When people think of subscription, they often think of cloud-based software, gaming, or media companies. While readers from those industries will benefit from this book, you can also apply the subscription business model to your company – no matter what your size or industry.
To appreciate the impact of recurring revenue on your company’s value, you have to understand what buyers are buying when they acquire a business.
At SellabilityScore.com, we know from our analysis that when an acquirer buys security business, it pays 75 cents for „one-shot“ installation revenue and 2 dollars for every dollar of monitoring revenue.
Every business can create at least some recurring revenue if it is willing to jettison the old way of doing things to pioneer a new business model.
Subscribers Are Better than Customers
Like many subscription models, Amazon Prime is a Trojan horse that is expanding the list of products consumers are willing to buy from Amazon and giving the eggheads in Seattle a mountain of customer data to sift through.
According to Morningstar, the average Prime member now spends 1.224 dollars on Amazon purchases each year, compared with 505 dollars for non-Prime customers. And even after you deduct all the costs of shipping and everything else, such customers still yield Amazon 78 dollars more of profit per year.
Amazon having learned a lot about the subscription business through Prime, is now applying the subscription model to other areas of its business.
Amazon is known for its wins in selling to consumers – but subscriptions can work for B2B as well as B2C. one of Amazon’s latest ventures is a subscription that offers to help other companies grow their subscription businesses.
The history of the subscription business model dates back to the 1500s, when European map publishers would invite their customers to subscribe to future editions of their maps, which were evolving as new lands were discovered, conquered, and claimed.
This model was then applied to early newspapers and magazines dating back to the periodicals of 17th-century Europe. The economics of information publishing deteriorated with the rise of the Internet, which eliminated distribution costs and commoditized content to such extend that consumers begat to expect it for free. The traditional publishing model was under attack from two sides: information was becoming commoditized and our appetite for it was becoming more specialized.
While the subscription business model has been around for centuries, over the last two decades it has been revitalized by technology and media companies. Most recently, a confluence of four factors has ushered in a subscription model renaissance across all industries:
- The Access Generation – they are behind the explosion of the new “sharing economy”.
- Light-Switch Reliability – we just expect the lights to come on because electricity has become so dependable. The internet is becoming almost as pervasive and reliable.
- Delicious Data – manufactures sell to distributors, distributors sell to retailers, who sell to the end customers. Today, businesses are closer to their end users than ever before. Data has become an asset, and nobody has more customer information than a subscription business. Walmart didn’t launch Goodies Co. for the purpose of making measly 7 dollars a month. The world’s largest retailer wanted to know which snacks resonated enough to make you want to buy the full-size version.
- The Long Tail – today, the cost of merchandising product digitally is close to zero so companies no longer need to carry just “hits”.
Big companies like Apple, Time Warner Cable, Amazon, Target, Microsoft and Google are not necessarily walking away from their traditional business model entirely. In many cases, they are adding a subscription business to build recurring revenue, expand their relationship with existing customers, and understand what customers want.
Whether you like it or not, you are now competing in the new subscription economy.
Koge is a Toronto based start-up and vitamin retailers. For 49.99 dollars a month, you can subscribe to a monthly regimen of daily essential vitamins delivered to your doorstep. The market for any given commodity is a zero-sum game. For every customer who decides to subscribe to a vitamin regiment from Koge, one less person buys vitamin from the local health food store.
Why You Need Automatic Customers
Here are the eight reasons subscribers are better than customers:
- They increase the value of your largest asset.
How your company is valued without a subscription offering? The most common methodology used to value a small to mid-size business is called discounted cash flow. To improve the value of a traditional business, the two most important levers you have are: how much profit you expect to make in the future and the reliability of those estimates.
When an acquirer looks at a healthy subscription company, she sees an annuity stream of revenue throwing off years of profit into the futures. This predictable stream of future profits means she is willing to pay a significant premium over what she would give for a traditional company. How much premium depends on the industry. Some of the biggest premiums today go to companies in the software industry.
Dmitry Buterin founds the consensus valuation range being offered to his members’ companies to be between 24 and 60 times monthly recurring revenue (MRR), which is equivalent to two to five times annually recurring revenue (ARR).
Zane Tarence is partner in Founders Investment Banking, their formula is:
- 24-48 x MRR (2-4 times ARR) for less than 5 million in ARR, growing modestly and churn in the area of 2-4 % per month.
- 48-72 x MRR (4-6 times ARR) at least 5 million in ARR, growing 25-50 % per year and churn below 1,5 % per month.
- 72-96 x MRR (6-8 times ARR) at least 5 million in ARR, growing over 50 % per year and churn below 1 % per month and typically an industry-specific solution.
