Why Usage-based Pricing is a reliable way to hit high Net Revenue Retention

Recently, we heard that a venture capital firm in the Bay Area, Peakspan Capital, was closely evaluating one very important growth metric in SaaS companies before deciding to make an investment in them — the Net Revenue Retention (NRR) rate.

As per a report published together by Peakspan Capital and Ibakka in September 2023, companies that are delivering a Net Revenue Retention (NRR) of more than 130 are seen as very good targets for investment.

Those with less than 90 are expected to struggle in their growth. The report comes after surveying responses from 341 SaaS companies.

Keeping various different components into consideration, the survey evidently indicates that companies that employed usage-based pricing (UBP) clearly seem to have a better Net Revenue Retention (NRR) performance, over those that did not.

When we learnt of this venture fund’s strong focus on NRR and the statistics in the report, it immediately resonated with all of us at Zenskar.

One of our cofounders went on to gladly have his ‘I told you so’ moment, especially because he has always been a relentlessly vocal advocate of including a component usage-based pricing (UBP), and that enterprise businesses might want to consider having it in their pricing model, sooner than later.

Speaking of which, if there is one singular problem that has been constantly on our minds ever since we started Zenskar, it is that most businesses of today often struggle with having to alter their business models in a way that they are compatible with the billing softwares that they use. ‍

The way their contracts are designed and priced, it gets difficult to encode these contracts on the billing softwares.

It is only mildly putting it to admit that this is where a lot of our customer empathy stems from. Because this is a very real business problem, and it has a real monetary impact on cash-flows and revenues. The billing software and tools that most companies use today, are not really able to solve this business problem.

It is also not very easy to solve it, while continuing to use these billing softwares the way they are designed to be used.

All in all, we had observed that because of these complexities in not being able to solve the business problems, these companies are not able to be consistent with achieving higher Net Revenue Retention (NRR) rates year on year. And Usage-based pricing (UBP) poses a reliable way-forward.

However, it is not very easy to execute or ship usage-based pricing (UBP) as an additional layer in the infrastructure, especially when companies use their in-house billing softwares.

Here is why

Any increase in revenues would have to be initiated by the seller or vendor in the case of simple subscriptions. Any changes in the contractual pricing would have to be initiated by the customer in the case of usage-based pricing.

It is also not very easy to increase the subscription amount in the middle of a billing cycle. Here are some more challenges involved while using subscription-based pricing —

• If your buyer is an enterprise or any decent sized company, you have to go through the full approval cycle — from procurement, another round of negotiations, a salesperson from your team is involved when it comes to upgrades, and finally altering the contracts accordingly.

• It is not only expensive and time-intensive, but it also does not entirely make sense to have to go through all this cycle, from a business perspective.

• Because in most cases, the increment in cash-flow you will get with these altered subscriptions by following the tedious process, often turns out to be far lesser than the cost of the overall effort that goes into it.
  

In case of usage-based pricing (UBP), the customer would find it concerning if the bill mounts up to an incremental number every month, and he or she would want to renegotiate the contract.

While in the case of subscription-based billing, the customer is actually quite happy making recurring payments because he does not have to indulge in any extra complexities or renegotiations with the seller, while continuing to use more and more of the product.

The vendor however, is concerned because the customer is getting far more value than the amount he is paying for, for a fixed subscription amount.

This little dichotomy is where the entire dynamic goes for a toss.

Before we dive into the subject, here is a little introduction into the concept of Net Revenue Retention (NRR), for the uninitiated.

What is NRR, really?

(Feel free to skip this section, if you are already familiar with the fundamentals of what NRR is.)
Net Revenue Retention (NRR) is often interchangeably referred to as Net Dollar Retention (NDR).

In simpler terms and practical considerations, if you are an enterprise business signing a contract of $1000 this year for a new customer, how much is the value of this contract amounting to, by next year? Is it becoming $900 or is it becoming $1100? If it becomes $900, the NRR growth would be 90% while it would be 110% if it is $1100.
This growth metric is what you are precisely measuring with the concept of Net Revenue Retention (NRR).

It throws a nuanced overview of how much revenue is being retained and has grown, from an existing customer base. Holistically, NRR is a growth metric that measures the amount of revenue retained from existing customers over a given period, accounting for upgrades, downgrades, and churn. It often poses as a powerful indicator of customer satisfaction, product value, and the overall health of your SaaS business.

Here are all the components that constitute the calculation of Net Revenue Retention (NRR).

• Starting Revenue
• Expansion Revenue (upgrades)
• Contraction Revenue (downgrades)
• Churned Revenue
  

Net Revenue Retention (NRR) is often calculated by adding a sum of all the four different sources of revenue, dividing this sum by starting revenue, and multiplying this number with 100.

NRR = (Starting Revenue + Expansion Revenue - Contraction Revenue - Churned Revenue / Starting Revenue) x 100

Why is NRR important?

It is fairly established that Net Revenue Retention (NRR) is a crucial metric for SaaS enterprises for several reasons. It drives revenue growth without proportionately increasing customer acquisition costs, while also enabling better forecasting and planning, and eventually helps strengthen the company's position in the market.

Here are some other reasons, to show why achieving higher NRR is important for the growth and sustainability of any company —

• Customer satisfaction and value delivery — NRR measures the revenue retained from existing customers over a specific period, including upsells, cross-sells, and churn. A higher NRR indicates that customers find value in the product or service, leading to upgrades or additional purchases and reflecting overall customer satisfaction.
  
