A Primer: Subscription vs Usage Based Pricing Models
Unpacking the pros and cons of each model. And why Usage Based is best, if you're already the best
There’s been a lot of recent debate about which pricing business model is superior in tech: Subscription vs Usage Based.
Is Usage Based Pricing (UBP) just another hype-train contender, with a decent right hand but no jab? Or is it the real deal - a truly better way to align value to customer problems, and reap the benefits?
What I’ve found is there’s no single answer to the question - it varies depending on what you are selling and who you are selling to.
However, what I’m increasingly made aware of is how the “best” Usage Based companies are outperforming the “best” Subscription companies across two core metrics:
Revenue growth
How fast is your topline scaling y/y
Net dollar retention
How well are you able to land, expand, and retain customers
ICONIQ dropped a new report on business efficiency that painted a compelling story for Usage Based models. Actually, compelling may be an understatement. From reading the report, you’d think you were doing something gravely wrong if you were purely relying on Subscription.
The report shows that the “best” Usage Based companies are growing nearly twice as fast as the “best” Subscription based companies.
And net dollar retention followed a similar trend - the “top performing” usage based companies achieved net dollar retention 20% to 40% higher than their Subscription peers.
To put that in perspective, that would mean if the company picked up and went on vacation for a year, and didn’t acquire or lose a single customer, they’d still grow 20% to 40% more than their red headed Subscription step brothers. That’s nutty.
It made me wonder why this phenomenon exists - thumbing through the report, it looks like two regional champs went head to head in the state Superbowl.
But East Texas sent the D1 powerhouse Dillon Panthers, and West Texas brought a bunch of kids from a D4 art school. Not all champs are the same.
Calling out the differences in models:
If you are usage based, you are intimately linked to the underlying value proposition of what you are selling. You live and die by how embedded and critical you are to how the user solves a problem.
Subscription, on the other hand, where you are theoretically billed the same amount each period, is arguably less connected to the day to day value realization. Yes, you initially sign up for a plan based on a number of seats / licenses / widgets you think you “need”, which should ideally be connected to the value prop of the product. But it’s not like you get an update every day as to how many people are actually using those licenses. Subscription waste is a real thing… in fact, just this morning I exported a list of all our Salesforce licenses, filtered by last login, and vomited into my Mostly Metrics yeti.
As we’ll go through below, Usage Based models provide much more flexibility for the end customer, and also better transparency:
Stuff you’ll prob like about UBP
More upside: “Core to the UBP (Usage Based Pricing) strategy is the idea that you can’t predict your largest accounts. When you implement UBP, you’re making a bunch of bets with the hope that some of them will pay off spectacularly.” (Source: OV). In other words, you aren’t capping your upside, regardless of their initial spend.
Net dollar retention rate is like a video game cheat code: Customers start at a lower level than subscription, and ramp their activity over time as the product becomes a core part of their workflow. This puts the majority of their growth into the expansion bucket, which gets big time net dollar retention credit. If I were writing a book report, I’d cite Snowflake in my bibliography.
You can sell large commitments: It’s easy to tell a story to customers about why they’d want to buy up lot’s of credits at a discount now so they can realize a better rate at scale later. I don’t have any evidence of this, but anecdotally I see more multi year commitments for usage based contracts than subscription. Feel free to argue with me, though.
Easier access: Since you don’t really care about the number of seats or licenses being used, you can make the account accessible to a wider audience within the company. More use cases will inevitably evolve as a result, and when your product becomes ubiquitous, it’s great for revenue.
Stuff you might not like about UBP
Easier to scale back during macro headwinds: Dad might come home from work and turn the thermostat down. The same volatility on the way up, also exists on the way down. When times get tough, it’s much easier to “optimize” your consumption spend than it is to get out of an ironclad, annual ass Subscription contract.
Misconfiguration mistakes can frustrate customers: When you set up a usage based product incorrectly, it’s much more catastrophic than the mistakes you can make when assigning subscription licenses to the wrong folks. Many a developer has left the faucet on over night when testing something on AWS. I remember one time an infra developer blew up my GCP budget by like $18K in one day from a small mistake. This has been a common occurrence with new AI models that run on usage based pricing:
You know those horror stories of people who leave a faucet running in their house while on vacation for a week, returning to a flooded residence? That kind of thing is happening in AI.
