In recent years, there has been a significant uptick in SaaS companies, in particular, investing in usage-based pricing models. Datadog, Twilo and Snowflake are just some of the big names to become a part of this growing trend, creating a belief amongst many that it is the future when it comes to selling services.
Underpinning this shift in business strategy, The End of Ownership is a movement that has been underway for some time. Today’s consumer is less interested in the status that comes with owning things. They don’t want to deal with upfront costs, the hassles of maintenance and the frustration of obsolescence. Instead, they are motivated by a desire for positive and fulfilling experiences that bring true value and convenience to their lives. People want to get the most out of whatever they pay for. And they do not want to pay for services that they do not use. In fact, a recent report from Zuora discovered that nearly three-quarters of international adults (72 percent) would prefer the ability to pay for what they use, rather than just a flat fee.
However, in certain circles, the buzz around this model of usage-based pricing is leading to falsities. For example, there is talk that it is on its way to completely replacing other business models, such as subscription services. The truth is that subscriptions are a framework for an ongoing, customer-centric relationship. This relationship can be monetized with a pricing model, such as usage. Therefore, pitting subscriptions and usage against one another is a pointless exercise. Companies can have the best of both worlds; they just need to know how to get the balance right.
The challenge with solely relying on usage-based pricing
Use more, pay more. Use less, pay less. Usage-based pricing works for many businesses because their customers can grow with them. Instead of making customers pay a set price upfront, companies embracing this business model have flipped that paradigm to help customers only pay for what is used – whether that’s API calls made, miles driven, or invoices sent.
This flexibility means that consumers can avoid hefty upfront costs and ensure that their spending goes further. Customers that find initial success with a service and want to use it more can do exactly that. In turn, businesses that employ a usage-based model can get more revenue as customers increase their usage. It’s a win-win scenario.
However, whilst companies with usage-based pricing see faster growth compared to companies without any usage pricing, these models do have their limitations. For example, many companies today simply do not have the luxury of experimenting with usage-based pricing due to restrictions in their technology systems and architecture. And without the ability to experiment with usage-based pricing, there will inevitably be a tipping point where a company’s growth stalls.
The challenges associated with usage-based pricing are typically two-fold: the inability of legacy systems to support usage-based pricing models, and the downstream impact it can have on an organization’s finance teams. Since many legacy systems do not support usage-based pricing models, IT teams are usually forced to hard-code existing solutions or build a home-grown hack to support them. This can be both expensive and time-consuming. Moreover, after the initial launch, most companies iterate and tweak their pricing and packaging to find the right usage model and the right mix of recurring vs. usage. The problem is, every pivot requires the IT team to rewrite the hard-coded logic behind the models which can cause lengthy delays.
Meanwhile, essential finance operations – such as billing, revenue recognition and reporting – are all impacted. For example, companies using usage-based models will have to start invoicing customers after the billing cycle, rather than invoicing a customer in advance. This means that customers will get to see their charges at the end of a billing cycle. Whilst this in itself is manageable, implementing it alongside maintaining billing operations for customers that are using a non-usage model can get complicated.
Finding the right balance
To sustain growth, SaaS companies need to find the right balance between recurring and usage-based pricing. This is where subscriptions come in. When it comes to subscriptions and usage, it shouldn’t be a case of customers being forced to make a choice. This implies that subscriptions are a kind of pricing model that would be deployed instead of a usage-based model, when in fact many subscription models utilize usage-based pricing as part of their offering. Usage models are important in their own right but the most successful organizations will be those that think of them as a particular derivative of The Subscription Economy – not a separate entity altogether.
Rather than putting all their eggs in one usage-based basket, companies need to bake various pricing options into their subscription offering. They can employ the ‘Goldilocks’ principle to find just the right balance of usage-based growth and sustainable recurring revenue.
For example, a subscription model with too little usage-based pricing is very limited. In fact, Zuora’s recent Subscription Economy Benchmark report found that companies with no usage-based pricing are only growing 19 percent on average each year. Meanwhile, companies with 1 to 25 percent of revenue coming from usage are growing at 25 percent year over year. Whilst this is an improvement, companies should be cautious of relying too much on usage-based pricing and being at the mercy of that usage. If even just a few customers reduce usage, then revenues can fall dramatically. The most successful companies are those that have usage-based pricing that makes up between 1-50 percent of their overall revenue growth. They grew at 28 percent, which is 1.5x higher than companies with no usage-based pricing at all.
Using a tiered subscription pricing model in conjunction with a usage-based pricing component can help with both growing a company, and improving its services. It gives customers the flexibility to scale usage while staying grounded. It also means that companies can rely on a sustainable recurring revenue stream and combat some of the challenges posed by a usage-only model.
Despite what some of the headlines say, subscriptions and usage are not antagonistic entities. When used correctly and cohesively, they unlock a world of possibility. Finding the sweet spot for your company and customers might require Goldilocks-style experimentation, but once you have found it, you’ll also discover a whole new channel for potential growth opportunities.
John Phillips, EMEA SVP Sales and GM, Zuora