Pricing StrategyJan 17, 2022
Todd Gardner founded SaaS Capital, a leading venture debt fund, and has deep domain knowledge in SaaS. In this guest blog, he considers the circumstances in which usage-based pricing is a good fit.
It’s a pretty simple question, so I was surprised not to find more articles addressing the topic. Instead, much of the literature treats usage-based pricing (UBP) as a new "best practice" that all SaaS company executives should be pursuing. But, in reality, some SaaS businesses are not a good fit for UBP, and the specific nature of the application itself determines the fit with a particular pricing approach. In the following article, I will explore the characteristics of companies and products that lend themselves to usage-based pricing.
First, I would like to thank the dozens of SaaS CEOs who contributed to my research with a special thanks to James Wood, the pricing guru at Insight Partners. If you read something intelligent or valuable in the article, there is a good chance it came from James, who has helped hundreds of software companies improve their pricing.
As SaaS progresses further from software and closer to service, UBP is on the rise. According to Vista Point Advisors, 37% of SaaS companies in the Fortune 5,000 utilize usage-based pricing. In addition, in a recent study conducted by m3ter (a usage-based pricing data infrastructure company), 73% of SaaS companies have deployed UBP or are actively assessing.
The healthy migration toward customer centricity and product-led growth is driving the trend toward UBP. Software customers used to buy a house (on-prem), and then they started renting an apartment (SaaS), and now they are in an Airbnb, so to speak. Pricing needs to keep pace with this reality and requires more flexibility and granularity.
The financial rewards of UBP are also accelerating interest and adoption. Look no further than the performance of public companies like Snowflake and Data Dog. They are using UBP to achieve high levels of net revenue retention and thus high valuations. A single percentage point increase in net revenue retention for private companies leads to a 28% average increase in valuation over five years. [I've published a blog "the impact of NRR on SaaS valuations" that explores this subject in more detail.]
Given the powerful financial rewards, UBP is something all SaaS company executives need to investigate closely, so let’s now turn to the specific characteristics of companies and products that most readily lend themselves to this pricing strategy.
Usage-based pricing can be found at all levels of the SaaS "stack," from infrastructure through applications. However, there are common characteristics of products with a high concentration of usage pricing. Below is a list of the most common types of products priced on a usage basis.
If you look at the recent flock of SaaS IPOs using usage-based pricing, you will notice they mainly perform services wrapped around lower-in-the-stack cloud functions that incur real direct costs to the provider. It’s not to say these are low-value solutions; it's just that they consume physical resources like storage, compute, and bandwidth. Nine out of the top ten highest NRR SaaS companies are infrastructure companies. Examples include Snowflake, Elastic, Data Dog, MongoDB, Fastly, and Sumo Logic. Customers understand that the service costs money to provide, and they see UBP as "fair." It is a natural extension of the utility model.
While not as prevalent, there are other examples of SaaS applications that are higher-in-the stack, yet require real incremental costs to deliver. These businesses also tend to price on a usage basis. Example types of companies include those delivering communication solutions (voice, text, email, etc.), as well as Artificial Intelligence and Machine Learning businesses.
At the top of the application stack, successful SaaS businesses deploying UBP have identified linkages between their product and an increase in their customer's revenue. Once the link is established, the application will "pay for itself" in the customer's eyes. Based on a quick scan, revenue generation is tied to approximately 75% of the top SaaS application layer businesses (most of the companies in the Lower-in-the-Stack section above were not considered application layer products). Examples include Shopify, HubSpot, Eventbrite, Chargebee, Toast, and Klaviyo. Other less obvious types of functionality also tied to revenue include appointment setting, pricing optimization, and out-of-stock reduction.
Of course, not all SaaS applications can be linked to revenue, but understanding the potential connections and possibly building modules that can connect to revenue is worth exploring. One good example of this trend is the convergence of SaaS and payments. Payment companies are buying SaaS companies and vice versa to connect software to revenue and drive UBP.
