• Ingrid Bonde Åkerlind, Investor at Oxx

Use it or lose it: why usage-based pricing drives high net revenue retention

Usage-based pricing is a trending topic in SaaS conversations with founders, featuring regularly on tech websites and SaaS blogs. In short, usage-based pricing means a company picks a price model where price scales as product usage scales.

The attractiveness of usage-based pricing is understandable with prominent success stories from companies that scaled very effectively to IPO using usage-based pricing in the past few years. Usage-based pricing advocates often point out that companies with usage-based pricing models grow 38% faster and have 18 pp higher net revenue retention. Various studies indicated that at least 16% SaaS companies primarily have a usage-based pricing model, and 45% SaaS companies incorporate a usage-based pricing component. SaaS companies are paying attention!

It's easy to understand why: high growth attracts investors and SaaS investors in particular drool over high net revenue retention, especially in weaker market environments. But that in and of itself isn’t reason enough for every SaaS company to switch to usage-based pricing. Like most company-building wisdom, usage-based pricing is highly effective for some products, markets and customer segments, and less effective for others. After all, there’s no one-size-fits-all solution to scaling a SaaS company. This two-part series dives into why that is and what that means for a SaaS company. If you're a startup leader pondering what pricing model to implement, looking for some tips to maximize the success of your usage-based pricing model, or looking to understand if you can glean learnings to drive up net retention, read on.

In the first article, we'll discuss why usage-based pricing is effective. Does it drive a company's net revenue retention up?

Let's dive in.

Usage-based pricing: the pricing theory explanation

Let’s start by backtracking to econ class. The demand curve shows the total number of buyers willing to purchase a product at a given price. Individual buyers are willing to pay different amounts for a product. Why? Because they value the same product differently, and thus have different willingness-to-pay.

When a company markets a product at a single price, it arrives at two problems. First, the company creates a significant amount of consumer surplus. In less technical jargon, the company leaves money on the table because many buyers would have willingly paid more. Second, there's a number of potential buyers who don’t convert into customers because the price point is above their individual willingness-to-pay.

To resolve this, classic pricing strategy dictates that a company should sell the same product at different price points to different customer segments based on each customer segment's willingness-to-pay. This allows a company to capture more consumer surplus and more buyers. In pricing theory, it’s referred to as price discrimination.

In the SaaS world, price discrimination has usually been achieved by tiering products: including the fewest features in the low price tier, more features in the standard tier, and reserving specific features for the enterprise tier. This is similar to third-degree price discrimination (where different customer segments purchase the same product for a different price), especially if the majority of the functionality is the same across the tiers and is essentially the same product.

To create even more possible price points, SaaS companies also often scale price by number of users. When those companies lower per-seat costs for higher-volume customers, it's an example of second-degree price discrimination, where price varies based on the number of units purchased.

Usage-based pricing is a more granular form of second-degree price discrimination. More granular = less consumer surplus from buyers who would have paid more, and fewer potential buyers who don’t convert because the price point is too high. This is similar to a pricing model that scales with seats, but there are more possible individual price points. Each customer has a unique price point based on their own usage, and no customer needs to pay for additional potential usage they wouldn't value. Even better, customers engage in this price discrimination on their own accord, without company intervention. It sounds like magic!

However: for usage-based pricing to be effective, a key assumption must hold true: more usage must correspond with more value. Often but not always the customer who uses a product more values the product more. After all, this is one of the reasons growth teams obsess over predictive product usage patterns and investors often pore over product usage data during an investment process. But if that isn't true, a usage-based pricing scheme will not deliver the promised benefits of price segmentation. In that case, a customer with occasional product usage might value it more than a customer with daily product usage and would be willing to pay more!

Usage-based pricing: why it works

When value scales with usage, usage based pricing can be particularly potent:

  1. Customers can scale much faster because there's no time delay between increasing usage and price. In theoretical terms, there's no consumer surplus left uncaught because you're only working via annual renewal cycles. So if you sell to a very high-growth customer base - or if your products show patterns of viral spread within an account - usage-based pricing can help you price the quickly-increasing value generated for the customer.

  2. It takes less effort to upsell accounts. Entry price can often be much lower than with standard tiered pricing because the product is split into smaller discrete units by usage rather than by access to a set of product features. This usually means companies capture a high number of small customers with high potential account value. If your sales team upsells these small accounts, while the process may operationally look similar to a new sale, it's still far easier than selling to a pool of prospects: there's not a competitive solution to outshine, and existing usage data can be used to great effect to identify accounts ripe for an upsell or showcase value generated in a personalized way. And if the company harnesses a self-serve upsell motion, there’s even less friction.

  3. A company can often cater more easily to very small and very large customers with the same product feature set. Instead of crafting specific features to fence off the basic plan from the standard plan, or the standard plan from the enterprise plan, the feature set can remain quite similar for different customer account sizes. Do note that this relationship isn't perfect: larger organizations generally still need specific enterprise functionalities.

Overall, the above factors taken together are what drives the very high net revenue retention figures in usage-based pricing companies.

Beyond the metrics and upsell motion, there's further operational upside.

  1. Usage-based pricing couples well with a relentless customer-centric product approach. Because customers can quickly decrease usage, it's imperative to focus on driving high customer satisfaction and building a product that delights. And a product that delights is a competitive advantage.

  2. Usage-based pricing can also drive operational efficiency. For example, on the product side, toggling individual features on and off (as with tiered pricing) is more cumbersome than giving all customers access to the same product.

  3. Finally, and perhaps most importantly, usage-based pricing feels fair and transparent. Customers feel they receive exactly what they pay for. They feel they’re in control. This builds trust. And this translates to customer loyalty as well as a clear brand reputation.

Overall, think of usage-based pricing as a retention amplifier. When deployed with a world-class product that customers love, it further catalyzes the company's growth. Conversely, if customer satisfaction starts dipping or strong competition emerges, downsell and churn can appear quickly with more rapid negative financial consequences.

In other words, among the public SaaS companies - all companies with world-class products - those with usage-based pricing are the successful companies for whom usage-based pricing amplifies growth. Usage-based pricing makes winners win more.

The lesson for the broader set of SaaS companies, then, is that coupling a more granular pricing model - usage-based or not - with a focus on customer-centric processes and low-friction upsell is a powerful recipe to driving high net revenue retention and growth.

Enough theory! The next article will examine which SaaS companies are well suited for usage-based pricing, different variants of a usage-based pricing scheme to implement, and practical tips for success.

Informative? Thought-provoking? ... Wrong? Any thoughts, comments, or questions, reach out at iba@oxx.vc !