Why are so many high-growth subscription companies currently unprofitable? The answer is quite simple: the revenue acquisition expenses are front-loaded, but the recurring subscription revenue stream comes over the life of the customer.
The high revenue acquisition costs to grow a subscription business often exceeds the profits from the recurring revenue stream, and as a result the company loses money.
The faster the subscription company grows, the greater the ratio of revenue acquisition costs to profits from existing subscriptions, resulting in GAAP losses. But GAAP doesn’t consider the value of future revenue generated by subscription growth! Dave Key
As the company grows, they have a larger base of existing customers to pay for new customers. If the company values profits over growth, they can reduce the money they spend on revenue acquisition relative to their recurring profits, and then become profitable.
As a subscription business, you have to decide between investing in growth,or pocketing the margins from the existing customer’s subscription revenue stream. To accurately assess that trade off you need to look at two metrics, Growth Efficiency Index and Recurring Profit Margin.
Growth Efficiency Index
The cost of growing the subscription business is called the Growth Efficiency Index, or GEI. Lets say you spend $1 on sales and marketing. How many new recurring revenue dollars does that buy you? That’s your Growth Efficiency index.
More formally, GEI is the Revenue Acquisition Costs (RAC) of an additional dollar of Annual Contract Value (ACV) of the subscription revenue (the ACV is the subscription revenue run rate at an instant in time).
Efficient subscription companies target a GEI of less than one, though initially the cost of new sales may be higher, as the company invests in acquiring strategic customers whose revenue (and profits) won’t build until later years.
Note that the greater the GEI, the less efficient the company is at actually growing their sales – just the opposite of what you expect! A low GEI means for the same number of dollars you’ll generate more sales, and that’s a good thing.
Recurring Profit Margin
Your Recurring Profit Margin is simply the difference between your recurring revenues and your recurring costs. Leveraging this metric is critical. Why? The higher the recurring costs, the less money you have to play with — aka, book as profits or invest in one-time growth expenses.
It’s the Recurring Profit Margin that funds growth. If you spend less than the RPM, you’ll grow less and be profitable. If you spend more than the RPM, you’ll grow more and lose money. But it’s your GEI that tells you how much you will actually grow.
Break Even Growth Rate
So how are these two metrics related?
They can be used to determine your company’s break-even run rate.
The formula is really quite simple:
For example, let’s say you have a recurring profit margin of $100,000 a year, and your GEI is 1.25 (for a subscription-based company this would be considered at the high range of acceptable GEIs).
Your break even growth rate is 100,000 / 1.25 or $80,000 a year.
But let’s say you have the same recurring profit margin but a much more healthy GEI of 0.75.
In that case your break even growth rate is $133,333 a year.
So with a GEI of .75 you’ll be able spend $133,333 a year and still grow, while with a GEI of 1.25 you’ll only be able to spend $80K a year. In both cases you are “investing” $100K in growth, but with a lower GEI, you’ll be able to grow more for the same investment.
As long as your subscription company has a positive recurring profit margin, it can choose between growth and profitability. Grow faster than the break even growth rate, and lose money, or grow slower and make money. History shows that growing companies are more successful, particularly in the fast moving Subscription Economy.
How fast should a subscription business prudently grow? Dave Key
The subscription company should prioritize growth as long as the ROI on the revenue acquisition expenses relative to the net present value of the subscription revenue stream supports the operational expenses of the company. The company should expand as long as cash is available.
Early in the life of a company, the ROI may be less favorable until critical mass is achieved. If the company can prudently forecast a favorable ROI on its revenue acquisition costs, it should still consider prioritizing growth over profits. Until the company can prudently forecast a favorable future ROI, it should invest cautiously in growth.
The company will become profitable when the recurring profits are greater than the costs to grow the company’s subscription revenue. That requires either achieving very good sales and operational efficiency, or slowing down the growth rate.
The prime financial goal of management is to maximize shareholder value, more than maximizing near-term GAAP profits. To the extent that the company can fund growth and can grow efficiently, the subscription company should accept the loss to achieve high growth. The company still must demonstrate that it can be profitable once growth subsides by demonstrating a strong Recurring Profit Margin – the calculated profits of the company without growth.
Growth trumps profit, as long as expenses are justified by the level of growth.
That means that the ROI on the Revenue Acquisition Costs are favorable and Recurring Profit Margins which fund growth are trending to the 20% to 30% range. Both factors will improve as the company achieves economies of scale while it grows and gains more revenue from its installed base with a “Land and Expand” strategy.
If you have the market opportunity to grow efficiently, it’s in the interest of the company to step on the gas. Profits will come when growth slows, but grow fast as long as possible.