Usage-Based Pricing: A Company-Wide Effort

The Rise of Usage-Based Pricing in SaaS

Usage-based pricing (UBP) is experiencing a significant surge in popularity within the Software as a Service (SaaS) industry. Companies are increasingly adopting UBP due to its potential to accelerate revenue generation and facilitate a more effective land-and-expand strategy.

However, simply altering the pricing structure doesn't automatically guarantee faster revenue growth. Successful implementation of UBP necessitates a comprehensive, company-wide commitment and a re-evaluation of traditional SaaS metrics.

Snowflake: A Case Study in UBP Success

Snowflake, a leading data warehousing provider that launched its IPO in 2020 and currently boasts a $100 billion market capitalization, serves as a compelling example. While a net retention rate of 100% or higher is often considered a benchmark for SaaS businesses, Snowflake consistently exceeds this, reporting a remarkable 169% net retention rate.

This exceptional performance is directly attributable to their effective consumption-based pricing model. Notably, Snowflake’s net retention has demonstrated consistent growth, increasing from 158% in the second quarter of fiscal year 2021.

This means that an initial investment of $1,000 from a new Snowflake customer could potentially grow to over $13,000 within a five-year period. This raises critical questions for businesses.

Key Considerations for UBP Implementation

Companies transitioning to UBP often grapple with similar strategic inquiries. These include determining appropriate customer acquisition cost (CAC) levels to justify acquiring new customers.

Furthermore, it's crucial to decide how to structure sales compensation – should representatives be rewarded solely on initial spend, or should they participate in the subsequent revenue growth generated by the customer?

Finally, significant investment in product development and engineering is essential to ensure that customers realize increasing value as their usage, and therefore their costs, expand.

Many organizations embracing usage-based models are actively seeking answers to these complex questions.

Companies Thriving on Customer Growth Through Usage

Organizations that center their business models around usage are uniquely positioned to achieve substantial growth by expanding alongside their current clientele. Data from OpenView indicates that companies primarily utilizing a usage-based pricing structure demonstrate a top-quartile net retention rate of 122%.

This contrasts with 110% for those offering usage-based options as part of a subscription, and 109% for businesses without any usage-based pricing.

This type of growth isn’t typically driven by increased sales volume or restricting functionality to encourage upgrades. Instead, it stems from customers increasing their product consumption as they achieve greater success and identify additional applications.

Consider Twilio, which reports a net retention rate of 132% among its extensive customer base of over 200,000 active users. Approximately 85% of Twilio’s net expansion is attributed to increased usage, while only 15% originates from the introduction of new products, as detailed in their 2020 investor presentation.

High-performing companies with a usage-based model prioritize customer success throughout the entire organization. Dedicated resources within product and engineering are allocated to product adoption and user experience.

Marketing teams focus on providing resources and fostering a community that encourages broader product utilization. Furthermore, pricing structures are generally designed for simplicity – New Relic, for instance, strategically offered valuable features at no extra cost to enhance customer retention and, consequently, lifetime value.

The Transformation of Product Investment into Revenue Generation

A common belief suggests that SaaS businesses primarily achieve growth through expenditures in sales and marketing. However, with a usage-based model, expansion frequently centers around current customers. Investments made directly into the product to enhance adoption can be demonstrably linked to increased revenue.

It is logical that companies utilizing usage-based pricing allocate a significantly larger proportion of their resources to research and development compared to sales and marketing, when contrasted with traditionally subscribed businesses.

The data revealed a median ratio of 1.5x for companies predominantly employing a usage-based pricing (UBP) model. This contrasts with 1.0x for those offering usage-based subscription options and 0.8x for those without UBP.

Usage-based revenue can be conceptualized as product-led growth (PLG) in its most fundamental form. Indeed, 92% of companies operating on a usage-based system anticipated increasing their PLG investments throughout 2022.

Principal areas for PLG investment encompass “try before you buy” options, product analytics tools, and experimentation focused on product growth.

Logz.io, a provider of cloud observability solutions, intensified its focus on self-service capabilities while simultaneously strengthening its commitment to UBP. Providing users with the ability to independently evaluate the product, coupled with a pay-as-you-go pricing structure, minimized barriers to conversion.

This self-service initiative began as a trial involving just two engineers. It has since evolved into a substantial driver of growth. Within one year of its launch, Logz.io observed that this channel accounted for 50% of all new customer acquisitions.

Furthermore, customers acquired through self-service increased their spending by an average of 300% during their initial year of usage.

Understanding the Importance of Profit Margins

A company's pricing strategy should be dictated by the value it provides to customers, not solely by its internal costs. However, implementing Usage-Based Pricing (UBP) can be more readily understood by clients when linked to demonstrable costs, such as those associated with services like Stripe or AWS.

Furthermore, usage-based models effectively mitigate the potential for accumulating a substantial base of unprofitable customers, particularly for SaaS businesses with significant Cost of Goods Sold (COGS).

UBP and Cost of Goods Sold

For businesses experiencing high COGS, adopting UBP may be essential. Data indicates that companies with gross margins below 60% are significantly more inclined to embrace a predominantly UBP approach.

The typical company utilizing usage-based pricing reported a gross margin of 72%, which is lower compared to its competitors. Moreover, the lowest 25% of these companies exhibited gross margins of 51% or less, as per the collected data.

Margin Improvement and Avoiding Pitfalls

Suboptimal margins don't automatically hinder growth prospects. Many SaaS companies can enhance their product gross margins as they expand and secure more favorable cloud service agreements.

However, it’s crucial to proactively prevent avoidable issues. These include a lack of control over discounting practices and the introduction of unlimited pricing tiers for high-volume users, both of which can rapidly diminish profitability.

• Consider linking UBP to tangible costs for clarity.
• UBP minimizes risk with high COGS.
• Companies with lower margins (<60%) often adopt UBP.
• Focus on improving margins through scale and negotiation.
• Avoid excessive discounting and unlimited pricing.