Subscription Finance: Key Concepts Explained
What is Subscription Finance?
Subscription finance is a specialized discipline focusing on the financial dynamics of subscription-based business models. Subscription-based business models are becoming increasingly popular across various industries due to their ability to generate recurring revenue streams.
Here are some examples of subscription-based business models:
Streaming services like Netflix, Spotify, and Hulu offer monthly subscription plans that grant users access to a wide range of content.
Meal kit delivery services like Blue Apron and HelloFresh provide subscribers with pre-portioned ingredients and recipes on a weekly or monthly basis.
Subscription boxes, such as Birchbox and FabFitFun, offer curated products and samples delivered to subscribers’ doorsteps on a regular basis.
Online learning platforms like Coursera and Udemy offer subscription plans for individuals to access a vast library of courses and educational content.
Subscriptions are replacing the traditional product sales models, and are fundamentally changing the face of businesses, industries, and the job of the CFO in the process. CFOs long-accustomed to product-centric, single-purchase transaction businesses need to get smart on the shift to businesses built around long-term recurring revenue relationships that are becoming the hallmark of the 21st century.
The Subscription Economy is becoming pervasive for a variety of reasons. Customers are demanding a more flexible consumption model. General Managers have the flexibility to test pricing and bring new functionality to consumers at an accelerated pace. Executives are realizing this allows for a longer lasting relationship with their customers. And investors recognize that, if executed well, Subscription Economy companies have fantastic revenue and return models.
Traditional finance is broken
As a finance professional, if you haven’t already participated in the shift to subscription, you need to know that you will soon. When you do, you need to be aware of a critical difference: finance as you know it is broken. Double-entry bookkeeping – the cornerstone of accounting for 500 years – cannot capture the dynamic, ongoing revenue relationships that are the foundation for the subscription business model.
The fact is that a company with a subscription business model is fundamentally different than a product company.
For example:
You need to value one-time revenue very differently than recurring revenue.
You need to measure your business across multiple dimensions of time – not just the past, but the future as well.
You need to manage complex changes that can create chaos in downstream processes, such as mid-month subscription cancellations that can result in credits or refunds thereby impacting revenue recognition.
As a result, the shift to subscriptions can wreak havoc on finance departments that are not prepared to handle recurring revenue. Why? Because every accounting system in existence today – including ERP – was built around the rules of double-entry bookkeeping. That means your accounting system is still great as a general ledger, but nothing more than that.
CFOs and their teams are in pain because it takes longer for them to close the books. Many revenue teams are drowning in spreadsheets with a row for every customer – spreading revenue across a multitude of columns. This has forced some CFOs to maintain one set of GAAP books to please auditors and another to run their business.
On the executive side, CEO and board members demand insights into more than just balance sheets and income statements; they need insights into forward looking metrics, like ARR, Churn, and ACV.
The market is moving towards subscription businesses
Recognize that making this shift may not be by choice. Subscriptions are here to stay, and you need to adapt. Customers from all walks want more control over their relationships with vendors, brands and service providers. With widespread internet access and the proliferation of mobile devices and social networks, more and more customers are taking charge. The customers want you to serve them how, where and when they want. Will your company be ready?
The basic subscription finance equation
With subscriptions, your business strategy must now be focused around offering innovative services that breed long-term relationships. So instead of being about single, discrete sales it’s about monetizing and retaining relationships for a predictable recurring revenue.
But you’ll need to change the way you measure your business when you shift from the old world of chasing after each and every dollar to this new world of monetizing relationships. Here is the basic equation behind all subscription-based businesses:
ARRn + ACV – Churn = ARRn+1
ARR / MRR
Annual Recurring Revenue, or ARR (Monthly Recurring Revenue / MRR), is the amount of revenue you expect to repeat. It’s that simple. Note that this does not include one time revenue, it only includes revenues that recur. And with that said, ARR is different from revenue. Revenue is a backwards looking number while ARR is a forward looking number — emphasis on “Recurring” in ARR.
The problem? Well, your traditional financial statements only show revenue for a past period and have no concept of recurring, forward looking revenue. But for recurring revenue companies, because of ARR, they can actually start each fiscal year knowing what their revenues are going to be for that year. In the formula above, we call this Starting ARRn.
Churn
In its simplest sense, churn is the number (often noted in revenue) of subscribers who will not renew. Typically, downsells are also factored into your churn number. It’s a hard reality to swallow, but even if you’ve got the best service offering in the market, you’ll still have customers that leave you. So, in the formula you’ll need to subtract your churn from your ARR for the year.
ACV
Annual Contract Value (or ACV) is your new revenue brought in by new customers or customers upgrading or renewing their existing contract. You invest in sales and marketing to drive new revenue, because ultimately this increases your ARR.
If you add up all of these metrics, you not only have a complete financial picture of your subscription business, but you also have your recurring revenue for next year or your ending ARR.
