SaaS has progressively become a dominant model for software utilization – increasingly replacing perpetual license / maintenance models – and is likely to continue growing through the 2020s, driven by the ongoing expansion of digitalisation, cloud computing and artificial intelligence.
Though the emphasis is often – deservedly – placed on products and solutions, SaaS pricing should not be overlooked, as it is a lever that lies at the core of a company’s success and assists in defining and enhancing its business model. SaaS pricing is often equated with recurring fixed subscription-based licence fees, but we show why the reality is more complex. We also explore the reasons behind some trade-offs with more usage-based models.
I. Pricing in SaaS: An essential contribution to the success of a company’s business model.
a. Value-based pricing centered around the client.
In the SaaS industry, there is a relatively clear tendency to adopt value-based pricing compared to cost-plus or competitor-based pricing. It is not that there is no benchmark when setting prices or that cost structure doesn’t matter, but innovation-based offerings – supported by strong R&D – as regards to competition or that the cost structure does not matter, but the innovation-based offers – supported by strong R&D – are less subject to commoditisation and more prone to differentiation, driven by business models that have lower variable costs and are designed to scale.
Value-based pricing is customer-centric, and focused on the value delivered to clients/users. This why the triad of Positioning/Packaging/Pricing is all the more important in SaaS, whether the company has a land and expand penetration or profitability strategy [note that in this article, when referring to pricing, we think of it as a process that includes the three “Ps” mentioned above].
b. Pricing drives adoption, ARPU, retention and upsell.
Though the literature on customer acquisition and retention is far more developed than that on pricing, the latter indirectly contributes to the former.
Decisions in terms of pricing have an impact on client adoption, in setting more tailored combinations of offers, making sales and marketing processes easier and lowering the cost of acquiring clients (CAC).
With consistent positioning and segmentation of the client base, a company can expect to capture a greater share of the value created and thus achieve a higher ARPU (average revenue per user).
For the same reasons, and without neglecting the quality of the products and competencies of the workforce – especially customer success and account managers in the present case – an appropriate pricing results in less churn and higher upsell/cross-sell potential.
Pricing impacts personnel motivation, be they product, marketing, sales, account executives or customer success employees. In the case of sales especially, pricing becomes all the more efficient as it is perfectly understandable and appropriately tied to variable compensations.
As a result, pricing can be considered a key determinant to the evolution of LTV/CAC ratio, as the life-time-value is determined by the ARPU and churn, and as the CAC results from a more efficient acquisition funnel stemming from easier adoption.
The impact of pricing on recurrence is more subtle. Though flat-fee subscriptions may appear to be the ideal option, as they notably generate recurring revenues – particularly valued by investors –, more variable, consumption-based models offer other benefits, which are increasingly valued by both software providers and their clients. Indeed, the quest for recurring revenues from fixed fees should not be pursued at the expense of LTV/CAC considerations.
II. The growing adoption of usage-based pricing.
a. “User-based” vs. “Usage-based” pricing.
SaaS pricing has historically been defined more as a fixed flat-fee per “user” within the framework of a subscription model. When we talk about a “user”, we are referring to a broader definition, which includes a seat, an account (or even an “active” account etc.), and other metrics such as a company’s size, the sector in which it operates, and more generally any other factors not directly related to the usage of the service (1). User-based pricing has the merit of being simple and predictable for both the software provider and its clients, while revenue can be scaled as the number of users grows, both with the existing client base and new clients.
Usage-based models scale with the actual consumption units of a product – also sometimes referred to as “pay-as-you-go” or “pay-per-use” (1). These pricing schemes involve metrics that can be directly tied to the customer’s perceived value: gigabytes of data, number of transactions processed, number of SMS or emails sent etc. These models used to be common among “Infrastructure as a Service” (IaaS) companies (AWS, Microsoft Azure, Google Cloud, Digital Ocean, OVH…). Though less predictable than user-based models, they facilitate easier adoption for clients while reducing cost-related barriers to entry, and they can better link the price paid (cost incurred) to the value received. On the software provider side, they help to better absorb potentially higher variable costs of sales (hosting, data, customer success…), while unlocking the potential upside.
