EVERY SMART SUBSCRIPTION BUSINESS I KNOW FOCUSES ON SOMETHING CALLED ARR, OR ANNUAL RECURRING REVENUE.
What is ARR? Simply put, it is the amount of revenue that you expect your install base to repeat every year. It is the revenue that recurs, as opposed to the revenue that gets booked only once. Every quarter, subscription businesses look at how much their ARR has grown, using the following formula:
Based on this formula, we constructed a subscription economy income statement, one that better reflects how we think about the business. But first, to compare/contrast, here’s a typical income statement that they teach in any Business 101 class (in $ millions):
Pretty straightforward, right? This says you sold one or more units of a product at a total sale of $100 million. The income statement brings out the fundamental costs that went into that unit. There are four of them:
- How much it took to make that unit (cost of goods sold), including the raw materials, production costs, etc.
- How much it took to sell that unit (e.g., commissions to salespeople, money for the channel).
- How much R&D the company is spending to create the current unit.
- And, finally, how much overhead (e.g., finance, HR, executives) management needed to run the company.
As you can see, some of these costs are fixed, like how much R&D you need, so the more units you sell, the lower your per unit cost. That’s why they call the people who keep track of all of this “accountants” — it’s their job to account for all the costs that go into making the unit of sale. Congrats, I just saved you a hundred grand in MBA tuition.
But, given the formula above with a focus on ARR, a subscription economy income statement should look more like this:
Let’s break this down.
ARR — Notice that instead of starting and ending with income, now we’re starting and ending with ARR, or annual recurring revenue. Again, that’s because this income statement looks forward, not backward. Whereas a traditional statement says “you made this much revenue in the past quarter,” this statement says “you are starting the quarter with this much recurring revenue.” That’s a huge quantitative difference. ARR is known recurring revenue that you can bank on.
Churn — Sadly, not all recurring revenue manages to recur. Even if you’ve got the best offering in the market, you’ll still have customers who leave you: If they’re a consumer they might get bored with your offering or switch to a competitor who’s offering them a shameless discount. If they’re a business you might lose your advocate, or they might get acquired or go under. Other reasons, of course, are more self-inflicted: poor adoption or utilization, product gaps, weak consumer marketing, a lack of resources and expertise. Regardless, this is called churn and is a reduction of ARR. So instead of being able to bank on $100 million, in this example the company subtracts a projected churn of $10 million to get a Net ARR of $90 million. This is what they can bank on. Now, how will they spend that money?
Recurring Costs — The first question is: what do we need to spend on to service that ARR? After all, your existing customers are expecting a service! Here is where we’ve rearranged some costs. We’ve pulled up COGS, R&D, and G&A to be “above the line,” in the sense that these are the costs you need to spend to service your ARR. Now, some companies or analysts do get fancy and try to allocate only some percentage of these costs as what is needed to service the ARR, but we decided to simplify things and assume that COGS, R&D, and G&A are all associated with servicing the recurring revenue. Hence, they are recurring costs. The benefit of this assumption is it makes it easy to benchmark against other public companies by using their available financial data.
Recurring Profit Margin — Your Recurring Profit Margin is simply the difference between your recurring revenues and your recurring costs. This number gives you the intrinsic profitability of your subscription business, as there is certainty in your recurring revenue as well as certainty in the costs to service that revenue. In the example income statement it’s $40, which represents a very healthy margin. There’s a lot of hand-wringing around how profitable subscription businesses can be. When we look at a subscription company’s financials, we always look at the recurring profit margin first, to get a sense of how strong the business truly is.
“When we look at a subscription company’s financials, we always look at the recurring profit margin first, to get a sense of how strong the business truly is. ”
— Tien Tzuo, Founder and CEO, Zuora
Growth Costs — So what about Sales & Marketing? Here lies one of the biggest differences between traditional and subscription businesses. In a traditional business, the cost of sales reflects how much I spent to get that dollar of revenue. But in a subscription business, sales and marketing expenses are matched to future revenue. Why? Because the sales and marketing I spent this quarter adds to the ARR, but the revenue I will see from that ARR growth will come in future quarters. In traditional accounting lingo, your sales and marketing now acts more like a “capital expenditure,” or capex. Essentially, these are costs you spend to grow the business, either from existing customers, or from acquiring new customers. That’s why we call them growth costs. Again for simplicity and ease of benchmarking, we assume that 100 percent of a company’s sales and marketing costs are spent in order to grow.
SO NOW YOU CAN SEE THE RELATIONSHIP BETWEEN THE RECURRING PROFIT MARGIN AND GROWTH.
The higher your recurring profit margin, the more you have to spend on growth.
In the example above, the company actually chose to spend almost all its recurring profit margin on growth, and wound up 20 percent bigger at the end of the period. At this point you may be asking, why not spend all of the recurring profit on growth? Why not indeed? If you believe you have a big potential market and have control over your churn, you can run this play year over year, and you’re growing by 30 percent annually. And when the time comes to finally start taking profits, you’re working off a much bigger recurring revenue stream.
THIS IS WHY A LOT OF SUBSCRIPTION COMPANIES MAY “LOOK” UNPROFITABLE, BUT THEY ARE ACTUALLY AWESOME BUSINESSES.
It’s also why I roll my eyes every time I hear an analyst complaining about the lack of profitability at companies like Salesforce and Box. Even while the Subscription Economy has taken hold across multiple, multi-billion-dollar industries, investors, analysts, and investor media continue to miss the fundamental differences between product and subscription companies that make their financial measurements just as disparate.
When I was at Salesforce, we spent a lot of time and energy educating investors and analysts on the vast performance differences between subscription software companies and traditional software companies. Lots of them remained fixed on the P/E ratio, and could not fathom investing in a company trading — at that point — 200x future earnings. We knew that operating profit was essentially meaningless to measuring our value. Honestly, as an investor, I would ding a subscription business that brought operating profit to the bottom line, seeing it as a signal from the company that it’s cutting sales and marketing spending because it can’t efficiently acquire new bookings!
Here’s the key takeaway — it is perfectly rational for subscription businesses to spend all their profits on growth, as long as their bucket doesn’t leak. Remember, as long as you are growing your ARR faster than your recurring expenses, you can step on the gas. As Ben Thompson of Stratechery notes, “you’re not so much selling a product as you are creating annuities with a lifetime value that far exceeds whatever you paid to acquire them.”
Excerpted from Subscribed: Why Your Company’s Future Is the Subscription Model and What To Do About It, by Tien Tzuo with permission of Portfolio, an imprint of Penguin Publishing Group, a division of Penguin Random House LLC. Copyright Tien Tzuo, 2018.