Subscription business boost the value of your company.
- The 29 dollars Sale vs. the 4.524 dollars Sale
The most obvious benefit of the subscription model is that it increases the lifetime value of a customer.
- Smooth Out Demand
One of the biggest challenges in a traditional business is estimating demand. In a people business, when you underestimate demand, your employees burn out, morale sinks, the quality of your service suffers, and your brand is damaged. If you have too many employees, they spend time gossiping about when the layoffs will come, while your profit margin shrinks because you are paying for people to sit on the bench.
- Free Market Research
A subscription business gives you a direct relationship with your customers and an ability to track their preferences in real time.
- Get Paid Automatically
Assuming customers pay for your subscription by credit card, a subscription model means you get paid on the day you’re supposed to get paid.
- Make Your Customer Sticky
Subscribers knowingly enter into an agreement in which the convenience of uninterrupted automatic service is exchanged for their future loyalty.
- Subscribers Buy More
A subscription business model allows you to talk to your customers on a regular basis. This means you get an opportunity to up-sell them on products and services beyond their basic subscription. By adding a subscription offering, you create a legion of customers who interact with your company each month. Every touch point represents another opportunity for you to sell more to your existing customers.
- Recession-Proof Your Business
When you create a steady flow of recurring revenue, you insulate your-self from the worst of a potential recession.
There are also some challenges of adopting the subscription model.
Downsides involved in moving to a subscription model. The biggest risk is spreading the cash you receive from a customer over the life of the subscription.
The second-biggest challenge in moving to a subscription model is getting your employees onboards.
You may find the move to a subscription model weeds out the employees who are more loyal to your industry than to your company.
The Nine Subscription Business Model
Let’s begin where the subscription model started: selling information.
- The Membership Website Model
The membership website subscription model involves publishing your know-how behind a paywall that requires members to buy access to your secrets. The membership website model can work for your business if you have access to highly specialized information that keeps changing over time. The most financially successful membership websites tend to focus on helping business owners master a specific industry or skill.
Often a membership website can be used as entry into selling a larger-ticket item.
Consider the membership website model if you have: a tightly defined niche market, access to a steady flow of unique knowledge and another product or service you can sell to your subscribers.
- The All-You-Can-Eat Library Model
Few industries have been as disrupted by technology as the music business. Consumers no longer want to buy their music at all. It is no longer about individual tracks; it’s about access. The concept of buying music at 99 cents a song is becoming irrelevant. To compete against the subscription-based music services, Apple launched iTunes Radio in the fall of 2013.
The all-you-can-eat library subscription model offers unlimited access to a warehouse of value.
Consider the all-you-can-eat library model if you have: a library of “evergreen” content – or the wherewithal to acquire one or a legion of existing fans
- The Private Club Model
As any Porsche salesmen will tell you, exclusive things are brought on emotion and justified with logic.
One of the things that makes the private club model work is the privacy itself. For some achievement-oriented people, the higher you make the barrier to enter, the more they want to climb over it. In some ways, the private club model sells social status – think of it as social climbing on subscription.
The subscribe for status idea is not limited to attracting consumers to your subscriptions; it works in B2B as well, when businesses want to portray an image that allows them to punch above their weight class.
Consider the private club model if you have: something that’s in limited supply – almost always a service or an experience or a market of achievement-oriented “strivers”.
- The Front-of-the Line Model
The front-of-the-line subscription model involves selling priority access to a group of your customers. The model was popularized by the software industry but can be used by any company with customers willing to pay to jump the service queue.
Salesforce.com has doubled its bet on the subscription business model by also offering subscription-based services packs they call Success Plans.
When you adopt the front-of-the-line subscription model, you are publicly declaring that all of your customers are not treated equally.
Most people understand that businesses prioritize their customers and will understand as long as you explain how you prioritize.
To offer a front-of-the-line subscription, you’ll need to think through how you plan to handle customers who pay for a special service queue.
To use this subscription model, it’s important that you already have a good reputation for baseline services. And you should leverage technology and systems.
Consider front-of-the-line model if you have: a relatively complex product or service; customers who are not overly price sensitive or customers for whom waiting in line can have catastrophic consequences.
- The Consumables Model
This subscription model is representative of the growing category of subscription-based e-commerce.
The consumables model involves offering a subscription to a product that the customer needs to replenish on a regular basis. The value proposition is simple: life is too short to worry about mundane tasks like remembering to pick up diapers or razor blades. Subscribe and you’ll never run out.
