Companies leveraging a subscription-based business model are more complex than traditional companies. If we use traditional business metrics to measure the performance of a subscription-based business, these metrics will not provide us with a clear understanding of the company’s performance. In a nutshell, the success of such a company can be measured by its customer acquisition and customer retention rate. The higher the retention rate, the higher the lifetime value per customer. This article seeks to demystify some key subscription-based business model concepts.
Growth Results in Early Losses
Even the most successful subscription-based companies (e.g., Hulu or Netflix) made accounting losses in the early years of their operation because they were required to invest heavily in product development and customer acquisition. However, once that sort of company has a sizable customer base, and if it is able to continuously keep its customers happy with its services, the customer base will likely stick around for a long time.
Subscription-based software companies can further improve profitability by monetizing ongoing long-term relationships with its customers. Growth is essential in subscription-based business models because capturing market share early on means higher total lifetime value. Therefore, it is very important to understand that the more quickly stakeholders want their subscription company to grow, the larger the initial losses will be. However, once the company earns enough profit to cover its initial investments, it’s more likely the profits from the early investment will be more sustainable over time than the profits made by more traditional companies.
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Profitability of Companies Leveraging a Subscription-Based Business Model
The cost of acquiring a customer is often understated and higher than optimistic entrepreneurs anticipate. To assess whether a subscription-based company is performing well, we need to understand the relationship between lifetime value and customer acquisition costs. Based on industry research, a viable and healthy subscription-based software company should have a lifetime value to customer acquisition cost ratio of at least 4 to 1 and take less than 12 months to recover customer acquisition cost.
Net monthly recurring revenue for a subscription-based company consists of:
- Revenue from its existing customers,
- Revenue from its newly acquired customers and
- Revenue lost from its churned customers.
It is essential that company leaders track these three key elements closely. These key elements can be better understood by breaking them down into two broader groups: existing customers and new customers. For companies that have been around for a few years, the behavior of existing customers impacts their ARR and MRR more than new customers added in the year (or month).
Churn for Subscription-Based Business Models
Early on, churn might not be an issue for a subscription-based company because at smaller scales, it can easily acquire new customers to replace churned customers. However, as the company grows, the impact of churn becomes a lot more significant. For example, a company with a million customers with a 2% churn means that it is losing 20,000 customers monthly. This 2% churn has a detrimental impact on the company’s growth rate because it is extremely challenging to replace these churned customers compared to when it first started operations. To offset the impact of churn, the company can acquire more new customers or monetize its existing customer base through upsell and cross-selling.
It is important to differentiate between revenue churn and customer churn. For example, let’s say a subscription company has 800 major customers paying it $1,000 a month and 200 smaller customers paying it $100 a month. Its MRR would be $820,000 ($1,000*800 + $100*200).
Let’s then say that the company loses 15% of its smaller customers (i.e., customer churn). Its revenue churn in this case is <1% (15%*$100*200 / $820,000). As illustrated, revenue churn and customer churn numbers can be very different. But each is important to understand, and we must differentiate these two metrics if we want a complete picture of what is going on in the business.
Customer lifetime value is the accumulated value that a customer brings before churning. Understanding lifetime value is important because it helps subscription-based companies evaluate whether their business is viable: Lifetime value should be greater than customer acquisition cost.
One of the main challenges of calculating lifetime value is factoring the churn rate, which is often unrealistically assumed to be linear over the customers’ lifetime. Be mindful that subscription companies with small numbers of customers will have lifetime value fluctuate more than companies with larger customer bases. Therefore, because of the smaller population size, estimating lifetime value might not be as useful for subscription-based companies with smaller customer bases.
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About the Author
Prior to joining 8020 Consulting, Joe was an Investment Banker with experience in capital and debt markets, M&A, IPO readiness consulting, credit, distressed assets and financial assurance. His key responsibilities include buy-side and sell-side M&A, subsidiary spin-offs, capital raising through the debt and equity markets, structuring of hybrid securities, financial turnaround and restructuring and due diligence support. Over the years, Joe has advised and raised capital for REITs, property developers and major palm oil players. Joe has also lived and worked in a few of the world’s major financial cities such as Los Angeles, London, Singapore and Hong Kong. Joe graduated from the University of Southern California and he is Chartered Accountant with the Institute of Chartered Accountants in England and Wales. Joe also holds the following FINRA licenses: Series 24, Series 63 and Series 79.
Categorized in: Financial Planning & Analysis