Some products and their related usage metric will hit a natural limit that might be relatively low: lawyers are only going to have so many cases, and dentists will only see so many patients. On the other hand, UBP provides considerable upside for products like marketing automation, code testing, text messaging, and many others attached to activities that can grow asymmetrically. UBP may still provide a compelling entry pricing methodology, but it will not have the revenue upside of a product that increases in usage intensity. Keep this dynamic in mind while selecting your usage metric.
One of the advantages of usage-based pricing is that it eliminates any cost barrier to customer trial. Customers can use very little of your product and see if they like it before committing significant financial resources. If, however, your product still requires a heavy lift in implementation or training, the lower financial barrier afforded by UBP will have no real impact on the ease of adoption. Ease of implementation is one of the reasons usage-based pricing is so popular with Product Led Growth (PLG) companies.
The intent of the list above is to begin to build a framework of situations where UBP has historically been successful and why. As mentioned, it's not an exhaustive list, and as UBP evolves and expands, creative SaaS companies will find new pricing vectors that link to customer value. This list is designed to let you know if you are breaking new ground, which is always more challenging and carries higher risk. That leads us to our next topic: per-seat pricing.
Per-seat pricing has been the default pricing model in SaaS from the beginning because it was the pricing model for perpetual software products. To some degree, it was the only way to price on-premise and early SaaS software because companies had limited ability to track data around any other usage metrics. Because it was (and is) the default pricing approach, it is over-represented in SaaS companies where other metrics would be better.
That said, per-seat pricing is not a bad fit for all SaaS businesses and makes sense when the software delivers discrete value to an individual person. For example, the software may train that person, make them more efficient, or allow them to collaborate better. According to James Wood, per-seat pricing is suitable for applications like learning systems, collaboration products, even Salesforce management products. For example, HubSpot is known to have pricing based on the number of contacts in the application, but that is only for their marketing suite. For their Salesforce automation product, they price per seat because the value is delivered according to how many salespeople it is helping.
Whether pricing by seats or usage-based metrics, tiered pricing has some hidden costs. Wide tiers are simple to administer, but some customers may feel like they are paying for seats they are not using, and tiered pricing may constrain usage for fear of tipping over into a much higher price band. Large software vendor Atlassian addressed this by switching to a granular per-seat pricing structure based on the actual number of users. That switch unlocked organic growth while allowing customers to only pay for what they used. Abandoning tiers altogether is unnecessary to have the desired effect. Still, it is essential to make them more granular, so that usage progression is more natural and customers aren't afraid of the price to jump to the next tier.
Combining allowances (which can be seat- or feature-based) with billing for overages, and then layering-on customer protection rules like rollover credits and overage grace periods better aligns value with pricing than the use of tiers. This is effectively usage-based pricing. James Wood thinks that “eliminating wide or fixed tiers and moving to more granular tiers or ‘per X’ pricing can improve net dollar retention by five percentage points on average.”
Research from m3ter and OpenView indicates that somewhere between 23% and 45% of SaaS businesses are looking to adopt usage-based pricing in the next 18 months. That's great; however, if you're running a SaaS business of any scale and you are not already using UBP, it is because it was not the obvious answer from the beginning. Almost half of the SaaS companies running UBP as their primary pricing model have done so from their founding. Openview “There is very seldom a ‘silver bullet’ metric that is the obvious choice." According to James Wood, "most companies considering UBP need to carefully think about trade-offs between potential metrics to pick the best one." Be prepared to talk to many different customers and track several metrics to see how usage behaves over time. Also, be ready to use more than one metric and combine usage with other pricing approaches. Approximately half the SaaS businesses that use usage-based pricing do it in combination with other pricing approaches.
The excitement around usage-based pricing is real. It can have transformative ramifications for your business, and its deployment is clearly on the rise. That said, UBP is not a good fit for all SaaS businesses. Understanding which applications have historically succeeded with UBP should help management teams and boards better assess both the risks and rewards of deploying usage-based pricing in their business.
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