This definition is an extension of one of the simplest statements we’ve come across for what a revenue model is. ‘A presentation
’ from the Centre of Innovation and Entrepreneurship at Carnegie Mellon states:‘A revenue model is how a business makes money.’ And at the heart of it, that’s all it is.
Of course it gets steadily more intricate as you delve into the models themselves, but understanding the basics is a good foundation to begin your pricing journey. It’s going to be a long, but hopefully rewarding one.
The Five Basic Types of Recurring Revenue Models
- Usage-based billing: Customers are billed for their usage on a regular schedule.
A good example of this kind of recurring revenue model is Zapier. Their prices scale based on how much you automate from $0 to $250 a month (Data from December 2017).
Pros: Saves the customer money when there’s irregular usage. It’s good value for low to mid-volume users.
Cons: Unpredictable revenue for the business because of customer usage fluctuations, and unpredictable and surprising costs for customers. It may not provide good value for high volume customers.
Who it works for: Usage based models work best for businesses that can easily track usage whether it’s the number of emails/messages/invoices sent, APIs used or triggers activated.
- User-based billing: Teams pay for the number of ‘seats’ or people using the product every month or year. A good example here is Atlassian, that charges $7 a month per user for teams with more than 10 people.
Pros: More predictable revenue and scales well for large/enterprise teams. There’s no need to track usage.
Cons: May serve as a barrier for economical teams who will limit number of seats to control costs. It doesn’t always align with product value, in which case you’ll be leaving money on the table. For instance, a customer may end up paying for users who aren’t active. Slack addresses this issue by adding prorated credits for users who have become inactive in a billing cycle, and only charging for active use.
Who it works for: User-based billing works optimally for team collaboration or customer service tools.
- Tiered billing: This pricing structure is built in ‘tiers’. Each tier is constructed for a specific buyer persona and is capped off in price. Once a user hits a ceiling on a particular tier, they are upgraded to the next tier offering more functionality or usage. A popular example is Hubspot with its Basic, Pro & Enterprise tiers.
Pros: It allows you to appeal to a wide range of users and their specific needs, so there’s something for everyone. It also helps businesses understand where customers see the most value.
Cons: ‘Something for everyone’ is not always a good bet, because it has the potential to become sprawling and complicated very quickly.
Who it works for: It’s most commonly used by businesses offering sales or marketing products.
- Hybrid Billing: This model takes a mixed approach, choosing aspects of two or more revenue models. Eg: Both Zapier and Atlassian have hybrid pricing, where hitting specific usage levels or number of users will require you to upgrade to the next tiered plan.
Pros: It’s a flexible way to structure pricing — it allows businesses to overcome the disadvantages of a single model by bringing more nuanced pricing that’s aligned with value.
Cons: It may bring in more complexity, so businesses need to take additional effort to keep their hybrid models simple enough for everyone to grasp.
Who it works for: SaaS businesses where the value customers get from the product/service doesn’t clearly fit into any one model.
- Freemium: Freemium offers a lifetime free plan with a premium upgrade to convert free customers into paying customers. Evernote, Dropbox, Buffer all offer a freemium model.
Pros: Low barrier to entry. It’s relatively easier and quicker to acquire a sizeable customer base.
Cons: If businesses don’t think it through, they could easily run at a loss servicing new customers and find themselves unable to give paying customers the time and attention they need. It could also attract the wrong kind of customers who see the most value in the ‘free’ part of your freemium model.
Who it works for: It works well for businesses where the cost of servicing new customers on a free plan is low and the potential to convert them into paying customers within a certain period of time is reasonably high.
Building a Recurring Revenue Model Based on Value
The end game of figuring out the right recurring revenue model is to facilitate a fair exchange of value between a business and its customers.
Many businesses unknowingly charge lower than they can. The other side of the spectrum is charging too much for something, which will lead to obvious results. Customers will use the product for a few months and when the price and value don’t match — they churn and find other solutions in the competitive SaaS market.
The best path to knowing if a fair exchange is happening, is to identify and align your recurring revenue model with a value metric. It will enable you to price your offerings optimally for you and your customers, resulting in a win-win for both in terms of growth.