I smiled and puffed out my chest: "over $10M!"

"And what did they sell for?"

My smile disappeared.  I knew where this was going…

"Uhhh. Over $1 Billion."

Dan Feldstein, the co-founder of Red Ventures, looked at me intensely but kindly:

"There's nothing wrong with the $10M in fees you made, that's great.  But going forward, there's a huge opportunity to get paid based on the VALUE you're creating."

This was my first exposure to what the MBAs called "value-based pricing."

The concept is rather simple: when you price things, especially services, do you charge based on what it COSTS you?  That's the norm.  Or do you price based on the VALUE created for the customer?

Let's use an example:

Say I have a conversion rate optimization agency for e-commerce companies.  So I go in, analyze client data, design and test new landing pages, and then deploy them hoping to improve the conversion rate.

The two simple ways to price this:

It takes 2 full-time employees 3 months to deliver the service.  Say that's $20K per month, so I mark that up 50% and I charge $30K per month and pocket $10K.  Not bad.

Let's say the client has revenues of $20M. If my people improve the conversion rate by 10%, that's $2M in incremental pure revenue. 

Rather than $30K, what if I asked for 10% of the gain I drove? Now that's $200K!!  For the SAME work.

Once you understand this concept, you'll see it everywhere in business and realize that it's not a binary either.

In the most extreme cases, some businesses are paid purely on performance and completely disconnected from their costs.  Investment bankers, for example, get a % of the deal fee.  For a $1BN deal, they may take fees of 1%.  It doesn't matter what it costs them.

On the other hand, there are government contractors where their markup is transparently shared and regulated.  Whatever your costs are, you can take 20% more.

Your Levers

So what drives the difference between these models? And more importantly, how do you shift your business towards a "value-based" model?

Well, everything in value pricing comes down to your ability to actually take responsibility for and deliver results. A few factors here are:

This may be somewhat obvious…but the more of an expert you are, the more likely you can command a premium for your service.  Knowing your category well means:

• You know what to do and how to do it.

• You know what challenges may occur.

• You know how to solve them.

Your expertise allows you to make good decisions and drive results.

The more expertise you have and ability, the less likely there are other people who can do what you do. 

This makes it easy for you to take a larger chunk of the results you deliver.

A VERY important 4-letter word. The more risk you take on, the larger your upside.

Dive into examples

In the cost v.s. value-based example above, the first model seems like small money, but there's no risk regardless of the results.

What if I had spent $60K and gotten no improvement in conversion?  Then I'd be out $60K with NO revenue.  Ouch.

Let's take two of my businesses as examples. They’re on opposite ends of this spectrum:

Shifting your model

So if you want to shift towards value-based pricing, what do you do?  Here are some steps:

This is the most common miss I see for entrepreneurs (including myself back in 2015). 

You really need to understand how valuable what you're doing is for the client and how rare it is.

If it's very valuable and rare, then consider tying your pricing to that value.

Everyone has a different mindset here.

Some people enjoy taking on a challenging problem and are willing to bet on themselves.

This is how most financial services firms work, including Red Ventures.

Other people don't care to do this because they want security and predictability.

If you can always deliver a win and know the exact formula, then value-based pricing is the right move.

If instead, you can do the work and the results may vary, then value-based pricing can be quite challenging.

My results

Ric Elias, Red Ventures other co-founder, suggested we use value-based pricing at Ampush.

I scoffed: "We are VERY performance oriented."

He said, "Sure, sure. But watch what happens when your fees are tied directly to that performance."

So I tried it. And we got WAY better at what we were doing for two main reasons…

Reason 1: Focus

I started paying attention to client campaign performance daily because my revenue was tied to theirs (whereas we just charged fees before).

As I focussed in on this, I tried to drive the numbers more.

This meant that I worked with the teams to improve, finding new ideas, leveling up skills, etc. The team CARED more.

All of a sudden, we were WAY better at marketing.  This all came from changing our pricing model.

Reason 2: Picky

We became more picky about the clients we took.

Almost like a bank, we had to "underwrite" the customer.  We only wanted to take on problems we understood well and were CONFIDENT we could improve performance.

If we didn't understand the problem or didn't know how to fix it, we would say no to the opportunity since our fees were tied to RESULTS.

The end result was a fun, high-margin business with performers (although a business that was tough to scale at times.)

So there you have it: Value-Based Pricing 101.

“So Jesse…do you recommend a full switch??”  Probably not.

BUT - if there’s an opportunity to add an element of value-based to improve your margins, the answer is likely yes!

Go try what's possible!

-jesse

PS I wrote about this after responding to multiple questions about pricing from readers like you. What other topics do you want me to write about?