Subscription Pricing

What is Subscription Pricing?

Subscription Pricing is a business model strategy wherein customers issue payments on a recurring basis for continued access to the product, contributing toward the generation of recurring revenue.

Since the customers are paying on a recurring basis, rather than one-off payments, the subscription-based pricing model facilitates the creation of more robust forecasts on operating performance, from which insights can be derived to implement strategic adjustments to improve its recurring revenue.

Table of Contents

How Does Subscription Pricing Work?
What are the Benefits of Subscription-Based Pricing?
What are the Different Types of Subscription Pricing Models?
How to Analyze Effectiveness of Subscription Pricing Model
How to Analyze LTV/CAC Ratio in SaaS Business Model

How Does Subscription Pricing Work?

The subscription-based pricing model is a business strategy whereby customers pay to access a product or service on a recurring basis.

In the software-as-a-service (SaaS) industry, the subscription-based pricing model has become the norm, which is attributable to the value placed on recurring revenue nowadays.

The SaaS business model is oriented around the continued generation of recurring revenue. In fact, the long-term viability of SaaS companies is predicated on establishing a revenue stream that is recurring, rather than one-off payments.

Simply put, not all revenue is created equal. The quality of the revenue produced by a business is equally, if not more important, than the quantity, particularly when it comes to the valuation of the business (i.e. the implied valuation of a company is on a forward-looking basis).

Said differently, recurring revenue is perceived as more valuable than one-off payments because it is more predictable and stable, which has broad implications on the valuation of the business and ability to raise capital from venture capital firms (VC), growth equity firms, and private equity (PE) firms.

Therefore, the subscription-based pricing model charges customers a recurring fee on a monthly or annual basis.

Hence, subscription-based pricing has become the industry-standard for the SaaS industry, and in recent times, software has become increasingly become an inherent part of practically all industries, which is a structural shift that is here to stay, to say the least.

What are the Benefits of Subscription-Based Pricing?

The main benefit of subscription-based pricing is inherently tied to the concept of recurring revenue, to reiterate from earlier.

The predictable nature of recurring revenue allows businesses to forecast future income with greater accuracy, which is a critical attribute considered in the valuation of the business (and ability to raise capital from institutional investors).

The collection of payments on a recurring basis provide customers with ongoing value since they can use the product over an extended period rather than purchasing it once—and not to mention, the product will likely continue to improve over time.

Subscription-based pricing offers companies with more autonomy over their revenue model, where the strategic changes applied are based on the insights derived from the analysis of the underlying revenue drivers (i.e. historical data, trend analysis).

To elaborate on the prior statement, subscription-based pricing offers more optionality (or “levers”) to hone in on the optimal customer acquisition strategies that maximize recurring revenue.

The two core KPIs to measure a SaaS company’s recurring revenue are monthly recurring revenue (MRR) and annual recurring revenue (ARR).

The formula to calculate a company’s monthly recurring revenue (MRR) multiplies the average revenue per account (ARPA) by the total number of active accounts.

Monthly Recurring Revenue (MRR) = Total Number of Active Accounts × Average Revenue Per Account (ARPA)

The ARR metric, on the other hand, can be perceived as the annualized MRR of subscription-based businesses.

The formula to calculate the annual recurring revenue (ARR) is rather simple, as the ARR is equal to the MRR multiplied by 12.

Annual Recurring Revenue (ARR) = Monthly Recurring Revenue (MRR) × 12

Note, however, only the “recurring” portion of a company’s revenue is part of the MRR and ARR metric, so one-time fees must be removed.

Why? Contrary to subscription-based payments, one-time payments—such as professional service fees from onboarding new customers, installation fees, and set-up costs—are not recurring in nature and should thus be excluded.

What are the Different Types of Subscription Pricing Models?