Edo Liberty, founder of Pinecone, a buzzy infrastructure startup which helps developers build AI applications using their own data, says he heard about an intern at a company who accidentally spent half a million dollars worth of compute because he forgot to stop some AI model testing. We’d guess that intern won’t be hired when they graduate.
-Source: The Information
More prone to calendar seasonality: As an FP&A analyst, you pick up on weird fluctuations in cost during the year. You’ll notice how cheap it is to run your cloud infrastructure during the holiday season - your hosting bills mysteriously dip. Why? There’s less “usage” or activity or queries or whatever, because everyone is on vacation. I see the same thing with our BI tool usage during holidays.
Stuff you’ll prob like about Sub pricing
Easy to forecast: There’s more predictability from period to period. It’s the easiest model to build an ARR waterfall for. You already know what they agreed to pay you. Duh.
Easy to understand: More customers are familiar with how Subscription works. It’s like a gym membership, but for software. See, that was easy.
Shower thoughts: Imagine if Equinox adopted a hybrid pricing model where they charged you a monthly subscription based on membership plus usage based add ons for sauna minutes and Kiehl's Body Wash. That would drive a few junior investment bankers in NYC broke.
Churn mitigation: It’s harder for a customer to shrink in-period.
Stuff you might not like about Sub pricing
You have to wait longer for a compelling opportunity to upsell: It’s more difficult to increase spend in-period. Subscription companies often circle renewal dates on the calendar to upsell additional products. With usage based pricing, the conversations with sales reps are more frequent, as customers look to optimize the core product and then add-on additional modules. DataDog, who relies predominantly on usage based pricing, is great at this. Peep their multi product attach rate:
Source: Datadog August 2023 Investor Day Net Dollar Retention has less room to run: Subscription customers usually start at a higher commitment amount than consumption customers, and mathematically have less room to run when it comes to expansion.
So, does Usage Based inherently make you better?
It seems like usage based success is a self-fulfilling prophecy of sorts if you are already selling a superior product. But if you are selling something that’s just run of the mill, it makes you more susceptible to downturns; there’s a larger surface area for both success and failure. And if you suck, you’re going to REALLY suck with UBP.
It’s no wonder why the best companies seem to be leaning into this new-age pricing model (as if taxi cabs and electric companies haven’t been using it for over 100 years, lol). By tying pricing to usage, companies encourage customers to actively engage with and derive value from their tech, fostering stronger customer relationships, which plays out in their metrics.
Afterall, at the end of the day, we’re only as good as our metrics say we are.
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One of the hidden, albeit profound advantages of UBP is that it drives spectacular operational efficiency. This is an aspect less talked about but there is credibility to this statement if we look at companies who are leading with UBP. They not only are clocking in higher NRR, as you called out, but are also innovating faster. One can argue that higher NRR leads to a virtuous cycle of growth so net, net UBP is that lever. I personally saw this firsthand at AWS.
The concerns often cited - lack of forecasting, inadvertent spend, etc. are well intentioned but are mostly coming from the quarters where they have not actually lived or implemented UBP, but are pondering. And therefore, the concerns are warranted. But the data speaks otherwise. Companies leading with UBP are only further doubling down on it - no matter what kind of product, application, or service. Pain points cited are simply a function of not having the right tooling or infrastructure in place to operate UBP, they are not limitations of the UPB model itself.
I love your quotes, and this is one for the books -
"...in fact, just this morning I exported a list of all our Salesforce licenses, filtered by last login, and vomited into my Mostly Metrics yeti."
It is a fallacy to think that the model of counting seats upfront is a superior model because the customer does not have a choice to dial it down midstream, and therefore the vendor is better off. The reconciliation is going to come due - no matter what. Better to align with customer's needs and usage patterns (giving customer a choice), rather than the excel model.
And while we debate, the UBP pioneers and leaders continue to eat their subscription counterpart's lunch...
:)
Excellent article summarizing the pro and cons of UBP vs Saas license-based pricing. It’s not always a all-or-nothing. Saas companies on license seats may be better off using an hybrid model based on use cases and competition. Another factor slowing down UBP adoption is the fear from Leadership to lose revenue. It is a hard sell and nobody is incentivized to put their head on the line... As you said, UBP can be cheaper for customers with shelfware license seats, thus a swap is an obvious play for customers. Still, I agree with the long-term view that UBP seems superior. Once all your competition sells that way, you find yourself at a competitive disadvantage in deals, with analysts, SIs (higher commit spend), etc.