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Usage-Based Pricing (UBP) as a Competitive Advantage in SaaS
SaaS companies are increasingly introducing usage-based pricing model. Why does this matter?
History of Software Pricing
I remember installing on my MS-DOS computer software or games that were shipped on a pack of 20 floppy disks.
As we transitioned from on-prem to the cloud, the “transfer of value” changed from one-time to continuous. Similarly, we transitioned from perpetual licenses (bye bye lumpy one-time revenue) to subscriptions (hello recurring revenue). The way we “consume” software continues to evolve.
Today’s grand transition is towards usage-based pricing (UBP).
Usage-based pricing makes sense
Intuitively, it makes a lot of sense that you should charge customers based on the value you create for them. One area where value-based pricing is fairly popular? Health care.
At an extremely high level, value-based care is a system where healthcare providers are paid based on the quality of the care outcome they deliver rather than the number of healthcare services provided or the number of patients seen.
Unfortunately whether it is health care or software, 1) figuring out the ROI of a product is not straight-forward, and 2) getting started with value-based pricing requires thoughtful preparation and implementation.
Usage-based pricing (UBP) in software simply approximates value-based pricing.
Benefits of UBP
In today’s economic environment where there is a lot of budget reductions and scrutiny on new purchases, it is a competitive advantage to make it as easy as possible for your customers to get started.
UBP allows customers to start at a low cost, minimizing friction to initial adoption.
A snippet from the Acquired podcast episode on AWS:
“Every month, I get a bill from AWS for 71 cents, and I have no idea what old project it was for. It's one of these things where it's priced so dynamically. If it was a big successful project holding a lot of data, then it would be expensive.” - Ben Gilbert
Part of AWS’s success is that they made it super easy for anyone - single practitioners, SMBs and large enterprises - to get started with a credit card. You are charged next to nothing for your small project.
In turn, your revenue scales with your customer’s growth and success.
Because UBP is fundamentally a volumetric approach to pricing, you are afforded greater flexibility in pricing and packaging your product especially if your product serves a heterogenous set of customers, greatly varying in size and usage (e.g. SMBs as well as large enterprises).
You can incentivize higher consumption with volume-based discounts.
When you charge $10 for the first 100 events and $5 for the next 100 events, $5 feels like a bargain.
UBP aligns pricing to the value delivered to customers.
I was surprised by how many buy decision-makers that I interviewed mentioned “fairness” as a key benefit of UBP.
If your product delivers tremendous value and everyone uses it a ton, you will be paid more. If your product is a bummer, usage will trend down, you will make less.
Simplify process to upgrade / downgrade without manually changing plans.
Because nobody likes having to talk to an account manager to add the 101st user.
Why has UBP been gaining momentum?
I will highlight three, out of many, trends fueling the momentum for UBP.
Product-led growth (PLG)
Gone are the days of universal top-down buy decisions. End users are trialing products, buying them with their credit card, and telling their colleagues and managers to buy.
PLG SaaS companies rely on their product as the main vehicle to attract, acquire, activate and retain customers. Typically customers start small and grow over time.
UBP lowers the barrier to trial, as customers can start as small as it makes sense. In turn, UBP allows SaaS companies to benefit from the upside as customers grow with them.
Show me your value
Customer success, customer success, CUSTOMER SUCCESS!
In an era where software buyers are increasingly bombarded with products that claim to make their life incrementally better, proving your product’s value needs to come before closing a sale.
UBP lowers the barrier to trial, and allows customers to experience the value of your product on a smaller scale before ramping up usage.
We already crossed the chasm for UBP. The 800LB gorillas that drove this? AWS, Azure and GCP.
Cloud service providers typically charge based on the resources that you consume. While UBP has been embedded in our life for a long time (e.g. utilities), the hyperscalers really made UBP the norm in tech.
In addition, I recently noticed that all of the large language and AI models charge based on usage.
Is your company UBP-ready?
While the benefits of UBP are compelling, not every product makes sense to be charged based on consumption, for example, if availability or “streaming” is an important feature. Taking “streaming” quite literally, what would happen if Netflix were to start charging based on each show you watch? (For one, I would be racking up a big tab.)
Even if your product is a great candidate for UBP, not every company is ready for UBP. Enterprise-wide buy-in of the UBP business model needs to happen before UBP can be implemented successfully.
To demonstrate how this impacts everyone in the enterprise:
Pricing is one of the most important business decisions that leadership teams and product managers make.
Engineering needs to build and maintain, or buy metering and billing infrastructure. In addition, you need a dashboard that shows real-time usage data to both customers (so that they can understand and plan their consumption) and internal stakeholders (who need this data to interact with customers).
Accounting needs to understand the financial impact of introducing or altogether switching your pricing to UBP. They will also need to handle any changes to billing and payments.
Customer success needs to communicate with existing customers, help them understand how UBP would affect them, and equip them with appropriate tools — so that they have real-time, high-fidelity visibility into their consumption. This is important for “trust”.
Sales needs to consider new pricing and rewrite parts of their playbook.
A quick aside on sales: typically, software sales teams are financially incentivized to eke out as large an upfront committed spend as possible.
As you transition towards UBP, sales compensation structure needs to be updated and tied to actual billable consumption in some way. This might mean that the potential of large one-time payouts from signing up large deals is being diminished.