So, by now you get the subscription business model. ARRn – Churn + ACV = ARRn+1, right? But how do the ERP financial systems you have in place today support a new model based on fostering and monetizing relationships?
But tracking recurring revenue is a forward-looking process. So, when it comes to tracking metrics for subscription businesses, traditional systems just can’t account for the whole picture. Sure, financial metrics like bookings, billings, cash and revenue were tracked in the old world of commerce, but they were backwards-looking and focused on one-time transactions. Let’s look into some of their limitations.
Key Elements of SaaS Subscription Finance
Understanding the SaaS subscription model is crucial for businesses in the subscription economy. Unlike traditional sales models, where customers make a one-time purchase, SaaS subscription models offer ongoing services or software access for a recurring fee. This model benefits both businesses and customers.
A key element in subscription finance is revenue recognition. In subscription-based businesses, revenue is recognized over the subscription duration rather than upfront. This presents unique challenges for financial management, as businesses need to accurately track and report revenue streams. Effective revenue recognition practices are essential to ensure compliance with accounting standards and provide transparency to stakeholders.
Challenges in SaaS subscription finance include managing customer churn, optimizing pricing strategies, and forecasting future revenue. Understanding the reasons behind churn and implementing strategies to minimize it is crucial. Optimizing pricing strategies is another critical aspect, as businesses need to balance attracting new customers and maximizing revenue. Forecasting future revenue helps businesses make informed decisions and plan for growth.
At Zuora, we understand the complexities of subscription finance and provide solutions to overcome these challenges. Our subscription management platform offers robust revenue recognition capabilities, allowing businesses to accurately track and report their revenue. With advanced analytics and forecasting tools, businesses can make data-driven decisions to optimize pricing strategies and predict future revenue. Additionally, our customer retention features help businesses reduce churn and enhance customer satisfaction. With Zuora, businesses can streamline their subscription finance operations and unlock the full potential of the subscription economy.
Subscriptions are about committed relationships
Recurring revenue is the output of a committed long-term customer relationship, where both the customer and the vendor hold up their part of the bargain. A committed relationship needs constant attention, whereas a one-time purchase is casual and transactional.
Thus, businesses need to account for recurring revenue differently from one-time revenue. But traditional financial systems don’t know how to differentiate between a one-time transaction and a recurring customer relationship, and so they tend to just lump the two together and treat them the same.
With subscriptions, relationships will evolve over time. Customer needs and wants will constantly change. Your relationship will have to evolve to service their needs and wants.
This means you need to be able to iterate on your pricing and packaging. And do it quickly — before your customer goes elsewhere. But this can result in quite a burden for the finance team. Every tweak to pricing or bundling can mean an entirely new SKU(or stock keeping unit) in your system, or make things very difficult if there are multiple time periods in play.
In fact, because traditional finance systems do not know how to spread a series of changing transactions over time, they limit you to simple debits and credits. And if your ‘system’ is a spreadsheet, well good luck tracking the business impact resulting from these changes — things like bookings, billings, cash and revenue – across multiple dimensions of time.
Decisions in relationships will have downstream effects
Don’t let yourself think that when a customer decides to cancel their subscription mid-month that it’s as simple as flipping a switch. Complex changes like this can create chaos in downstream processes and will have a direct impact on your revenue recognition. Especially if every notable change the customer makes is managed manually.
You need to be able to quickly adapt to changes in the relationship and automatically calculate how this will impact the account, as well as the business. But the core functions of old world financial systems are around tracking raw goods. They are not powerful rule engines. They are not smart enough to adapt to subscription changes in real-time, and re-calculate any schedules impacted by those changes.
Subscription finance industry trends
Subscription finance is a rapidly evolving industry witnessing several emerging trends and innovations. These trends are reshaping how businesses manage their subscription-based models and transforming various industries. Let’s explore some key trends and their impact on different sectors.
One of the emerging trends in subscription finance is integrating artificial intelligence (AI) and machine learning (ML) technologies. AI-powered algorithms analyze customer data, predict churn rates, and optimize pricing strategies. This enhances customer experiences, improves retention rates, and drives revenue growth.
Another significant trend is the rise of industry-specific subscription models. Companies in sectors like software-as-a-service (SaaS), media and entertainment, and healthcare are increasingly adopting subscription-based pricing to provide flexible and personalized offerings to their customers. This shift creates new revenue streams and enables businesses to build stronger customer relationships.
The impact of subscription finance extends beyond specific industries. It has revolutionized how organizations approach revenue recognition, financial planning, and forecasting. With recurring revenue becoming a prominent feature in many businesses, there is a need for robust financial systems that can handle complex billing, invoicing, and revenue management processes.
Looking into the future, subscription finance is expected to continue its rapid growth. As more industries recognize the benefits of subscription-based models, we can anticipate an increase in adoption across various sectors. Moreover, advancements in technology, such as blockchain and predictive analytics, will further enhance the capabilities of subscription finance, providing businesses with even greater insights and opportunities.