Usage-Based Pricing for SaaS: Why the Shift?

The Growing Trend of Usage-Based Pricing

Is usage-based pricing (UBP) becoming increasingly common? Evidence suggests this is the case, particularly when examining the findings from OpenView’s annual Financial and Operating Benchmarks survey. The survey, conducted by the Boston-based venture capital firm, reveals a significant shift in pricing strategies among SaaS businesses.

Out of the almost 600 SaaS companies participating in the survey, 45% currently employ this adaptable pricing approach. This represents a notable increase from the 34% reported in 2020.

Performance and Impact of Flexible Pricing

The survey investigates the performance of companies utilizing flexible pricing models in relation to those that don't. It also assesses the broader implications of adopting such strategies.

Recognizing that implementation isn't without its hurdles, the report offers valuable insights for founders who are still evaluating whether to transition to UBP.

Insights from OpenView's Kyle Poyar

To gain a more comprehensive understanding of the survey’s results, we consulted with Kyle Poyar, an operating partner at OpenView. He is a strong advocate for usage-based pricing and previously co-authored the firm’s 2021 State of Usage-Based Pricing Report alongside partner Sanjiv Kalevar.

Defining Usage-Based Pricing

Before delving into the key findings, it’s important to clarify the report’s definition of UBP. The definition encompasses companies like Twilio, which primarily operates on a pay-as-you-go model.

It also includes businesses that offer subscription levels based on usage, such as Zapier.

The report’s authors don’t focus solely on the presence of a subscription component. Instead, they prioritize whether pricing is directly linked to how customers consume the product.

This contrasts with traditional methods like seat-based pricing, where charges are based on customer size, features, services, or other variables.

The Changing Landscape of Software Pricing

A significant trend is emerging where the traditional method of charging per “seat” is becoming increasingly obsolete, as highlighted by OpenView. According to Poyar, the perceived value delivered to a client is seldom directly proportional to the number of users accessing the platform.

This is particularly true with the rise of startups offering solutions centered around automation, artificial intelligence, and APIs. In many instances, the effectiveness of these solutions actually decreases the need for multiple user logins.

Poyar argues that seat-based pricing is an antiquated approach that fails to accurately reflect the value a company provides and hinders investment in features that could enhance that value. He observes that companies achieving successful IPOs frequently leverage automation, APIs, or AI as core components of their offerings.

This observation aligns with a broader change in investor sentiment. Companies preparing for public offerings are increasingly emphasizing usage-based models in their S-1 filings and investor presentations.

Previously, there was concern that usage-based revenue wouldn't be viewed as reliable or recurring. However, it is now recognized as a key advantage and a catalyst for sustained expansion.

The Evolution of Software Purchasing

This shift in perspective isn't sudden; it's the culmination of decades of evolution in how software is purchased, as noted by both Poyar and Kalevar. The purchasing decision is now frequently initiated by the end-user.

SaaS companies are increasingly adopting a product-led growth strategy, an approach actively promoted and well-represented within OpenView’s investment portfolio. This signifies a move towards prioritizing user experience and value delivery.

• Seat-based pricing is losing relevance due to the rise of automation.
• Usage-based models are now seen as a competitive advantage.
• The software buying process is increasingly product-led.

The focus is shifting from simply providing access to a platform to delivering tangible value through innovative features and efficient solutions. This requires a pricing model that accurately reflects that value.

Improved Metrics Fueling Increased Adoption

The growing popularity of product-led growth and usage-based pricing models stems, in part, from the demonstrated superior performance of companies that implement them. Data from OpenView indicates that these businesses achieve both elevated net-dollar retention (NDR) and a quicker return on customer acquisition cost (CAC).

This conclusion is drawn from a survey encompassing companies with differing annual recurring revenue levels. However, analysis of recent SaaS IPOs reveals a trend: publicly listed SaaS companies exhibiting the highest NDR frequently utilize a usage-based pricing structure, as highlighted in the report.

The enhanced performance of usage-based businesses is further supported by recent findings from Battery Ventures, an investment firm. Their State of the OpenCloud 2021 report links consumption-based, or pay-as-you-go, pricing to increased NDR, improved sales efficiency, and generally better key performance indicators when contrasted with traditional subscription models.

While acknowledging the principle that “correlation does not equal causation,” Poyar believes his experience demonstrates a causal link. He notes that assisting portfolio companies with the implementation of usage-based pricing often results in growth acceleration of 15%, 20%, or even 25%.

This context clarifies the current trend of companies actively promoting their usage-based pricing, as Poyar observes, and explains the overall increase in adoption rates.

• Net-Dollar Retention (NDR) is a crucial metric for SaaS businesses.
• Customer Acquisition Cost (CAC) payback measures the time it takes to recoup investment in acquiring a customer.

The shift towards usage-based pricing is driven by tangible benefits, including faster growth and improved financial performance. Companies are recognizing the value of aligning pricing with customer value and consumption.

Growing Acceptance of Usage-Based Pricing

As previously noted, 45% of the 600 companies participating in the survey are currently utilizing UBP. Further data reinforces the idea that usage-based pricing is becoming increasingly common: 11% are planning trials within the next 6 to 12 months, and an additional 23% intend to explore it starting in 2023. Poyar stated that the report’s findings demonstrate a clear demand for usage-based pricing, with continued growth anticipated in the near future.

However, a complete shift to a new pricing strategy can be daunting, and organizations must thoroughly evaluate whether and in what form UBP is suitable for their business.

Poyar suggests a phased approach for companies considering a trial: “A step many companies are overlooking is conducting preliminary, offline testing. This includes customer surveys and interviews, providing valuable insights comparable to those gained from a live test, but without the disruption of altering existing pricing structures.”

For new product launches, Poyar recommends offering existing customers limited access before implementing charges for additional usage. Organizations with free tiers should incorporate usage limits, mirroring Zoom’s approach with its 40-minute restriction on free group calls.

The report also outlines pricing structures designed to enhance customer confidence, drawing on examples from companies like Twilio, Snowflake, Datadog, and AWS. A key concern with this pricing model remains the perception of unpredictability, particularly for larger enterprise clients.

Nevertheless, this perception is evolving, Poyar explained to TechCrunch. “Procurement departments are increasingly adapting their perspectives,” he noted. “The GSA Schedule, the government’s procurement system, is revising its rules to permit purchases based on consumption, a previously unavailable option. This reflects a growing recognition that this is a beneficial practice, preventing payments for unused software and ensuring a stronger correlation between value received and software costs.”

UBP fosters a strong alignment between provider and customer, he emphasized: “Adopting usage-based pricing conveys a strong commitment to your product and a genuine belief in your customers’ success. If they don’t achieve success and aren’t actively using the product, they won’t incur charges.”

Companies employing a usage-based model generally deliver a superior customer experience, he argues. “Their focus is heightened on daily product usage, as this directly impacts their revenue. Consequently, usage-based companies are better positioned for long-term success.”