Q: As companies increasingly look for tailored solutions to growing their enterprise, how has the Software-as-a-Service (SaaS) industry evolved to meet these needs?
Brook Dane: SaaS companies are being leveraged by a variety of businesses to scale their enterprise and have evolved their pricing models accordingly. Over the last 15 years, software has moved from a traditional licensing and maintenance model to one in which the customer pays a fixed subscription fee.
However, with the rise of the cloud, consumption-based models are coming to the fore. Under these models, the customer only pays for what they use, allowing them to try different services. This is helping companies leverage software in three important ways:
- A customer will pay more if the software can be widely deployed across their organization, given the consumption-based nature of pricing. This means customers can experiment more easily with new technologies and align them to their needs while avoiding upfront commitments. In fact, most of these companies have a freemium model which materially lowers the cost to experiment.
- The software vendor is closely aligned in enabling the customer’s success so that the software can be widely adopted. This generates better outcomes and faster return on investment for customers.
- As customers grow, they usually want some flexibility around pricing. This could be in the form of decreased charges for overages, options to buy credits mid-year, or alternative pricing for scaled customers so that it is more predictable. Most vendors also provide a dashboard for monitoring consumption trends in close to real time.
In short, consumption-based pricing allows the software vendor to expand their top line, given the minimal customer acquisition costs and low barriers to adoption enabled by the freemium model. Furthermore, upselling and cross-selling with existing customers becomes easier as customers have a better initial experience.
Q: What are the implications for investors?
Brook Dane: Just like any other pricing model, there are benefits and drawbacks to consumption-based pricing, which we think is here to stay. On the plus side, the customers for these software companies tend to start small but rapidly expand, meaning their dollar-based net retention rate is much higher for them relative to traditional SaaS companies. Conversely, traditional metrics like billings and recovery point objectives (RPOs) go from being leading indicators to lagging metrics because most customers pay post usage.
These changes mean fundamental investors need to shift their focus a bit. In our view, the best metrics under consumption-based pricing models are new customer acquisition, net retention rate and the number of $1M+ revenue customers. Taken together, they allow us to gauge adoption across new and existing customers and whether the software monetization is scaling appropriately.
