Usage-Based Pricing: Strategic Considerations for SaaS Startups

Also commonly known as consumption-based pricing, usage-based pricing is a SaaS pricing model in which customers pay based on how much they use a specific software or its features. Specifically, it’s a way to align a pricing strategy with the customer value associated with the product or service.

While implementing usage-based pricing has various benefits (e.g., customer flexibility, lower barrier to customer entry, etc.), it also has numerous challenges, which can pose a risk for SaaS startups. For example, startups must have reporting systems in place to track usage accurately. There is also more than one usage-based pricing model to consider. Finally, usage-based models can also pose challenges to revenue forecasting and cash flow, which can make it difficult to plan for the future and reinforce the importance of having the right financial assistance and infrastructure.

Yet, consumption-based pricing models are increasing in popularity, underscoring the need for SaaS startups to implement their own plans while avoiding many of the challenges. Graphite Financial is here to help. As an experienced financial services firm, our specialty is helping startups grow and meet their long-term goals — and we can help your SaaS startup implement the right flexible pricing strategies to facilitate this growth.

Understanding the Rise of Usage-Based Pricing in SaaS

Just why has usage-based pricing become so popular? It’s largely because consumers want more flexibility and want to pay for products and services on a more on-demand basis. Usage-based pricing also aligns costs with value and minimizes a consumer’s initial commitment, making it easier and more convenient to try out a product or service without going all-in. Pay-as-you-go models are particularly utilized by AI startups, which have significant compute costs and are increasingly charging based on usage.

While usage-based pricing models can help facilitate SaaS startup growth, they can also create financial complexity. Fluctuating revenue streams, challenges with tracking and billing, and difficulties managing forecasting and revenue recognition are all common pain points SaaS startups often need to navigate.

Benefits and Risks of Usage-Based Models

Usage-based pricing models have their share of benefits and risks.

Benefits include an easier path to acquiring customers due to a lower barrier to entry, the ability to align cost with value, and the ability to foster customer growth and revenue generation. For instance, at Rillet, an AI-native ERP aiming to automate accounting for complex revenue models, it’s estimated that up to 60 percent of its existing customers operate on usage-based models, and even more use partial usage component models.

Yet, usage-based models also have challenges. As Graphite Financial Chief Strategy Officer Chris Mossa stated in a recent webinar, customers don’t like unpredictable expenses, so it’s important not to complicate pricing too much and be transparent with customers on their usage and what their prospective costs might be. Other challenges of usage-based pricing include unpredictable revenue for your startup, increased billing system complexity and potential issues with customer perspective.

Usage-based pricing is becoming increasingly popular in the AI space because of the cost structure involved in operating these types of operations, which means passing some of those costs onto the customer.

Financial Modeling Challenges with Usage-Based Pricing

One of the biggest challenges associated with usage-based pricing is the financial modeling difficulties that accompany it. For example, key SaaS metrics such as ARR and MRR become more complex with usage-based components. Achieving predictable revenue stability can be difficult due to fluctuating customer usage patterns, underscoring the importance of understanding the complexity and conducting proper testing to find the right fit. As Rillet Founder and CEO Nick Kopp noted, it’s a pain to deal with financial models in this context, underscoring the importance of understanding the complexity and conducting proper testing to find the right fit.

Chris suggests taking a three-scenario forecasting approach with usage-based pricing: positive, negative and most likely outcome. From there, SaaS startups can assess leading indicators like revenue trends to determine which scenario they’re most likely to hit and adjust their forecasting as necessary.

Revenue Recognition Complexities

There are key differences in revenue recognition between usage-based and subscription-based SaaS startups. Subscription-based revenue is recognized throughout the subscription period, while usage-based revenue is recognized as the consumer uses the service. This is all to say that the right financial systems must be in place to handle the pricing model you choose.

Failure to manage revenue recognition correctly can lead to many issues, notably when it comes to investor confidence and fundraising rounds.

Billing Infrastructure Requirements for Usage-Based Models

Your SaaS startup’s financial infrastructure must implement usage-based pricing. Your billing models are likely to change over time, so it’s important to consider billing platforms that incorporate various models to allow for this flexibility.

Furthermore, consider platforms that incorporate automated usage tracking and billing based on actual usage. As Chris Mossa noted, manual processes can snowball and lead to more expensive overhead costs, which can cut into your startup’s bottom line. Consider billing platforms that integrate with full tech stacks to best optimize your billing infrastructure.

Avoiding the Manual Process Trap

Manual billing processes may have their place when you first launch your SaaS startup, but these processes don’t lend themselves well to scaling. Manual billing processes can snowball and become more expensive. Rather than hiring more people to continue manual processes, consider investing instead in the right SaaS software that can optimize accurate billing.

As Sidharth Kakkar of Subscript noted in a recent webinar, it’s important to test solutions against manual processes and not be afraid to abandon them when they no longer work for your startup. But if you’re testing a platform and think it could be viable and flexible enough to support your startup long-term, systematizing it becomes crucial. Getting the automated process right means you’ll be able to avoid overhead increases from hiring new people for manual processes.

