Ask YC: Competitor flying under us...
DISCLAIMER: This is kinda long, but if you take the time to read it I will buy you a karma lollipop.

I remember distinctly reading one of PG's maxims: Never let anybody fly underneath you. And we never have.

We are a low cost provider of a hotly demanded product that appeals to public/overnment clients. These particular entities usually pay anywhere between $100K and $20M to have this type of system installed, and can pay ongoing fees anywhere from $500 a month to $500K a year, depending on the size of the organization being outfitted. Suffice it to say that there is a huge market for this product...many many of these organizations all dying to have the product. We have done well with well over $500K in revenue in <2 years, no funding, and a win in a big name startup contest that netted us $100K in cash and prizes out of 250 entrants we competed against.

There are about 6 competitors in the space now. 2 of them are the rolls royce variety -- they don't do any contracts under $1M, have several contracts over $30M, and are public companies or owned by public companies.....they do big government only where the big federal money is, no smaller fish. We aren't really big enough to compete with these fish right now which is fine...we're hot on their tail right now and are very close to taking business away from them.

Two of them are in the middle....been around for 4-5 years, dabble in both big government and small government, both products fairly lackluster and way overpriced. Nonetheless, they are much cheaper than the rolls royces, so they have a smattering of clients that went with them for lack of better option over the years. We have consistently kicked the crap out of them multiple times; neither has ever beat us since we entered the market. We are way beyond them in features and way under them in price, and their customers hate them and call us all the time to switch. Lets call them the Mercedes of the world. They are the least threatening of the bunch.

The last two are "startups" and I use the term loosely. One of these startups scored several "prestigious" contracts before we were around, with a reallllly limited product. They were a little less than the Mercedes variety in price, but IMHO distinctly inferior in features to the Mercedes offering, which was distinctly inferior compared to us. We have had no problem beating them, but occasionally they good a get looking over because they're cheap(er) than Mercedes, but still way more than us.

Now to the issue at hand: the last startup. In this case we have a cornered animal. One man show, has one really small client and is barely a larvae. We knew about him, but never expected to have to take him seriously, because other clients never did and the government rarely goes with early stage startups for anything. The product is really obviously homemade, has zero features other than what we consider the one, basic, bare minimum feature of the product space.

We are at least a third of the way to closing up a large string of smaller government agencies that are associated with each other....we have 3 of them and there are only a few more left. One of the entities in this group is different from all the others in that they draw their funding from an atypical source and are a really ramshackle operation. They are extremely price sensitive. Their folks really love our system, and are totally sold. One thing though: they draw their funding from another department that doesn't give a crap about features, track record, quality or anything, only price. This department also doesn't have to deal with consequences of an inferior system -- they are really just Mom and Dad writing a check for junior to go play with, and are limiting him severely in his allowance. We gave them our standard pricing (which has little margin) and they welched and said semi-finally they are going with the little guy. There are HUGE risks with this because he is remote to them and we are local, and this is an on-site support type of product. We are also universes away in features and they know and are not happy about it. They are aware and objecting to the funding folks, but the funding department just doesn't care. They seem to have come about 75% of the way to a decision to not go with us.

So the dilemma is this: I can meet their price with little margin, and it's not a big deal, we'll still make money on the up-front but we'll make a lot less than usual on ongoing (not a problem). However, considering how closely associated potential clients X Y and Z are to this client, who are also very close to closing a deal, they might enforce the lowest available pricing on us later in the game due to us giving in on this one and really screw us. I don't think our friend the competitor has a prayer at matching us on features to X Y and Z (who are better funded and more demanding), but considering we might give this client steeply discounted pricing to beat the little guy, they might require it from us. If we don't though, it might give Junior just enough cash flow and exposure to not die, which we sure don't want to happen.

So, what to do! Ask follow up questions and I will try to answer.