In this guide we’ll be covering the primary appeal of recurring revenue-based business models from an investor’s perspective. We’ll look at a number of favorite Wall Street arguments in favor of subscriptions. Let’s start with predicability.
To investors, the primary appeal of recurring revenue models is the value of predictable recurring revenue, particularly in comparison to one-time transactions. For example, a $20 million dollar company with eighty percent recurring revenue can count on sixteen million dollars at the beginning of every year. That figure is stable and predictable. Management can plan and invest accordingly.
The same cannot be said of a $20 million dollar business with no recurring revenue. That company has to start the year at zero. Of course it can make some predictions based on past performance, but it doesn’t have a contractually obligated revenue stream to base ambitious expansion plans around.
Smart subscription businesses look at something called ARR, which stands for Annual Recurring Revenue, and consists of the subscription revenue from customers for an ongoing service. To get at ARR, subscription businesses take the value of their subscription contracts, normalize it to an annual amount, and add it all up. For a subscription business, more so than cash or revenue, ARR is the true indicator of your company’s health. You can start every year with a very predictable amount of future revenue.
In addition, a healthy subscription-based business benefits from excellent customer retention and robust customer insight for cross-selling or marketing. And relative to other retail models, recurring revenue models tend to be much easier to operate in terms of pricing. Most companies that use subscriptions only need to manage a few pricing tiers, rather than individually pricing an array of products.
All of these tools reinforce predictability. Stock valuations are forward-looking predictions, and subscriptions are forward-looking revenue models. It’s no wonder that Gartner predicts that by 2015, 35% of Global 2000 companies with non-media digital products will generate up to 10% of their revenue from recurring models.
When you have a recurring revenue business model, you rarely miss your monthly or quarterly numbers by more than 10-20%. Your forecasting process is much more accurate. At the beginning of the quarter, you start with a base to grow from rather than begin at zero. In a SaaS or subscription software business, you can predict your churn rate and new business closings to determine your growth rate. The management team and the investors are thus rarely surprised by major fluctuations in your results. Venture Capitalist Jeff Bussgang
Having a predictable revenue stream allows subscription-based businesses to invest aggressively in growth, particularly in kinetic market conditions with multiple players.
All companies are vulnerable to disruption. There is no such thing as a permanently established incumbent, particularly in a wildly disruptive industry like IT, where a majority of the top 25 enterprise companies are not predicted to be around in 20 years.
That being said, legacy product vendors have an advantage in their resources, customers and partners. It takes a an aggressive, disruptive approach to capture their customers. Subscription-based businesses provide that disruption with lower up-front costs, greater flexibility, intuitive delivery mechanisms and a keen ongoing sense of their customers’ needs and wants.
That’s why the median growth for SaaS subscription companies is over three times that of traditional enterprise software companies (see below). Those companies are growing rapidly at the expense of the incumbents.
Companies like Workday, Adobe, Box and Zendesk have proven that when managed well, a subscription-based platform is a healthy and financially attractive model that has disrupted some of the most established industries across the globe.
Predictability and visibility means you can manage your expenses more precisely relative to your revenue. One of the hard things about lumpy revenue models is that until literally midnight on the last day of the quarter, you don’t know how you did. Which means it is hard to ramp up or down expenses smoothly to match revenues. Ramping expenses up and down is a sticky process because it usually involves people and there are many friction points, delays and costs as well as externalities (such as morale) when you try to rapidly ramp down expenses in a quarter as a result of lower-than-anticipated revenue. Venture Capitalist Jeff Bussgang
Recurring revenue models have much better future visibility and therefore much easier expense management. They’ve also resulted in much more visibility into the consumer.
As companies have had to pivot from selling products to managing services, and services require huge amounts of customer engagement. Product metrics like units, margins, and inventory have been replaced by relationship metrics like renewals, upsells, and churn.
In other words, companies are less concerned about the number of units shipped than the successful outcomes they deliver to each and every one of their customers.
Investors value the fact that subscription businesses almost always require less effort for their implementation – reducing both the cost and the “time to value” for the customer. They also understand that a successful subscription-based business is by definition one that has keen insight into the needs of its customers.
It’s one thing to acknowledge that customer success is important, but it’s another to orient and define your company around it. This isn’t about surveys and thank you calls – smart recurring revenue-based businesses build their entire corporate DNA around ongoing customer outreach and a laser-like attention to customer usage patterns.
Of course a healthy operating profit is the main goal of any successful enterprise, but it’s actually very poor indicator of the value of a growing subscription-based business.
In fact, many of today’s more sophisticated investors would punish a subscription business that brought its operating profit to the bottom line, seeing it as a signal that the company cutting sales and marketing spending because it can’t efficiently acquire new bookings.
Wall Street now understands how to assess subscription finances beyond simple income statements. Investors are starting to look beyond the widget-based financial analysis to assess subscription vendor’s financial strength.
More and more, they are look at the value of the future revenue stream not included in GAAP statements to assess the financial prospects of subscription vendors. That being said, there is still a surprising amount of misunderstanding about subscription models from the investment community. And as in most misunderstandings, the problem stems from a lack of visibility.
The metrics that matter most to subscription businesses, like annual recurring revenue, churn, recurring profit margin and growth efficiency index, don’t even show up on traditional public income statements. But according to many traditional investors, revenue is revenue. They see subscription-based businesses as selling the same product for a fraction of the price and taking on considerable more risk of client flight.
It takes an enterprise company an average of two to three years to recoup the cost of a one-time sale on a subscription model. Product vendors that shift to subscription have less initial cash flows, and first quarterly report after this transition will reflect that.
We were really trapped inside the box that we shipped—both literally and figuratively. David Wadhwani, Adobe
Let’s take a look at what happened to Adobe when it made a broad, systemic shift to a subscription-based model. Adobe transitioned its Creative Cloud Suite to a subscription model in May of 2013.
“We were really trapped inside the box that we shipped—both literally and figuratively,” said David Wadhwani, SVP and GM of Adobe’s digital media division.
At least initially, market did not receive the news well. There was some debate as to whether the company should halt trading. But despite an 8% decline of overall revenue (but with a near doubling of subscription revenue) Adobe stock soared 55% in 2013.
Today the company says 20% of its customers that are purchasing the updated online tools weren’t Adobe customers before the switch. Piracy is down, and now it can can more accurately track how customers are using its products and constantly push updates to individual users. Microsoft is seeing similarly successful results with its transition of Office 365 to a monthly subscription.
Of course, companies don’t need to go all in on recurring revenue – they can experiment with various markets and product lines. Outside of relatively recent SaaS companies, most established companies are developing a hybrid approach to recurring revenue.
You can always test new models out on specific audiences. That’s part of the magic of recurring revenue.