One of the major shifts taking place is the growing adoption by consumers of subscriptions for goods and services instead of buying them outright. According to an October 2013 Economist study of 293 business executives commissioned by billing/subscription management platform provider Zuora , 80% of respondents believe that their customers are changing how they obtain access to goods and services.
During Social Biz Atlanta 2013, Zuora’s CMO Brian Bell (pictured left) presented on why a subscription business model is good for companies looking to build long-lasting relationships with today’s tech-savvy consumers. Below are some of the key points Brian delivered to help understand what’s driving the shift to a subscription business model, how companies are making the transition from the traditional product-driven economy, and how financial performance is measured.
Embedded below is a video of the full session, including a great introduction to subscription economy thinking by Denis Pombriant, a leading analyst in the CRM industry and thought leader on Subscription Economy development.
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Small Business Trends: What is the subscription economy?
Brian Bell: It really is this massive shift that we see in the market as you move from a one time transaction product based economy to this service oriented, recurring, relationship driven economic model. You see this across the board, you see it across all verticals and all parts of the economy. When the company started five years ago we didn’t anticipate that you would be able to subscribe to virtually anything as a consumer. We didn’t imagine that you could subscribe to Netflix and get DVDs; that you would never really as a consumer own music anymore. It is seldom that you would own movies, or even that you would own cars.
Small Business Trends: What kinds of businesses are getting involved in the subscription economy?
Brian Bell: Many of our customers — companies like Box and Splunk, Zendesk, Marketo — are designed around the subscription business model. So they knew that before they launched, they actually needed a platform to run their business. But what is more interesting is how it’s impacting a lot of the legacy technology companies — Dell, HP, and Informatica. Other customers that are really enterprise customers are adopting this, almost out of necessity. They are having to pivot and to essentially to embrace Cloud Computing in SaaS, because their legacy businesses are in decline, and they are finding they don‘t have the systems in place to manage it.
Media is another really interesting industry that is under a lot of pressure, and it is rapidly transforming. What is interesting about this industry is that you outsource your relationships to the customer. In media you would outsource circulation, and the circulation department, or the third party would go and get people to subscribe to print media, that was their function. Then the media company would take that demographic information and sell it to advertisers and that is how they made their money.
Now they are finding that they can’t survive that way, that as everything has moved online, and as people expect more from the media industry, they have to own that relationship with the customer.
The bottom line is if you run a business like Zuora we subscribe to virtually everything to run the business. You can subscribe to helpdesk software, CRM solutions, you can subscribe to accounting solutions; you can subscribe to real estate, virtual office space, telephone systems, this is a massive shift in the way you build and grow any business.
Then on the customer side I can subscribe to clothing, to wine, to prophylactics. The Dollar Shave Club is an amazing company that provides a disruptive model to the established shaving industry.
Small Business Trends: Why is it happening?
Brian Bell: It is happening because customers demand it. They like the flexibility, they like the ability to be current in technology and current in media, and it’s a great business model.
If you run a subscription business you have very different financials that makes it very attractive, and this is why the evaluations of these companies on Wall Street, and by the VCs is so high, because they look at the finances of a recurring model very different.
Small Business Trends: Why is this so different from a product economy?
Brian Bell: In a product economy, you are selling units, you look back and you say how many number of widgets did I sell? How many bottles of Coke did I sell? How many iPhones did I sell? That’s how you measure your success, where in a subscription economy your focus is on the relationship. How many customers did I acquire? If you look at and imagine, how many customers came in? How many converted? How many did I acquire? How many have I retained?
Instead of pricing per unit it’s all about service plans, so do we have bundle plans? Do we have a gold, silver, platinum? Do we have plans that are monthly, weekly, or daily, are they based on usage or based on user? How are we going to price the plans? They are not one time orders that are recurring, multiple orders of a life time of a customer.
Box.com was an early customer that started with us in the consumer space, and then they said we need to go to the enterprise because the money is in the enterprise, how do we start to sell to enterprises? They realized that it’s B2Any, and in the new world you can sell just as easily to enterprises as you can to any consumers. This is the fundamental shift in the subscription economy.
Small Business Trends: What are the financial metrics involved in the subscription economy?
Brian Bell: In a traditional product business you look at an income statement and an income statement is a backward looking financial statement that looks at how much revenue you did, and what it cost for you to deliver that business? In the subscription economy it is a forward looking annual recurring revenue based financial statement. I will talk more about this but this is a big, big shift and frankly, the industry has not kept up with how different the financial model is.