Changing your sales compensation structure is a huge undertaking. If handled poorly, it can result in costly consequences of talent attrition.
Challenges of UBP
As mentioned earlier, it lends better to some products versus others, for example:
If your product is sticky after initial adoption and usage generally trends up over time
If the consumption of your product is “event-driven”
When you charge per seat, there is no upper bound for how much customers can interact with your product prior to paying more. A common concern for UBP is that it makes customers hyper-conscious of their consumption and limit their interactions with your product.
As highlighted above, UBP implementation needs to be an extremely deliberate process.
While preparing for this post, I spoke with the VP Product of a software start-up who said:
“99% of my customers don’t have any problems with what we bill, but 1% of do. These people waste all my time. There’s nothing in-house I can use to investigate and fight these disputes. So I end up just letting these customers have it their way every time.”
Your metering and billing services need to hold up. Otherwise, UBP can be a headache to manage.
Customer success becomes high stakes. If your product sucks and customers use it less and less, there is no “fixed price subscription” that shields you (temporarily) from the financial blow.
Some customers still demand the predictability of fixed price subscriptions.
In other words, “how much should I put into next year’s budget for this?”
For existing customers, you already sit on a lot of historical data, and can drive an intelligent conversation around planning their consumption.
For new opportunities, it can be trickier, but might not be as complex as one imagines. Customer case studies can set expectations for what a customer’s consumption could look like over time.
Fundamentally, UBP is an opportunity offer more flexibility to customers, and can be a win-win. Can you design something where there might be 20% less predictability but perhaps 50% more exposure to share the upside? Wouldn’t this be exciting?
Your finance team might not love it initially. It might become more challenging to predict your revenues and cash inflows / outflows.
Some of the challenges of UBP highlighted above can be addressed through creative innovations and hybrids.
Larger upfront commitment = larger discount
Would you benefit from having some predictability in customers’ consumption for reasons, such as planning out your own infrastructure needs, or cash flow management? Do some customers still demand the predictability of fixed price subscriptions?
Customers can pre-commit to an upfront spend level in return for better pricing. Any consumption above this threshold can be billed based on usage metrics.
Usage draw-down is similar to pre-commits. The key difference is that customers choose between a monthly usage subscription or an annual allotment that can be used flexibly. With the latter, customers can protect themselves from any seasonal spikes in their usage, knowing that it will be offset by slower months.
Commit now, pay later
Customers have the flexibility to pre-pay or pay as you go. They receive discounts for any prepaid “credit”. Customers can choose to partially pay upfront for “credit” and pay for any overage as they go, or entirely pay in arrears.
Credits and tokens
In addition to standard recurring subscriptions, Autodesk offers a “Flex” pricing plan where you use pre-paid tokens to access a variety of products. Tokens can be used to access any product for 24 hours at a time, giving flexibility to SMBs and low-frequency users.
Back in 2014, WalmartLabs was Slack’s largest single customer. A closer look of that account unveiled that of the 800 users signed up, half were inactive. In other words, WalmartLabs would have to either pay for these 400 people not using Slack, or manually deactivate them one-by-one.
Today, Slack is well-known for its “fair billing policy” where they make pro-rated refunds for all inactive accounts.
Not only does this enforce the notion of “fairness” that I have discovered software buyers really value, it lowers the barrier to initial adoption, because:
“I hate buying software nobody is going to use”
How to get started with UBP?
Step 1 - Make sure UBP is right for your company, product and customers.
As highlighted above, UBP might not be right for every company, product and customers. Some guiding questions include:
How does my competition charge? Has anyone pivoted to UBP?
Would customers value greater flexibility?
How sticky is my product? Does consumption grow over time?
Is my team ready for this shift?
Step 2 - “You don’t know what you don’t measure”
Before implementing UBP, start measuring everything. Then assess which metrics track your customers’ consumption best and if these are well-aligned with the value created by your product and the costs incurring in delivering it. (You have a problem when costs scale faster than revenue!)
This might be a good time to start building your own metering and billing infrastructure, or buy from third parties (e.g. Amberflo, Octane, Metronome).
Aside: Interestingly, these UBP metering and billing companies charge all differently. Amberflo does UBP ($0.01 for 1,000 metering events). Octane charges basis points off your billing volume (like Stripe). Metronome sizes you up and charges a fixed subscription price.
Step 3 - Analytics
Make available analytics capabilities, dashboarding and usage forecasting tools to internal stakeholders and customers. UBP doesn’t work without trust, visibility and planning.
Step 4 - Pricing
Design a program that supports fair, transparent and attractive pricing.
I have been pondering UBP for the last 12 months, and interviewed over 10 startup executives and engineering leaders on this topic.
Over this time period, more companies have launched UBP. The level of interest in UBP among our portfolio companies has increased.
Pricing is one of the most visible parts of the customer experience. Today’s economic downturn is making pricing topical. It is pushing companies to think deeply about “how can we lower the barrier to adoption?”, “how can we make the buy decision as risk-free as possible?”, and “how can we become more customer-centric?”.
I learned through these interviews that implementation matters a lot. There is a large standard deviation on the good and bad stories about UBP implementation.
Just as a data point, apparently Twilio has over 40 engineers working on metering and billing alone.
I am encouraged by the promise of UBP as a source of competitive advantage for SaaS companies (with the right implementation and tooling), and have no doubt that 12 months from now, the software industry will look a little different because of it.
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