. Getting clients was harder than I'd imagined it would be. I'd done a good job for Arthur. His deal was proceeding smoothly. I decided that I'd undercharged him.
I had my secretary redo the bill and raise the fee to $2,500.
The bill was still on my desk when Arthur called a week later. "I haven't gotten your bill yet," he said.
"I know," I said. "I want to have lunch. I'll give it to you then."
"OK," he said, "but I'm going on vacation for a couple of weeks. We'll straighten it out when I get back."
So the bill didn't move from my desk, and I kept thinking about it. I'd really done a terrific job for Arthur, I decided. Why shouldn't I get paid top dollar when I'd provided great service? Besides, if I charged too little for my services, I might be sending the wrong signal. I might be reminding people that I was young and inexperienced instead of getting them to focus on the quality of my work.
By the time Arthur got back and we met for lunch, the bill had climbed again, first to $3,000, then to $3,500. I admit I was very nervous as I handed it to him.
He opened the bill and looked at it. "Hmmm," he said. "You're a young guy. That's a fairly expensive bill."
"Well, were you happy with my service?" I asked.
"Yes, I was," he said.
"OK," he said, and he paid the entire bill.
I learned an important lesson that day. I realized that if I'd followed my initial inclination, I would have charged Arthur much less than my work was worth -- and much less than he was willing to pay.
Thereafter I made a habit of waiting two to three weeks before sending out my invoices. (By the way, I later told Arthur this story, and we laughed about it together. His vacation had been more expensive than he'd realized, he said.)
Of course, most businesses don't have the luxury of deciding on a price after they've already delivered the product or service in question, but the same logic applies when they're setting prices in advance. Even today I put off giving quotes to customers until I've had plenty of time to think about what I should charge. Granted, some smart customers try to rush the process, knowing that they're likely to get a lower price if I'm forced to make a hasty decision. One way I avoid that trap is to let other people in my company talk to the customer during the negotiation phase. They always have the excuse that they can't commit to specific numbers without my approval.
Don't think that in warning you against undervaluing your product or service, I'm urging you to charge whatever the market will bear. The goal is to find the right price, meaning a price that (1) reflects the true market value of whatever you're providing, (2) allows you to earn enough gross profit to build and maintain a healthy business, and (3) doesn't leave you vulnerable to competitors.
Finding true market value usually requires some experimentation. You may not know you've reached it until customers start responding to your price by saying, as Arthur did, "Gee, that's a little expensive." Then you can explain why you charge as much as you do and either hold firm or compromise, depending on the circumstances.
But you should be careful not to go too far. There are times when you know you could get away with charging obscenely high prices, but that doesn't mean you should do it.
In a new industry, for example, it may take years before the market becomes educated about the product or service being provided. Competition is usually sparse, and customers don't really understand what they're buying. If you're a supplier in such a market, you may be tempted to take advantage of customers' ignorance by charging whatever you can get.
If you do that, however, you'll become a sitting duck for future competitors that can come in, offer a dramatically lower price, and still earn a good profit. Customers will think you were robbing them all those years. No matter what you do at that point, you'll never get them back.
But overcharging isn't a danger for the vast majority of people starting out on their first venture. It certainly wasn't Philip's problem. He took my advice and started leaving invoices on his desk for a couple of weeks before he sent them out. The more he thought about it, the more convinced he was that his prices were too low. So he started raising them -- and discovered he'd been charging a small fraction of the real market value for his services.
Now he just has to learn how to speed up his collections.
Norm Brodsky is a veteran entrepreneur whose six businesses include an Inc. 100 company and a three-time Inc. 500 company. This column was coauthored by Bo Burlingham. Previous Street Smarts columns are available online at www.inc.com/magazine/columns/streetsmarts/.
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