Pricing for Net Dollar Retention (NDR)
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talent.
The times they are a changing.
Over the past few months, we have seen a significant shift in what Ibbaka’s customers are looking to optimize. Ibbaka helps a lot of companies to design their pricing model, connect pricing to value and then to support execution. A new pricing model, better aligned with strategy, is a very good thing. It is even better if you can execute on it.
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The 1st step in the Ibbaka process is to make sure that internal stakeholders are aligned on the goals for the new pricing model. We use Roger Martin’s strategic choice cascade to do this (we have adapted it for pricing). We even have a menu of possible strategic goals that we use to frame these conversations and get people to alignment on pricing strategy.
Through most of 2020 and 2021, the most common goals were as follows:
Recurring Revenue Growth
Aggregate Lifetime Customer Value (LTV)
Category Creation
It is worth noting that one of the most common goals emphasized by many pricing experts does not show up: margin improvements. There are 2 reasons for this. Ibbaka works mostly with companies that already have high margin businesses, in general our customers deliver products and services with gross profit margins of 50% to 70%. The 2nd has to do with growth drivers. As Jeff Robinson has covered in his excellent book, “Price for Growth,” gross margin is only 1 of 5 inputs to company valuation.
Note that 3 of these are related to the net revenue growth rate: the new customer revenue growth rate, the existing customer revenue growth rate and the revenue churn rate. One is a measure of future risk, the present value discount rate. Only one, and in fact not the most important, is based on profit.
In 2022 we have been seeing a change to this. More and more of our customers have been asking us how to design packaging and pricing to reduce churn and to increase net dollar retention (NDR). Here are the Top 3 Pricing Design Goals in 2022.
Net Dollar Retention
Revenue Churn
Category Creation
It is worth noting that Net Dollar Retention (NDR) is the combination of the Existing Customer Growth Rate and the Revenue Churn Rate.
What is behind this change in pricing goals?
It is too early to say if this will be a persistent shift. There are many unusual things happening at present.
Global economies believe, or want to believe, that they are emerging from the Covid Pandemic.
Inflation and higher interest rates are resetting expectations and assumptions (see Pricing and inflation - how to respond).
Russia’s invasion of Ukraine has led to political uncertainty
Energy prices are sharply higher and security of supply for energy and other inputs has become an issue
Supply chain problems are leading many companies to rethink their value chains and how to manage them
These boil down to 2 things. Our customer’s customers are being hit with increased risks and increased costs. Increased risks drive up the discount rate. This makes everyone more focused on the short term and their current customers. One cannot afford to lose current customers when buyers have become cautious.
There is also a great deal of tension between inflation and cost pressures. Inflation means that many buyers are expecting some level of price increase to account for inflation, but at the same time they are becoming more and more price conscious.
Pricing for net dollar retention
How does one design a pricing model to improve net dollar retention? One needs to look at both factors:
Increasing sales to current clients
Reducing churn
Improving on each of these requires an understanding of value.
Pricing is not the first lever to use here. The first thing to do is to take a step back and look at the entire value cycle and how it plays out across the customer value journey.
Begin by making sure you understand how value is being created for different customer segments. Ibbaka uses value-based market segmentation and customer targeting to do this. A good value-based market segment is a group of prospective customers that get value in the same way and who buy in the same way. Discovering market structure means understanding how value is created for different types of customer.
Once you understand what value customers care about you can begin to communicate that value and, using a free or trial version, begin to deliver value. Value delivery should lead to value documentation. With value created, communicated, delivered and documented you are ready to capture value.
In the first sale, these steps are often abbreviated, and the buyer has to rely on promises, claims and external evidence. This is not the case for upsell and renewal. In upsell and renewal work the customer has experience working with you and knows your solution and what it can deliver. To reduce churn and drive upsell one must do five things.
Reduce time to value
Align value delivery and value capture
Document the value being delivered
Package to improve retention (reduce churn)
Reduce time to value
One reason companies churn is that they sign up for a subscription then find themselves waiting, and waiting, before they see value. This sours them on the experience early on and it can be hard to recover. First impressions are often lasting.
So your solution has to have at least some value paths that deliver value very quickly. Preferably on the very first session. One generally can’t do that for all value paths, but one can design in a shorter time to value.
Align value delivery and value capture
Building on the time to value concerns, there can be a disconnect between when people pay and when they get value. This is the main reason for the current interest in usage-based pricing. Assuming that usage and value are correlated (not always the case when the usage-based pricing is poorly designed) then usage based pricing can help to align value delivery and value capture.
Use the customer value journey to understand where there may be gaps between value delivery and value capture (and sometimes this may uncover opportunities to bring forward revenue).
See Value paths guide the customer journey
Document the value being delivered
Most companies do a poor job in actually documenting value delivery. A lot of energy is put into value creation, communication and delivery, especially during the sales process, but there is almost no effort put into documenting what value is actually being delivered. This leads to a scramble just before renewal to find that evidence and communicate it.
A better approach is to build value documentation into the customer success process, so that value documentation is an ongoing activity.
The Ibbaka Value Pricing Dashboard is designed to be a place where value delivery can be documented.
Package to improve retention (reduce churn)
In the case of companies that offer multiple packages or combine packages with value-added services it is critical to avoid creating packages that do not include critical services or functionality. Making the functionality that drives value and correlates to renewals optional is a very risky move.
Make sure that you know what combinations of functionality and what usage patterns correlate with renewal. Then design packages, bundles and pricing that encourages the adoption of bundles that correlate with renewals. This may include discounts for the pieces of your offer that drive renewals, but discounting should be used with caution. Discounts can undermine value propositions.
Is there a role for direct pricing action?
Yes.
There are several pricing actions to consider.
Align value capture (when you get paid) with value delivery (and document the value being delivered)
Introduce a usage based pricing metric that helps align value capture with value delivery
Usage based pricing is not an all or nothing proposition, in most cases you will want a hybrid of predictable subscriptions and usage based pricing; see Usage based pricing - a complement and not a substitutePrice to encourage use of functions and services that correlate with renewal and net dollar retention
The third point needs some expansion. One can use time series analysis of usage patterns to identify the combinations of functionality and use that predict net dollar retention. One then needs to design packages and bundles that ensure that the combinations associated with renewal are being sold. Pricing needs to support sales and adoptions of these packages and where necessary provide incentives.
Pricing needs to be a holistic discipline. Base pricing strategy, tactics and the design of pricing models on an understanding of how value and pricing interact along the customer value journey. Make sure that you do not treat pricing as a zero-sum game, where what the buyer wins is taken away from the seller. See How to negotiate price - getting to positive sum pricing
Read other posts on usage based pricing
How to get ready for usage based pricing
Pricing under uncertainty and the need for usage-based pricing
Enabling Usage-Based Pricing - Interview with Adam Howatson of LogiSense
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