These are the the metrics that matter:
- Retention Rate: How much of your ARR are you keeping every year?
- Recurring Profit Margin: It is your annual recurring revenue less churn minus the cost to run a deliver that service, and
- Growth Efficiency: How much does it cost you to acquire a new dollar business? These are the three key metrics of this Subscription Economy.
Small Business Trends: How do you grow a business in the subscription economy?
Brian Bell: If you think about a product business how do you grow? In a product business Apple will design the next cool iPhone, they will innovate, build the distribution channel, get it out to market and then they will have their reps and partners selling that device, and then they start all over again they create the next version of that device.
The way that you grow in a subscription business is, as I mentioned before, you acquire the relationship, you reduce the churn you want to stop people from leaving and you need to understand why are they leaving if they leave, and how to you prevent them from leaving, and you need to increase the value.
These are the three ways that you grow a recurring business:
- acquire customers,
- grow the dollar per customer, or
- reduce the churn of the customer base.
There is a variety of strategies to do this. We have identified 12 different strategies that are supported in our platform that would allow you to do this. If you are trying to acquire customers you are launching new products, you might be delivering products or offerings in multiple currencies, or you might want to enter a new market.
You have reduced churn by looking at maybe having a different pricing plan. You might find that your churn is the result of only having a monthly plan when actually people want a weekly plan. Or you might find that you can increase the value by charging overages on consumption, or up-sales or bundles. There is a variety of pricing of packages strategies to really drive growth in this recurring model.
Small Business Trends: Tell us about the importance of automating process flows.
Brian Bell: The second area is process flows, automating these process flows; this is very, very different than the economy that was product based. Let me add a bit more color. In a product based business you book an order, you ship it, you invoice and collect for it, and then they receive it. This is pretty straight forward, we pretty much know how this works, but in a recurring model it is much more dynamic.
When you look at a process like “cash” it gets much more complicated when you start to look at renewals. If someone goes in and renews the system how do you actually manage that process? How does it change your processes? In view of your payment failures if someone is a subscriber and then their credit card doesn’t go through what do you do? Do you suspend them, can you stop them? Is it more expensive for you to turn off the service to them than it is to actually kept them on the service even if there are not paying?
As consumers we see this happening all the time, we will stop subscribing to something, we will continue to get the service, often the reason is because either they don’ t know, or two, they don’t know how to call sufficiently or effectively a turn off or modify the subscribers or the subscription that you have.
It is much more complicated and essentially in this new world you can have multiple orders coming in that you want to have in one invoice. You might have one order coming in that you might want to spread out across multiple invoices. You might have an order coming in that then it is going to be recognized in your accounting system in a very different way. Do you recognize revenue on a usage basis? Do you recognize it on a payment basis? What is the accounting policy you are going to use to recognize revenue? And what complexity does that have when your users are constantly changing the things that they subscribe to? How does that impact your financial systems? It gets very, very complicated.
Small Business Trends: What do you need to know for a subscription business model?
Brian Bell: Remember this from basic accounting 101, it is pretty straight forward. You say I did $100 of revenue last year, the cost of goods of the things that I sold was $30 so my gross profit is $70. Then I have a bunch of other expenses just in my company. I have sales and marketing, I have G&A, I have R&D and the bottom line is that is my total operating expense. I subtract that from my gross profit and that is your net income. This is how we run accounting in the business world today.
This is very different in a recurring revenue model, and the fundamental difference is that in a recurring revenue model you are beginning your fiscal year with a book on business. You are beginning with, let’s say $100 of annual recurring revenue (ARR) where as in a product business you have to go out and sell all of the new business you are going to generate.
We are proposing in the industry what we call a “Subscription Economy” income statement, or a recurring income statement.
This is different so it starts with your annual recurring revenue, you have $100 of annual recurring revenue. You say what was the churn? Well I lost 10 customers that were paying me a $1, so I lost $10. So I am down to $90 after my churn. Then I look at the expense that I incurred to run that business, and that would be your cost of goods, but also your R&D, your data center cost, and anything involved in delivering this service you are providing. And that delivers a number that we call the recurring profit, that is your recurring profit margin.
Finally you can take that $40 — you had $100, you lost $10 by churn, and you have a bunch of expenses that need to run the business so you are left with $40 of profit. The big question in a recurring business is what do you do with the $40? Do you invest it and try to acquire new customers, or do you just bring it to the bottom line?
This interview on the subscription business model is part of the One on One interview series  with thought-provoking entrepreneurs, authors and experts in business today. This transcript has been edited for publication. For the full interview, please view the video above.