The biggest challenge facing consumables subscription companies is how to differentiate their offerings from what big online retailers like Amazon and Walmart can offer. Just offering a subscription is no longer a differentiating value proposition, and if Amazon (or Target or Walmart) sees you getting traction selling a generic product or service it has access to, you won’t last long, as an independent company.
The small business can succeed with the consumables model if they build their brand equity and they guard their supply chain. Building a unique brand requires that your positioning meet two criteria: it needs to be important to customers and make you unique. A big part of building a brand is controlling the product itself.
The more we believe a product is unique and offers a better experience, the more the provider has the leeway to set his own price. For a consumables subscription model to work in the long term, you need something other than price and selection to compete against the big players.
Don’t underestimate the logistical challenges involved in fulfilling orders for a physical product or in providing service for thousands of subscribers.
Consider the consumables model if you have: something to sell consumers that naturally runs out or something to offer that is annoying to replenish.
- The Surprise Box Model
The second form of subscription-based e-commerce that companies leverage is the surprise box model. This model involves shipping a curated package of goodies to your subscribers each month.
Such boxes are typically built around a theme users feel passionate about.
A big part of the value these subscription companies provide is curation, which has become increasingly important as Google has made choice infinite.
To make the surprise box model work, you need a large and varied network of manufactures who are willing to give you a deep discount for a onetime order and who have the capacity to fulfill.
When you have access to all that customer data, you need to utilize them. The challenge is that once customers take the time to tell you what they want, they expected you to use that information to improve the subscriber experience. Reacting to all of that customer data creates a logistics and shipping challenge. It’s one thing to know what your customer wants, but it’s a bigger challenge to ensure you have just enough product to ship out in each box and on time.
Consider the surprise box model if you have: a passionate, clearly defined market of consumers; a large and varied network of manufactures; the ability to handle the logistics and a desire to use subscriptions to establish, Trojan Horse-style, a larger e-commerce site.
- The Simplifier Model
Technology was supposed to simplify our lives – so why do I feel overwhelmed?
Taken separately, no one system is too complex for the average person to master. It is the number of systems we each must now use on a daily basis, that causes our mental overload.
The big technology companies are starting to put serious money into helping people de-clutter and de-stress.
Virtually any company serving busy consumers can benefit from offering a simplifier subscription and the richer you customers, the more acute their need for simplification.
There is enormous value in the “set it and forget it” value proposition. You get recurring revenue and steady work, and your customer gets the benefit of knowing it’s one less thing to remember to do.
Consider the simplifier model if you have: a service that your customers need on an ongoing basis; the ability to sell to relatively affluent, busy consumers and a personal service business.
- The Network Model
One of the first subscription business models dates all the way back to January 28, 1878, in the town of New Haven, Connecticut. A new device called a telephone had recently been invented, and 21 subscribers paid 1.50 dollar per month to have access to a phone line.
One of the defining characteristics of the network model is that, unlike the private club model, the utility of the subscription increases as more people subscribe.
One thing that makes the network model unique is that the users themselves have a vested interest in promoting the subscription because the more people who subscribe, the better it is for everyone.
The world-of-mouth advertising that helps you build a subscription business using the network model can also work in reverse.
If you’re going to rely on an army of customer advocates to build your network model subscription business, make sure you have a listening mechanism in place so you can quickly react to subscriber dis-satisfaction before the world of mouth that helped you build the network starts to act against you.
Focus your limited resources on a small, tightly defined group of early-adopting customers.
Consider the network model if you have: a product or service whose utility improves as increasing numbers of people join in; the network model works best when you offer a remarkable experience people feel compelled to share or tech savvy customers and prospects.
- The Peace-of-Mind Model
In the peace-of-mind model you are there to help your customers when they need your service, but otherwise you stay out of their way. You make money from charging more in subscription revenue than it costs you to deliver the service when called upon.
An underwriting profit is the amount of money you earn for taking the risk of offering such service. Underwriting profit is the difference between premiums generated and claims paid, while float is the money you make investing the cash people pay in insurance premiums before they make a claim.
Calculating your risk is the primary challenge of running a peace-of-mind model company. You can limit your risk in a number of ways:
- Offer a peace-of-mind subscription only to a handful of customers.
- Limit your customer offer.
- Reinsure the risk by buying and insurance policy of your own.
It’s not just consumers who buy peace of mind. Businesses also buy monitoring and insurance protection they hope they will never need.
Consider the peace-of-mind model if you have: something that is difficult, expensive, or impossible to replace; a business that allows you to absorb the cost of a claim by leveraging your existing assets rather than paying out cash or a history of customer service calls that helps you predict the likelihood and frequency of claims.
