Thought Leadership

How to improve NRR with Usage-based Pricing

Daniel Elman

January 3, 2023

How to improve NRR with usage-based pricing

Net Revenue Retention (NRR), also called Net Dollar Retention (NDR), is emerging as a key northstar metric for evaluating SaaS companies as it gives insight into both the current state and the future trajectory of the company. NRR is supplanting annual recurring revenue (ARR) among the most valuable metrics because it provides visibility into how quickly a company is growing but also how well the company does to keep newly acquired customers from churning.

Usage-based pricing inherently offers levers for businesses to improve NRR by reducing churn and driving organic account growth. In challenging economic conditions, companies that are most successful in reducing churn and delighting existing customers will be the long-term winners.

Calculating NRR for usage-based businesses

To understand how NRR is traditionally calculated, consider a group of customers that have been using a solution for a year. NRR is given by dividing the monthly recurring revenue (MRR) from that group of customers for this month by the MRR for that group from the month one year ago.

For some group of customers A, calculated for month of December last year:

In a usage-based business, recurring revenue is difficult to measure since customers do not have to commit to any long-term contract, but instead simply pay for what is used billing period-to-billing period.

Some companies simply remove the pay-as-you-go option, and have customers pre-pay for usage with prepaid credits. In this situation, the recurring prepaid spend (or the prepaid spend divided by month) can be used as the recurring revenue in the traditional model. Other approaches include comparing the spend by quarter instead of month, annualizing the previous month’s usage-based spend and using this as a basis for ARR, or simply comparing the annual (usage-based) spend for a set of customers year-over-year.

For example, Twilio compares revenue from a set of customers from Q1 this year with the revenue from that same set during Q1 of the previous year. To calculate the NRR for the full year, it takes the average across the four quarters for the year. Snowflake compares the annual revenue for the current year generated by the customers who signed up exactly 1 year ago or greater with the revenue generated by those same customers during the previous year.

In all cases, regardless of the specifics for each calculation, the businesses are essentially identifying a set of customers and modeling how that customer’s spend on the platform evolved over time.

Usage-based pricing improves NRR

Understanding how NRR is calculated in a usage-based world, we can see that there are a two approaches a business can take to improve the metric; namely, to improve overall retention (decrease churn) or to increase the revenue generated per existing customer (land and expand). Usage-based pricing is a lever that allows businesses to positively impact NRR from both directions.

  • Reduce Churn
    Rather than giving customers the binary choice to churn or remain with a solution, usage-based pricing offers greater control and flexibility to the customer around their spend. Giving the option to throttle back usage of a solution without stopping completely will improve churn compared to the subscription context.
  • Drive Organic Growth
    Account growth can occur organically for usage-based solutions. As long as the customer does not churn and continues to be successful, then the overall usage of the solution should increase as the customer grows. Combining this natural trajectory with targeted upselling and cross-selling efforts from account teams who are able to leverage historical usage data from customers to better understand their use cases and recommend new solutions and areas of expansion has the potential to massively impact NRR compared to the traditional SaaS subscription paradigm.
  • Unlock Data-Backed Customer Outreach
    Tracking usage to enable usage-based pricing inherently provides a deeper level of visibility into customer activity and account health than has been easily achievable with legacy business models. Savvy businesses will leverage historical usage data in a complementary outreach motion to drive additional growth. Account managers and customer success teams should analyze past usage data to understand customer use cases and identify opportunities to add value and grow usage. With granular insight to how customers are using the product, customer outreach can be more targeted and successful.

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