Model	Description
Flat-Rate Pricing	Flat-rate pricing charges a fixed price for access to a product or service, typically on a monthly or annual basis. The flat-rate pricing model offers simplicity and predictability, making the pricing structure easy for customers to understand and budget for. Businesses benefit from stable and predictable revenue streams, which can be crucial for financial planning and forecasting. Flat-rate pricing may not cater to varying usage levels or customer needs, potentially leading to undercharging high-usage customers and overcharging low-usage ones. Particularly effective for businesses with a homogeneous user base and predictable usage patterns, flat-rate pricing simplifies marketing and sales efforts as the pricing is straightforward and easy to communicate. Ensuring the flat rate covers the cost of providing the service to high-usage customers is essential for maintaining profitability.
Tiered Pricing	Tiered pricing offers multiple subscription packages at different price points, each with varying levels of features and functionalities. The tiered pricing model allows businesses to cater to different customer segments and usage levels, providing a tailored experience for a diverse customer base. Customers can choose a plan that best fits their needs and budget, which can enhance customer satisfaction and retention. Opportunities for upselling arise as customers may upgrade to higher tiers over time, increasing the customer lifetime value (CLV). Businesses can use tiered pricing to segment their market and target different customer groups with tailored offerings. Higher revenues can be driven by encouraging customers to move to higher-priced tiers as their needs grow (and reduce churn). Effective tiered pricing requires a deep understanding of customer needs and behaviors to design tiers that provide clear value differentiation.
Per-User (or Per-Seat)	Per-user or per-seat pricing charges based on the number of users or seats that require access to the service. Per-user or per-seat pricing is commonly used by businesses that need to provide access to multiple individuals within an organization, such as in SaaS applications. The per-user or per-seat pricing model scales with the size of the customer’s team, making the pricing structure flexible and cost-effective for growing businesses. However, per-user or per-seat pricing may become expensive for larger organizations, potentially leading to customer churn if not managed properly. Ideal for B2B SaaS companies where the value of the product increases with the number of users, per-user or per-seat pricing aligns the cost with the size of the customer’s organization, making the pricing model scalable. Careful management of pricing is necessary to avoid alienating larger customers who might seek more cost-effective alternatives.
Usage-Based Pricing	Usage-based pricing, also known as pay-as-you-go or metered pricing, charges customers based on their actual usage of the product or service. The usage-based pricing model is flexible and scalable, making the pricing structure suitable for services where usage can vary significantly, such as cloud computing and telecommunications. Customers appreciate paying only for what they use, which can be cost-effective and fair. Precise tracking is required, however, so usage-based pricing can lead to unpredictable revenue streams for businesses, making financial planning more challenging. Highly attractive to customers with fluctuating usage patterns, usage-based pricing aligns costs with actual usage. The uptick in new customer acquisitions stem from lowering of the initial cost barrier. Investing in robust usage tracking and billing systems is required for managing usage-based pricing effectively and ensuring accurate revenue recognition, which can be costly.
Freemium Model	The freemium model offers a basic version of the product for free, with the option to upgrade to a premium version that includes additional features. Offering a free version helps in acquiring a large user base and converting a subset of users to paying customers, which can be an effective customer acquisition strategy. The freemium model lowers the barrier to entry, allowing users to experience the product before committing financially. However, the freemium model relies on a small percentage of users upgrading to cover the costs of free users, which can be risky if the conversion rate is low. The freemium strategy tends to be most effective for products with a low marginal cost of serving additional users. The freemium model can drive rapid user base growth and create network effects, if implemented well. Balancing the free and premium features is crucial to ensure the free offering is compelling enough to attract users, while the premium features are attractive enough to convert users to paying customers.
Per-Added-Module	Per-added-module pricing requires customers to pay a base fee for the core product and additional fees for extra modules or features they choose to add. The per-added-module pricing approach allows for customization based on individual needs and can increase customer satisfaction by providing a tailored solution. Per-added-module pricing provides a way for businesses to monetize additional features and functionalities, potentially increasing revenue. However, per-added-module pricing can complicate the pricing structure and may require more effort in sales and customer support to explain and manage. Offering a base product at a lower entry price and monetizing additional features as customers’ needs evolve can drive higher customer lifetime value by enabling upselling. Ensuring that the added modules provide significant value to justify the additional cost is necessary to avoid customer dissatisfaction (i.e. misalignment).

How to Analyze Effectiveness of Subscription Pricing Model

To maximize the generation of recurring revenue, a SaaS company must strive to improve its customer acquisition strategies, as well as its customer retention strategies.

