The CFO’s Guide to Subscription Proration

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Since customer success is the linchpin to any subscription business, nailing your proration model should be at the top of your priority list — because customers expect to pay “in proportion” to how they’re using your product and the value they’re receiving from it. Zuora got the lowdown on how to create a winning proration strategy from a pro: Neal McAtee, CFO of WorthPoint, the largest online resource for figuring out how much an antique, piece of art, or collectible you own—or want to buy—is worth.

What Is Proration?

First, a level-set. Proration is the system that allows a customer to change their subscription whenever they want without them being penalized and without wrecking your accounting systems.

So for example, if they’ve paid their monthly $10 fee for a newspaper subscription on June 1 and they cancel on June 15, they’ll get $5 back. Prorating makes things fair, both for your business and for your customers. And most importantly: fair feels like a win for customers, so they’ll be more likely to upgrade, resubscribe later, or recommend your business to a friend.

Proration and Usage Billing

That’s why it’s so crucial to align your usage charges based on how your customers are consuming a product across the lifecycle. Usage can vary wildly. You can have customers signing up mid month. You have upsell and downsells. And of course, you have the inevitable cancellations. So you need a system that can handle everything before you send out the first invoice.

As you’re probably well aware, the math on proration is usually way more complicated than the example we provided above. Multiply that complexity by thousands—or millions—of subscribers and you can see that things get tricky fast. And, given the growth of the subscription economy, auditors are now demanding more precise revenue recognition policies than ever.

WorthPoint learned the hard, expensive way just how important this all is. “When we shifted from an ad model to a subscription model back in 2008, there really weren’t any good billing systems out there,” McAtee says. “We used an internal billing system and by 2013, almost 100% of our IT budget was going to maintaining the system. If you’re spending 100% of your money on a billing system, then you don’t have any money left over to invest in your core business. We had to find a different way.”

It wasn’t easy. Their first foray into an automated billing system failed, and 40% of their customers disappeared overnight. Poof. “We seriously almost lost the company,” McAtee says. “I joked that at least their reporting was good enough to tell us they were putting us out of business.”

WorthPoint now has what McAtee says is a “very simplistic” billing model. They sell both monthly and (discounted) annual subscriptions to their database. They bill about $350,000 a month, and their post billings for the last few months have been anywhere from three to six percent.

The Proration Daisy Chain

In subscription businesses, it’s common for one business process to affect another and another and another — as you can see by WorthPoint’s experience, with proration. That’s why it’s so important to consider both billing and revenue recognition processes when you’re setting up your proration strategy.

“If you don’t get the proration right, you can have all kinds of problems besides just the legal and the accounting issues,” says McAtee.

“For example, if you bill somebody for an annual subscription, you can’t recognize all that revenue today; you have to recognize it over the next 12 months. Problems you’d much rather avoid ensue when you don’t recognize your revenue in the right period. And if you’re also selling a package—say, hardware and software—the hardware will have one recognized period and the software will have a different one. It’s not a simple process of taking that invoice and spreading it over a consistent period.”

6 Tips for Proration

Here’s what McAtee has learned about proration in his time as CFO of “the Kelly Blue Book of antiques and collectables.”

1. Be transparent. You need to be clear and unambiguous about how you prorate your charges so it’s fair to your business and to your customers. You want to make sure your invoices always match your requirements and that your customers understand exactly what they’re being billed for. Transparency isn’t just the right thing to do; it’s good for business. In a recent study by Label Insight, 94 percent of consumers surveyed said they were more likely to be loyal to a company that has transparent business practices.

2. Stay ahead of customer demand. You’ve got to be out in front of where your customers are so that when your company dreams up some type of change to meet demand, you can tell your product dev team, “No problem, we’ve got a system that can properly bill people and keep us in compliance.” This means you need a backend system that can evolve as quickly and gracefully as you do. The last thing you want is for your finance team to hold back growth due to back-office challenges.

3. Track proration’s effect on revenue and recognize revenue appropriately. Be mindful of the dates you’re entering when you’re creating that subscription so you’re accurately capturing how proration affects revenue.

Once you get the cash in house, then you’ve got to make sure you’re recognizing the revenue in the appropriate way. In the subscription business model, products and services are rendered over time, at various junctures, and the amount of revenue you get to recognize for each product or service you provide requires complex math and compliance with a very lengthy set of rules.

“We just let Zuora do it for us,” says McAtee. “That way when I’m on an airplane without internet and land in San Francisco, I can then go out and enjoy the beautiful weather instead of sitting in a hotel room doing pivot tables.”

When you’re trying to woo investors, you might be tempted to claim all that subscription revenue even though you haven’t delivered the product yet. “The last thing you want to do when you’re raising money is to go back and have to restate your revenue,” says McAtee. “That scares me to death.” Not to mention the problems that incorrectly recognizing revenue could cause for a public company…

And it’s not just about today’s compliance requirements; it’s about tomorrow’s growth opportunities; automation is what will help you recognize revenue appropriately and set you up for success.

4. Mind collections. Collections for subscription businesses can be complicated and painful. You have more invoices, more payment methods, more reasons payments fail, and many more ways to respond. By having modern payment technologies and a proration strategy in place, you’ll maximize automation of — and efficiency for — salvaging failed payments.

5. Review billing settings. Review your billing settings based on your business requirements and use either an assumed 30 days in a month or use the actual number of days. Whatever you choose, stick with it to keep things running smoothly. But remember our revenue recognition tip from above: make sure whatever settings you choose, your revenue recognition model is synced up with it.

6. Figure out your refund policy. If you bill monthly, when people cancel or downgrade their plan in the middle of a monthly billing cycle, almost all of them will expect to have access to your product until the end of the cycle rather than get a refund. That leaves more money in the bank for you and keeps 99% of your users happy. For the 1% who complain, you can always choose to ignore your policy and issue them a refund.

Quarterly or annual billing usually demands a refund policy that makes customers feel like they’re being treated fairly.

“On our monthly subscriptions, we’ll either refund all of it or none of it,” says McAtee. “Then on quarterly and annually, we prorate. Our chargebacks are less than one half of one percent; we have a pretty good reputation.”

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