Pricing TransformationJan 12, 2023
Uncover the keys to successfully implementing usage-based pricing and ensuring buy-in from your board. In this guest blog, Todd Gardner shares valuable insights on preparing your board for usage-based pricing, outlining both its benefits and drawbacks.
Shifting from a subscription-based pricing model to a usage-based model, or even adding usage-based pricing, significantly impacts the financial profile of a SaaS company and warrants board involvement.
Usage-based pricing can be a powerful tool to drive value, but it does not come without effort and risk, and the board needs to be in the conversation from the beginning.
Benefits: In general, usage-based pricing (UBP) SaaS companies are growing faster than their subscription piers and delivering higher net dollar retention. They also maintain a valuation multiple premium of 50% over their subscription piers, although their growth rate is only eight percentage points higher.
The desired end-state is straightforward – an installed customer base that generates expanding monthly revenue with little to no sales effort. When combined with even modest new customer acquisition, revenue growth accelerates quickly.
Separately, UBP lowers the financial barriers to new customer adoption. Whether paired with a product-led or sales-led approach, pay-as-you-go pricing reduces the financial risk of trial to new customers.
It’s easy to see why over half of SaaS companies are using some form of consumption pricing. If your product is a fit, "Is Usage-based Pricing Right for My SaaS Company," and you can align on the proper metric, "Choosing a Usage-based Pricing Metric," the path forward is relatively clear. Just be sure to bring the board along for the journey.
Drawbacks: The most important part of board involvement is making sure they understand all the implications of usage-based pricing, including the harder parts.
First, they need to know that implementing UBP is complex. In addition to the challenges of selecting the right metric(s) and pricing structure, operationalizing UBP has historically been challenging. The amount and nature of data involved in the model do not easily fit into the traditional subscription stack of applications, and it quickly overwhelms the one-off spreadsheets.
It's also vital for usage and billing data to be available outside the finance department. At a minimum, customers, customer success, and sales need to be able to track usage and billing in near real-time. The "surprise bill" is a problem when systems are not functioning well, but it is an opportunity when they are identified early.
Another operational challenged of UBP is its impact on sales compensation. However you choose to address UBP revenue in the sales comp plan (estimating usage or paying in arrears), it will be a disruption and worth highlighting to your board.
The final educational point everyone in the company must appreciate is the variable nature of consumption pricing revenue. Subscription revenue is incredibly smooth and predictable, and it is one of the strengths of the SaaS model. However, consumption pricing adds variability across various dimensions depending on your product.
First, there is always some random month-to-month variability in usage revenue driven by individual customer factors. This type of short-term variability is difficult to forecast or even understand, and the best way to treat it is to isolate it from other revenue streams. Change in MRR due to usage should be tracked and reported separately from changes in MRR due to new or churned customers. Also, some companies choose to report three-month trailing averages for usage revenue if the monthly numbers have too much noise.
Second, some SaaS products will have seasonal variability. For example, consider the SaaS infrastructure providers who support eCommerce companies and have revenue spikes in Q4. This variability is not seen much in subscription models and takes both forecasting and cash management capabilities.
Finally, UBP models will have increased sensitivity to cyclical changes in the economy. To the extent pricing metrics are tied to the economic activity of the customer base, and to the extent the customer base is sensitive to changes in the overall economy, revenue will fluctuate accordingly in real-time. As a result, UBP growth will decelerate more quickly in an economic slowdown and accelerate faster in a recovery than a comparable subscription model.
The Balance: The rewards of successfully implementing usage-based pricing are substantial. A 1% increase in NDR compounded over five years has historically resulted in an 18% increase in SaaS enterprise value. Check out “The Impact of Net Revenue Retention on SaaS Company Valuations.”
That said, the entire management team and board must understand everything involved in implementing and managing usage-based pricing. Consumption pricing is difficult to implement at any scale and impacts many different parts of the organization. UBP will also, undoubtedly, add variability to the smooth subscription revenue stream everyone has become accustom to seeing.