The effectiveness of the growth strategies employed will be reflected by an increase in the number of new customers, as well as an increase in the amount of MRR that is generated from existing customers who upgrade their subscription plan.

The underlying components of the monthly recurring revenue (MRR) metric can be broken into the following pieces:

MRR Component	Description
New MRR	The MRR that is generated from the acquisition of new customers who sign up for the product (i.e. conversion into paying customer).
Expansion MRR	The MRR that is generated from existing customers who upgrade their subscription plan (i.e. upselling, cross-selling, product bundling, Upgrades to higher tier plan, etc.).
Churned MRR	The MRR lost from existing customers who cancel their subscription plan (i.e. the outright discontinuation of paying customers or non-renewal).
Contraction MRR	The MRR lost from existing customers who downgrade their subscription plan (i.e. change to tier with lower pricing).

By understanding each component of recurring revenue, businesses can implement strategies to optimize each revenue driver, which is critical to the long-term viability of the business model.

The net revenue retention (NRR) is calculated as the beginning MRR plus expansion MRR minus churned and contraction MRR, which is then divided by the beginning MRR.

Net Revenue Retention (NRR) = (Beginning MRR + Expansion MRR − Churned MRR − Contraction MRR) ÷ Beginning MRR

On the other hand, the effectiveness of the customer retention strategies employed will be reflected by a decrease in the amount of MRR that is lost from existing customers who churned or canceled their subscription plan.

The concept of churn, or “attrition”, can be analyzed on the basis of customers, or MRR.

The customer churn rate is calculated by dividing the number of lost customers by the total number of customers as of the start of the period, expressed as a percentage.

Churn Rate (%) = Churned Customers ÷ Beginning Customers

The retention rate is calculated as the difference between the number of ending customers and new customers, divided by the number of beginning customers.

Retention Rate (%) = (Ending Customers – New Customers) ÷ Beginning Customers

The churn rate, or attrition rate, is the inverse of the retention rate, so the churn rate can be computed by subtracting the retention rate from one.

Churn Rate (%) = 1 – Retention Rate

If analyzing churn on the basis of revenue, the gross revenue churn and net revenue churn are the standard metrics.

The gross revenue churn is calculated by dividing the churned MRR by the beginning MRR for a given period.

Gross Revenue Churn (%) = Churned MRR ÷ Beginning MRR

The net revenue churn, however, subtracts the expansion MRR from the churned MRR, which is then divided by the beginning MRR.

Net Revenue Churn (%) = (Churned MRR – Expansion MRR) ÷ Beginning MRR

The latter is considered to be the more practical method of measuring revenue churn, since expansion revenue—which offsets churned revenue—is considered.

How to Analyze LTV/CAC Ratio in SaaS Business Model

The LTV/CAC ratio—or LTV to CAC ratio—is a fundamental KPI for SaaS and subscription-based companies used to measure the estimated value retrieved from a customer on average relative to the cost incurred to acquire said customer.

The formula to calculate the LTV/CAC ratio divides the lifetime value (LTV) by the customer acquisition cost (CAC).

LTV/CAC Ratio = Lifetime Value (LTV) ÷ Customer Acquisition Cost (CAC)

Generally speaking, the target benchmark for the LTV/CAC ratio is 3.0x in the SaaS industry.

The most practical insights can be retrieved by identifying the underlying drivers that are causing customers to churn (or remain a customer), and applying adjustments to improve the LTV:CAC ratio.

By comparing the lifetime value (LTV) to the customer acquisition cost (CAC), the LTV/CAC ratio answers, “Is the SaaS company’s current customer acquisition strategies sustainable?”

The retention rate is an integral part of a SaaS company’s business model, as the metric reflects a company’s capacity to achieve long-term, sustainable growth.

Therefore, the churn rate and retention rate are two sides of the same coin, but the former flags potential issues to fix (or in need of improvement), whereas the latter offers insights that pertain to the effectiveness of delivering sufficient value to the end-user.

Based on the information obtained via analyzing a company’s historical churn and retention rate, management must alter its business model if deemed necessary (i.e. continuous improvement).

From a high-level, the two concepts—the churn rate and retention rate—form the basis of the LTV/CAC ratio, which can be analyzed in-depth to understand the economic viability of a particular SaaS business and its pricing model.