We basically built a pricing model that surgically identified what people wanted to pay us for and what they didn’t want to pay us for. One of the things we figured out early on was that we could create value for people by creating a product that allowed them to design something that they couldn’t design without us. – Alexa Hirschfeld
I’ve been thinking about products and valuations and business models and thought I’d write about that. So I started searching for business archetypes – something that told me about businesses and categorised them into types, here’s a triceratops, there’s a pteranodon – that sort of thing.
But then I remembered something from my economics lessons – and I think it has something to do with price elasticity of demand but don’t hold me to that. I was just trying to see if I could remember a rule of thumb that might help me figure out what sort of business you should be in.
Here’s a made up example.
Let’s say you want to start a business and have a product. Ask yourself two questions. What’s the size of your market if you give it away for free? Let’s say that’s 10,000 units. And what’s the price at which no one will buy what you’re selling? Let’s say that’s $150,000.
Now you can draw a straight line between these two points and it shows you a price versus quantity graph. It’s sloping down so you can express that using a standard equation for a line.
Now, the sales you make at each point of the line is price times quantity, so if you work that out (y’) you end up with a parabolic shape, making no money if you charge too much and making no money if you give it away for free. Somewhere in between is a sweet spot where you can make the most money.
And you can work that out by taking the differential of the sales curve and finding the point at which that is zero – the tangent – and then using that to work back to the price. In this example, you’ll make the most money if you price your product at $75,000 and you’ll make 5,000 in sales.
Now, I haven’t used calculus in anger for two decades and I don’t really know why it’s useful to do it this way. So I checked my calculations with a spreadsheet and it comes out to the same number. That’s probably faster really, but I just wanted to have a go at the calculation…
Anyway, the point is that this equation tells you all you really need to know about your business model, if you use it sensibly. At what price will you have no business. And if you charge nothing, what’s the size of the market that will immediately contract with you? You’ve got to think about this carefully because even if your price is zero not everyone will do business with you. You’ll only get the people who really really want to be there. A good, modern way to test this is to see how many people turn up to free webinars. Our of a population of billions, it’s probably less than a hundred for the vast majority of webinars while a few rake in very large numbers.
The question for you is whether your product is something that has a large market or a small one and the price ranges that it will support. That will tell you what your optimal pricing strategy is going to be and the sort of revenue you can expect to make. And that is going to lead directly to a valuation of your business – what’s it’s worth when you exit.
This bit of maths is one of the few times I’ve come across something that seems genuinely useful, up there along with compounding. Just need to try and use it a bit more and see if it actually is.