  
• Predictable long-term revenue growth — A high NRR suggests that a SaaS business is not only retaining its customer base but also expanding revenue from existing customers. This is a strong predictor of sustainable, organic growth because it is usually more cost-effective to sell to existing customers than to acquire new ones.
  
  
• Enhanced lifetime value (LTV) — Increasing NRR directly impacts the lifetime value of a customer. Higher LTV means a business can afford to spend more on customer acquisition while maintaining profitability, which is often critical in competitive markets.
  
  
• Improved profitability — Acquiring new customers can be expensive for SaaS companies, often requiring significant upfront investment in marketing and sales efforts. Higher NRR means more revenue is generated from the existing customer base, improving overall profitability due to lower customer acquisition costs (CAC).
  
  
• More investment opportunities — Investors and stakeholders often look at NRR as a key performance indicator when evaluating the health and potential of a SaaS business. A high NRR signals a strong, sustainable business model, making the company more attractive to investors.

But what hinders higher NRR rates?‍

In this article alone, and after taking feedback from all of our prospects and customers, the answer to this question would be — not being able to price close to customer value, with the help of usage-based pricing.‍

“If you are offering usage-based pricing and it is not closer to the customer’s value, he or she would not be willing to purchase the product.”‍

For the longest time, software value was based on the number of users, hence, it was priced per user per month. However, with SaaS products that don't require human end-users, value is now tied to usage metrics such as SDK consumption, API hits, and more.

As a result, pricing is moving towards a very variable, consumption-based model to align with customer value. This has given rise to consumption based pricing, also known as usage-based pricing (UBP).

There is a distinct difference between simple subscription-based pricing and usage-based pricing (UBP) models when it comes to billing. In a subscription model, the contract itself contains all the necessary information to generate an invoice.

However, in usage-based pricing (UBP), the additional element of usage is not inherently part of the subscriptions in the billing system. As a result, when usage-based pricing is applied to existing tools, specific requirements must be met to capture and utilize usage data effectively for invoicing. Especially in in-house billing tools where the line of vision is only focused on one single axis — usage.

This places the responsibility of managing usage data on the customer, particularly the product teams. They need to tightly integrate their existing metering systems with the billing tools, understanding the intricacies of contracts, billable metrics, and mapping to ensure data is fed into the right place in the billing system.

It is a known fact that most businesses today find it hard to implement usage-based pricing. We have written about this extensively in one of our blogs, which also outlines the different reasons why it is hard to implement UBP.

Read more: Why are popular billing tools a nightmare for metered billing?

Having said that, at a broader business level, here are the other challenges involved —

• Your revenues are not predictable, especially when you want predictable revenues with classic subscription-based pricing.
  
• Your infrastructure suddenly becomes far more complicated when you want to offer usage-based pricing (UBP). \
• It is just easier to price with fixed subscriptions.

But there are bigger business problems with fixed subscriptions.

Why is usage-based pricing the way forward?

It goes without saying that for any enterprise business, the costs and expenditures are always closely associated with its revenues.

No company wants to spend more money than the amount of money it is receiving. If a vendor is able to change his pricing, in line with the way a customer’s revenues eventually scale up, the customer is naturally bound to choose to go with that particular vendor over others.

Having said that, any company in the world selling a SaaS tool to enterprise customers would have a fixed amount per month for a subscription. But however, the underlying usage only keeps increasing for the buyer, leaving the vendor or seller at a clear disadvantage.

With usage-based pricing (UBP), the vendor or seller is also at an equal advantage because there are now more options to be able to price closer to customer value.

• Case in point, this seller’s entire value proposition is now centred around customising the pricing of the SaaS tool way more closer to customer value.
  
• The seller is able to do so, without any significant effort or friction from his or her end.
  
• However, it is important to note that, it is not by virtue of usage-based pricing (UBP) alone — but being able to customise pricing for each different customer.

With this elevated value proposition, the seller is at a convenient advantage to be able to sell more with better conviction, acquire more customers and business into the company. It directly contributes to achieving higher rates of Net Revenue Retention (NRR) for the seller.

“If you want to achieve higher NRR rates, usage-based pricing (UBP) is simply not negotiable. Period.”‍

As for the buyers, usage-based pricing (UBP) is a clear win because the price they are now paying is scaling equally along with the value that they are actually paying for. When they are able to see this direct correlation between the investment and the utility they receive, they are more likely to expand their usage over time, contributing to increased revenue per customer.

• For SaaS businesses catering to enterprise customers, scalability is a key concern. Usage-based pricing (UBP) poses an inherently flexible model that can adapt to changing business needs. This flexibility means that — as customers grow and their usage increases, so does the revenue from those customers, contributing positively to NRR.
  
• The pay-as-you-go nature of usage-based pricing (UBP) reduces the financial risk for customers, making them less likely to churn due to rising costs of acquisition. Because UBP encourages customers to adjust their usage without substantial financial penalties, they are more likely to stay and adjust their plans rather than leave for a competitor. This flexibility helps maintain and gradually grow the customer base — a crucial factor for sustaining high NRR rates.
  
• Usage-based pricing (UBP) can cater to a wide range of customers with varying needs and usage patterns, whether it is a smaller startup or a large enterprise. This wide net not only increases the potential customer base but also accommodates growth, and the changing needs within existing accounts, which in-turn contributes to both acquisition and retention metrics.

‍“As long as there is predictability in revenues and cash-flows, by virtue of retaining customers year-on-year without churn, both the seller and the buyer are bound to be happy. Subsequently, the seller is also able to achieve higher Net Revenue Retention (NRR) rates.”

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