The frontier between user and usage-based models can be relatively porous. Within the framework of “tier-based” models, packages can refer to a user, while encompassing usage components in the proposed features (through ranges or incremental volumes).
As shown in the “State of Usage-Based Pricing Report” conducted in Nov.21 by K.Poyar and S.Kalevar of OpenView, there is an interesting trend of larger SaaS companies moving to usage-based pricing, at least in hybrid forms.
b. The growing contribution of usage-based components in SaaS pricing.
In their report, K.Poyar and S.Kalevar investigate how SaaS companies price their products (2). They found that 45% of SaaS companies deliver their product through usage-based schemes (compared to 34% last year), with half employing “largely usage-based pricing” and the other half using more hybrid models that include a portion of fixed subscriptions.
Usage-based pricing is still not relevant for some products, business models and types of clients, especially those who are likely to continue to favour predictability – notably when usage metrics are too variable or too sensitive to the marginal costs of consumption. Still, the growing trend towards more usage-based pricing reflects a certain convergence of interest among buyers and sellers for more flexibility and consistency in the relationship between pricing/cost and value. Also, as the software industry is increasingly driven by the automation of manual processes and artificial intelligence, user metrics appears to be becoming less relevant, as the more successful a product becomes, the fewer user seats a customer actually requires.
The expansion of usage-based pricing is also going to be linked to the growing success of “product-led growth” SaaS business models (a notion also coined and promoted specifically by OpenView), which consists of a “go-to-market strategy that relies on using your product as the main vehicle to acquire, activate and retain customers” (see Wes Bush’s book “Product-Led Growth”).
The evolution of SaaS pricing should be closely watched in the coming months/years, as it is an interesting signal of more underlying changes in business models, which will redefine not only the way customers use and consume products or investors value a target, but also how a SaaS company itself is organised and the role and interaction of its different functions.
Pricing in SaaS – User-based vs. Usage-based models:
Notes:
(1) To underscore the separating lines between pricing models, in our article, we propose a distinction between user- and usage-based pricing, referring in both cases to extensive definitions. These definitions may vary in other studies, and in some cases, user- and usage-based pricing can relate to consumption-based models (the increase of in the number of users is then assimilated to an increase in the consumption of the solution), or tier-based pricing can be presented separately.
(2) The OpenView report is based on a survey encompassing around 600 SaaS companies, of which 51% are based in the U.S. and 18% in Europe.
Sources of information:
- Ghuman, Ajit. “Price to Scale: practical pricing for your high-growth startup”, 2021.
- “The Anatomy of SaaS pricing strategy” – Price Intelligently, https://www.priceintelligently.com/hubfs/Price-Intelligently-SaaS-Pricing-Strategy.pdf
- Law, Ryan. “The ultimate guide to SaaS pricing models, strategies and psychological hacks”, Jul.2021, https://www.cobloom.com/blog/saas-pricing-models#
- Poyar, Kyle; Kalevar, Sanjiv. “The 2021 state of usage-based pricing report” – OpenView, Nov.2021, https://openviewpartners.com/blog/2021-state-of-usage-based-pricing/#.YgFf–rMJPY
- Poyar, Kyle. “Playbook: Scale to $100M + ARR with a usage-based pricing model” – OpenView, Nov.2021, https://openviewpartners.com/blog/usage-based-pricing-playbook/#.YgFfk-rMJPZ
- Bush, Wes. “Product-Led Growth: How to build a product that sells itself”, 2019, Product-Led Institute.
[The views expressed above are those of IterAxon, based on (i) the knowledge and experience acquired from multiple engagements in the SaaS sector and (ii) on the analysis/studies conducted by third-party sources, as mentioned below in the “relevant and recommended sources” section.
IterAxon is a financial consulting firm specializing in innovative, fast-growing sectors, including SaaS: When performing financial due diligence or providing financial expertise to its clients, understanding the pricing strategy is an essential prerequisite to a better appreciation of the business model and the identification of growth and profitability levers].