Testing and Implementing Usage-Based Pricing

If your startup is considering moving to or adding a usage-based pricing model, don’t just launch it and hope it works. As Siddarth explains, testing is an important step that your startup can’t afford to miss. Siddarth suggests testing your usage-based model with at least three customers before implementing it.

Prepaid credit models are one option. According to Rillet’s Nick Kopp, the usage consumption is in line with the value that is being provided to the customer and there’s also the certainty of upfront payments. It’s a good hybrid system that allows startups to straddle both worlds.

As Mossa points out, look at pricing from the customer’s standpoint and then back into the right model that makes the most sense for your startup. If those two things are not the same, then there’s a problem.

Customer Communication and Change Management

When you’re setting any type of pricing, let alone usage-based pricing, the customer should never be surprised. There needs to be a level of predictability for the customer so they aren’t shocked with any extras at the end of the month. Not long ago, wireless providers offered packages based on the number of minutes you used or texts you sent/received each month, and charged extra if you went over. Carriers ditched this model because customers hated it and were often surprised by expensive phone bills. The bottom line is, don’t institute a billing plan you know your customers will dislike. What’s more, your pricing should be transparent and allow consumers to monitor metering and breakpoints to ensure customer satisfaction.

Cross-Team Alignment for Usage-Based Success

To ensure success with your usage-based pricing strategy, consider the following:

• Mossa suggests coordinating regular check-ins with sales, the product team and the finance team to assess the structure and make any adjustments.
• Integrate sales into the billing process just as much as any other team. Keep in mind that most sales teams get paid on commission, and commissions usually aren’t paid until the startup receives money.
• Product teams should consider billing implications in feature development.
• As Nick Kopp noted, early sales process involvement can help avoid overly complex forms.

The Strategic CFO’s Role in Usage-Based Pricing

Today’s CFO does more than just accounting for a startup — they’ve largely emerged into more of a strategic role. As Sidharth Kakkar notes, today’s CFOs are strategic finance leaders who do more than report financial numbers, but advise the startup. Part of this is using data from cohort analysis and delivering insight back to the product and sales teams.

If your startup is lacking a strategic CFO, consider utilizing Graphite’s fractional CFO service for specialized SaaS guidance.

Measuring Success with Usage-Based Pricing

What does “good” look like with usage-based pricing? There are several factors to consider. For instance, beyond standard KPIs, startups should consider other metrics, such as track usage efficiency, consumption patterns and LTV.

Cohort analysis has evolved to the point that it can be done using any set of parameters to really understand customer patterns and what should be incentivized and downplayed. Advanced analytics that focus on usage based metrics are crucial for these insights.

Advanced Analytics and Reporting Needs

Usage-based pricing also requires more sophisticated reporting. For example, real-time usage metrics monitoring and predictive analytics are required.

It’s also important to have clean, organized data for fundraising purposes. Graphite can help startups with investor-grade reporting from an early stage.

Transform Your Pricing Strategy with Expert Financial Guidance

While usage-based pricing is the new trend in SaaS, implementing it can be more challenging than it may seem. That’s where relying on a trusted financial services partner like Graphite can help. As an experienced, accomplished service firm, our track record with SaaS companies and understanding of complex billing scenarios speak for themselves. Contact us today to learn more and to schedule a consultation.

Frequently Asked Questions

How do we forecast revenue accurately with usage-based pricing models?

It requires a combination of knowing customer behavior, tracking usage data and using the right forecasting models.

What billing infrastructure changes are required to support usage-based pricing?

Tech infrastructure needs a significant overhaul. In addition to real-time metering, your startup needs a robust invoicing system and your data should integrate with other programs.

How should we handle revenue recognition for usage-based services?

Revenue recognition tends to align with the period when the service is used, thereby recognizing it as the consumer uses the service.

When is the right time to transition from manual to automated usage billing?

The best time to do this is when the manual process becomes too cumbersome or inefficient due to startup growth or increased complexities.

How do usage-based pricing models impact our fundraising and investor reporting?

It’s a challenge, as revenue recognition and forecasting are more difficult. Careful planning and the right systems can help manage these complexities and report clean, organized data.

What are the key metrics we should track with usage-based pricing beyond traditional SaaS KPIs?

Key metrics include usage efficiency, consumption patterns and LTV.

How can we maintain predictable cash flow with consumption-based revenue?

In addition to developing a good cash flow management practice, work on building financial buffers, analyzing different customer segments and leveraging the right forecasting tools.

What are the biggest mistakes startups make when implementing usage-based pricing?

Challenges involve overcomplicating pricing structures, poor transparency with consumers, failure to test with consumers prior to implementation and more.

Should we use pure usage-based pricing or a hybrid model with minimum commitments?

Hybrid models are ideal approaches that offer predictability while still leaving room for growth. Your startup’s pricing model should be considered based on the service you provide, your customers and any goals.

How do we prevent customer surprise and maintain transparency with usage-based billing?

This can be prevented with education and by providing them with the monitoring tools that show their usage and when they might be nearing limits.