Usage-based pricing is the best way to drive net revenue retention

Net Revenue Retention (NRR; also called Net Dollar Retention) is the single most important metric for a SaaS business because it indicates both the growth and stability of a company’s revenue stream -- and those are the two biggest drivers of any company’s valuation. In this research brief I will discuss the unique advantages of improving NRR by deploying usage-based pricing (UBP), and in a future article, I will more precisely quantify the relationship between NRR and valuation.

Definitions and Context

Net Revenue Retention is: (the monthly recurring revenue (MRR) generated in the current month by the cohort of customers the company had one year ago), divided by (the MRR that cohort generated one year ago). Example below – it’s not as confusing as it sounds.

In the chart above, the company had 5 customers one year ago who collectively generated $130,000 in MRR. Since then, one of them churned and the other four grew their MRR slightly. Revenue growth at the individual customer level (what we call organic growth), more than offset revenue lost by the churned customer and the company’s NRR was 102%, (also known as “negative churn” when NRR exceeds 100%). NRR is a great metric because it concisely describes the trajectory of the company if there were no new customers. 

The definition of Gross Retention simply ignores any growth at the individual customer level and is considered a cleaner measure of the “stickiness” of the product – essentially a measure of logo retention. Gross Retention cannot mathematically exceed 100%, and in this case, is 92%.

Retaining current customers

There are two obvious ways to increase net retention: retain more customers (gross retention) or sell more to existing customers (expansion). There is an entire industry (Customer Success) dedicated to retaining customers, so we won’t dwell on it here other than to point out the following fact: Gross retention is subject to diminishing returns. Some churn is inevitable, and as a company reaches its maximum potential retention level, more and more resources will be required to retain those last few customers. Every industry has companies that go out of business, and all SaaS companies have a customer or two they will lose no matter what they do. 

We recommend investing some time to understand the rate at which companies in your customer cohort go out of business (something we call structural churn). Once you know this, set your benchmarks and Customer Success investments to target a gross retention level a few points below the structural churn level. If companies in the industry you serve fail at the rate of 5% per year, your gross retention target should not be 95%, it should be closer to 90%, or maybe a little higher.

Selling more to current customers

The other lever to move NRR, increasing revenue from existing customers, can happen in two ways: Change how much you charge your customer, or sell more product to them.

Actively selling more product to existing customers is great and should be pursued in combination with any other efforts. Research shows that selling more product to existing customers is more cost effective than attracting new ones, and customers who buy more modules tend to be “stickier” over time. 

And while more cost effective than new logo sales, expansion sales are not free. Not only do sales motions cost money, but product development needs to keep a steady flow of new features and modules flowing to support upsell. 

Usage-based pricing as a net retention lever

Deploying UBP as a way to increase Net Revenue Retention has three key advantages over other approaches:

1) It lowers friction to growth for both the customer and the company

2) It’s virtually cost free, requiring no incremental sales or product development costs

3) The approach is mathematically asymmetric - it has significantly more upside than downside and can drive revenue growth much higher than other approaches.

Reducing friction

When done properly, UBP is aligned with a value driver of your customer. Once that relationship is established in the mind of the customer, it’s much easier for them to pay more each month because it means more value is being delivered to them. Great examples include usage metrics that can be linked to revenue. This can include things related to payments or collections, or other revenue drivers like “visits” for doctors, or “members” for gyms, or even “leads” for sales organizations. Conversely, if your application saves a customer's money each time it’s used, and that connection is made clear, there is little to no pushback as they pay you more and more each month.

Cost

While there may be some modest cost in setting-up and monitoring usage (it must be done well, and it must be flexible), there are few other costs associated with revenue gains driven by higher customer usage. In most cases, the incremental revenue will flow through the P&L and add to profits at your gross margin rate or better. If there are any incremental sales efforts encouraging customers to use more, they tend to be highly efficient because they are focused on customers who are already using the product. 

Upside potential

Per seat pricing, at best, will grow along with the headcount growth of your customers and average out to nominal GDP growth unless you are serving a high growth vertical. If, however, your SaaS product is producing value for customers each time they use it, its intensity of usage will grow, and that is where the real upside can happen. Some groups of customers will grow usage significantly over the years and double, triple, or even grow by 10 times. Churned customers will cost you 1 times their ARR, but growth customers can net you 10 times their ARR. It takes a relatively modest number of high growth customers to significantly impact company-wide NRR and growth.

In the chart below, we show the impact a small group of high-growth customers can have. 

In this example, with just 5% of customers in the high growth category and 10% of customers churning each year, the ten year compounded growth rate of the business is 13.6%, without booking any new business. Importantly, the growth of the business is much more sensitive to modest changes in the High Growth segment than any other segment. In the example above, if the business increased its pool of high growth customers from 5% to 6%, its ten year growth rate would improve 1.5 percentage points to 15.1%. Conversely, were it to improve its churn from 10% to 9%, growth would only improve .2 percentage points. This is the asymmetric nature of growth customers vs. churned customers, and UBP is an amplifier on the much more powerful growth side. 

Driving Net Revenue Retention with usage-based pricing

Net Revenue Retention is the most important metric in a SaaS business, and deploying UBP can drive higher NRR in powerful ways that other approaches can’t. Cross-selling, upselling, and reducing churn are all important and should be pursued, but they all take time and resources and have limited upside. Combining those efforts with UBP could have a dramatic impact on your NRR and your valuation. Usage-based pricing deserves serious exploration by all management teams running SaaS companies.

About M3ter

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