Building your Subscription Business
Many traditional businesses become successful based on the sheer force of the owner’s personality. A traditional business requires more brawn, while a subscription business requires more brain. In a subscription business, any decision you make affects your entire base of subscribers all at once.
The New Math
One of the most challenging aspects of building a subscription business is the need to relearn the basic of how you measure your progress. In a subscription business, instead of selling a finite offering, you are essentially renting access to your product or service over time. The moment you switch to a subscription model you P&L will start to look ugly.
The foundation of your subscription business is built on your monthly recurring revenue (MRR). The next number you need to understand is the lifetime value (LTV) of a subscriber. The next data point you need to assess the health of your subscription business is your customer acquisition cost (CAC).
To truly understand your CAC, you want to know what your CAC is at scale, meaning what is sustainable after the “love and guilt” subscription have been signed up.
Arguably the most important factor contributing to the viability of your subscription business is the rate at which customers quit subscribing; this is known as your churn rate.
The other number you need to consider is the cost of serving each new subscriber.
List of sales approaches often used by subscription business, ranked from most expensive to least:
- Field salespeople – these are the people who visits customers face-to-face.
- Telesales – salespeople who contact customers remotely – via telephone and e-mail – work over shorter sales cycle.
- Self-service – subscribers don’t need direct salesperson access in this system
There is one more essential ingredient you’ll need in order to build a subscription business. Cash is to a subscription business as oxygen is to humans. If you don’t have it, no matter how healthy you are on other measures, you’re dead.
The Cash Suck vs. the Cash Spigot
There is a big difference, however, between viability on paper and viability in the real world, and the difference is a little something called cash.
In a subscription business, you receive your cash over time. In almost all cases, your MRR will be less than the cost to acquire a customer, which means it will take you a number of months to gain back the cash you spent to win that customer.
The CAC payback period measures how many months it takes you to make back the cost of acquiring a customer.
CAC Payback Period = Total Sales and Marketing Costs for the Month/New MRR added for the Month
To do it correctly you need to add margin into the equation.
CAC Payback Period = Total Sales and Marketing Costs for the Month/New MRR added for the Month * Gross Margin
For SMB (Small & Medium Business) CAC Payback Periods of 6-18 months are typically needed, whereas enterprise business periods of 24-26 months. A CAC Payback Period of 36+ months is typically a cause for concern. A Payback Period of under 6 moths means you should invest more money immediately and step on the gas.
You have three choices to fund your growth:
You can use cash from nonrecurring sources of your business to build your subscription offering. You take the profits from your traditional business. This bootstrapping approach to building your subscription business allows you to keep all (or most) of the equity in your company.
Your second option when building your subscription business is to go outside for capital. FreshBooks’s McDerment is saying that outside capital is risk capital and it’s a great opportunity to become misaligned. The main benefit of outside money from a professional investor is that it is usually “smart money”.
The third strategy is to flip the traditional subscription-business cash flow model on its head so you’re getting paid before your deliver the service. Author is using metric he calls CUF:CAC, where CUF stands for cash up front, the amount of money your subscriber pays when he signs up for your subscription, CAC is your customer acquisition cost.
One way to improve your CUF:CAC is to charge a setup or initiation fee. HubSpot cleverly disguises a setup fee as a 2.000 USD Inbound Marketing Success Training package.
In order to grow your subscription business while minimizing the amount of cash you need from other sources, shoot for a CUF:CAC ratio north of 1:1.
Charging up front for your subscription can lengthen the sales cycle and increase your cost to acquire a customer, but if you want to maintain control of your subscription business, it may be your best approach.
The Psychology of Selling a Subscription
With a subscription, you’re proposing a relationship over time.
Increasingly subscription businesses need to overcome the subscription fatigue that is deepening with every credit card statement we open.
Here are seven ways to sell a subscription:
- Think 10 x vs. 10%
A consumer with an acute case of subscription fatigue is unlikely to subscribe just to save 10 %, but she might be convinced to subscribe if you could make a case that she will enjoy 10 times the value of alternative.
- Appeal to Their Rational Side
The subscription business model has gone mainstream, and people are demanding that their subscription offer better value than the alternative. In short, we’re buying more rationally. This strategy can work when selling a subscription to a consumer, but it is essential when you’re selling a subscription to another business.
- Give Customers an Ultimatum
The ultimatum strategy can be doubly important of you’re targeting customers who are already buying from you on a one-shot basis.
- Give Them a “Freemium” Option
If you’re going to force people to subscribe as your only pricing model, one way to overcome their anxiety about committing is to offer a free taste of what they will get from a full-blown subscription. A good taster gives you just enough to assess the product but leaves plenty of temptations behind the curtain. Use the freemium model when you have something that impresses your potential subscriber while still leaving them wanting more.
