THE SUBSCRIPTION MODEL
The so-called “subscription economy” is not a new concept.
We’ve seen it with newspapers, magazines, and cable for decades. What is new is the combination of subscription revenue models and cloud-based product delivery. Software as a Service (SaaS) has become the dominant business model in the applications space, and it has radically changed how we think about every aspect of the business: what we sell, how we sell and service, and how we monitor and measure success.
The approach of a traditional product sales model was “sell it and forget it.” The customer relationship often ended when the contract was signed, even if you “locked up” a customer with painful installations or replacement costs. The subscription model turned that on its head. The lifeblood of the subscription business model is acquiring customers, building ongoing, long-term relationships and monetizing those relationships.
Since monthly subscriptions mean no committed revenue, it’s critical to stay ahead of customers’ product needs and keep them happy. How do you get there? Trusted data. Real-time, trusted data is the CFO’s new best friend
NEW RULES, NEW OPPORTUNITIES FOR A SUBSCRIPTION ECONOMY CFO
The traditional software revenue would be set at the time of sale and forgotten.
In comparison, SaaS models may charge based on seats, volume, services, overages, usage, or a combination of them all – which brings together multiple dimensions of billing and revenue recognition. Subscription revenue can change constantly depending on upgrades, downgrades, more or less volume or services, etc. This can happen on a yearly, monthly or even daily basis.
Today’s systems need to be automated and flexible to change and adapt with the ever-changing revenue models. For example, changes to a subscription, such as mid-month plan upgrades, seat additions, cancellations, additional services, or increased volumes can result in retroactive or pro rata pricing changes during the month that can impact billing and revenue recognition.
An equally important shift, is how the cloud generates a wealth of real-time data about how customers are using the service, as well as help us identify what features to build next. We now have visibility into data and usage patterns to help customers optimize how they’re using our tools. We can identify leading indicators (e.g. in SendGrid’s case, users sending more or less email, deliverability trends, types and patterns of emails sent) that may represent a customer’s future needs, their need for help with deliverability, or their likelihood to churn. That data allows us to proactively help the customer or intervene before we lose the customer.
Gone are the days of living quarter to quarter with zero insight into customer usage. What was previously a black hole is now a true partnership between cloud vendor and customer, and the foundation of customer retention.
THE METRICS TELL THE STORY
A subscription business hinges on understanding customer-focused metrics. Understanding your key metrics means understanding your business.
• Churn Rate.
You need to understand and manage churn to the nth degree for both logo churn and revenue churn. With different volumes and price levels (e.g. $10/mo vs. $1000/mo customer), a 5% churn on customer base may only equate to a 1% churn on revenue or vice versa. Looking at it based on a cohort analysis is very valuable. Let’s say of 100 customers who signed up in any given month, how many are with you at 3 months, 6 months, 3 years? Over time, churn from a dollar standpoint may be negative, since the customers who stay with you eventually pay more than those lost. Looking at churn from many different angles and the ability to drill down is critical to understanding your business.
• Customer Acquisition Costs (CAC).
It is obvious, but many times overlooked. It costs more to get a customer than maintain a customer, and it’s critical to know exactly how much and how long the payback period is for each plan, service, seat, etc. If a customer leaves before reaching the payback period, you don’t cover your costs and you’ve lost profit potential. This metric, along with churn and lifetime value of a customer, will give you a good barometer of the sales and marketing cycle as well as the quality and value of customers.
• Lifetime Value of a Customer.
While CAC can tell you at which point you will break even on a customer, it does not tell you how profi table these customers will be over time. Analyzing the lifetime value of your customers will help you identify the customers or class of customers that are most important to your bottom line. This is critical to make the right decisions that can drive growth and increase that lifetime value. Which services are those customers using most? What features are most valuable to them? These are the keys to unlocking more profit in your subscription business.
• Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR).
MRR/ARR is the lifeblood of this growing subscription economy – satisfied customers are committed customers, and committed customers lead to financial stability and compounding growth over the long haul. MRR/ARR is your leading economic indicator: how are you performing, where are you growing, where are you losing and why? In order to forecast within the best possible accuracy every month, you need to look at MRR/ARR from four angles:
- Revenue for new customers
- Revenue increase from existing customers
- Revenue decrease from existing customers
- Revenue lost due to customer churn.
You can roll this forward every month, trend it, and, with the ability to drill down in to these categories, you can gain an insight to your company that you never thought existed. You can use these same four angles on a customer basis as well.The heart of the cloud subscription business model is dynamic, ongoing revenue relationships, and the best way to measure success is to have the metrics that match. As a data junkie, I’m always trying to understand the business from top to bottom, and confidence in numbers breeds predictability. For example, I can determine, within a very precise margin of error, our revenue for the month on the first day of the month and how much cash we are going to collect. As a team, we can better understand all facets of the business, from financing strategy to customer profitability to sales and marketing efficiencies. And, tough questions like how to scale the sales team, or where to make marketing investments are now based on trusted numbers.
“A subscription business hinges on understanding customer-focused metrics. ”
EQUIPPING YOUR BUSINESS FOR THE SHIFT TO A RECURRING REVENUE MODEL
The unwelcome reality to many CFOs is that many of the financial systems we’ve lived with for the last 20 years are obsolete for a subscription/SaaS business.
They’re designed around product-centric businesses, traditional accounting models, and legacy metrics. Traditional ERP systems tell you all you want to know about bill of materials, products, invoices and payment status, but little about your customers. Many accounting systems are built around one-time transactions and only look backwards at how much money you made or how many products you sold. And while Excel may seem like a passable solution, it quickly fails as data becomes more complex or large in volume.
CFOs will be best served by looking at new systems that are designed specifically for subscription businesses, and that enable you to make business decisions more quickly. Running a sound subscription business isn’t rocket science, and it’s not something to fear. The basic principles of good business still apply: provide a great service for a good price, treat your customers well and they’ll stay with you and continue to pay. Embrace the new model, shift your thinking, and the transition will be well worth it: for CFOs and the business, for customers, and for the bottom line.