- Offer a Trial
If you have a product or service that is very hard to describe and that customers have to use before they will understand the benefits of subscribing, you may want to consider offering a trial.
- Offer Your Subscription as a Gift
The problem with a one-shot gift is that it’s easily forgotten a few days after being received, which is why increasingly consumers are buying subscriptions for friends and family members as a way to express their appreciation over time.
The challenge is that gift subscriptions are notoriously difficult to renew. The consumer of the subscription did not make the original buying decision and therefore has to go through his own buying process in order to renew.
We can sell a gift subscription as a way to “top up” an already successful subscription offering.
- Set Fire to the Platform
From a consumer’s point of view, the best part about a subscription offering is that it is always on. This always on feature is fantastic for consumers but can be frustrating when you’re trying to sell a subscription. If your service doesn’t change from one day to the next, why should a prospect buy today?
As cheesy and cliched as it is, one way to get people to subscribe is to set fire to bridge and artificially simulate a burning platform that causes the customer to act to avoid losing something.
The burning platform strategy can, of course, backfire. If what you’re offering is always offering another deal, you train the customer to wait to see what offer will come next.
This strategy usually works best when you have salespeople who can quietly and selectively communicate the offer to only those prospects who have decided to buy and are just dragging their feet on committing.
Selling internally
Convincing your own staff to build a recurring revenue stream can be one of the hardest sales of all. Employee resistance to adopting a subscription model is common when you operate in an industry that has a traditional way of billing customers.
Scaling up
If you decide you want to expand and grow your subscription business, there are two things you need to focus on:
- You need to find a way to consistently acquire customers for no more than a third of their lifetime value.
- You need to reduce the number of customers who cancel (churn).
The larger your business becomes; the more corrosive effect churn has. A little bit of churn will always happen, and trying to wind down your churn to zero is a futile battle. There is a point of diminishing returns where eliminating all churn is so costly that you undermine your entire business model. It is the avoidable churn that leaves you running on a treadmill to nowhere.
Your first step to reducing churn is to understand why people leave and to do what you can to improve your offering.
Some ideas of churn-lowering:
- Be a Rouge Jet – the stickiest subscription businesses make it their mission to insert themselves into the daily lives of their customers. Salesforce.com’s monthly churn rate is around 1%. Even 1% is relatively high compared to companies like SAP, who are so integrated into the daily lives of their very large enterprise customers that they have annual attrition of around 5% and less than one half of one percent on a monthly basis.
- Watch the 90-Day Onboarding Clock – one of the biggest reasons people stop subscribing to any service is the perception that they are paying for something they are not using. Therefore, your biggest competitor for your subscription business is not the rival services; it is your customer’s inertia in not using your service. Optimizing your onboarding experience is an inexact science that most subscription companies are always tweaking.
- Reduce Your Time to Wow – part of getting people to adopt your subscription products or service in the first 90 days is to give them a quick win that provides the motivation for them to learn more.
- Charge Up Front – charging up front for your subscription means you’re locking in a year’s worth renewals (unless you provide refunds) and getting your customer’s cash up front. It prompts a customer to make a bigger commitment to learning and adopting your subscription; making them much more likely to renew.
- Communicate like a Giddy Lover – think of a new subscriber as a new lover. New lovers have a thirst to understand you intimately. After the 90-day mark, the new subscriber settles into the relationship, and overcommunication can actually cause churn.
- Drop a “Happiness Bomb” – as with any good relationship, it’s important to keep a degree of spontaneity and surprise in your dealings with your subscribers. The best subscription companies always sprinkle in a little something surprising for their subscribers.
- Target Larger Business – if you target other businesses with your subscription services, your churn rate is going to be higher if you attract primarily small businesses. Therefore, one way to lower your churn is to target slightly larger businesses. While larger businesses tend to be stickier customers, they are also harder to win.
- Focus on “Net Churn” – Net churn = Gross Churn – Upgrade Revenue
- Reduce “Logo Churn” by Cross-Selling – Logo churn is the cardinal sin of any subscription company. Logo churn also means you break the regular billing cycle on a current credit card or your status as an “approved vendor” with an enterprise company’s procurements department. The key to reducing logo churn is to offer a number of different subscriptions to the same company or person.
- Go Evergreen – the problem with having an end date for your subscription is that it is extremely expensive and time-consuming to convince someone to resubscribe. Total Revenue per Year = Total Budget per Year. The one exception to the evergreen rule is selling expensive subscriptions to large companies.
