Subscription Models: Changing the Economy, SaaS
In today’s world, customer needs and wants change with technology. New alternatives and new dynamics come into market everyday. This makes it difficult for brands and products to differentiate themselves from their competitors. Today, the main differentiator is how strong the customer engagement is. The main goal of the firms is not to just acquire customers anymore, but having a long lasting relationship with their customers instead. So, it is the customer engagement that adds value to the product. There should be a win-win relation between two parties according to today’s market conditions, so the firms should ensure that products offer 'end to end' solutions and continuous improvement. Customers look for products and brands to meet their continuously changing needs without a binding commitment to one product only. Customers don’t want to follow a planned structure of ownership, they want customized and improved products that will go along with their lives.
These new customer dynamics change the way of traditional business economics and pricing. More and more products are being served to the market with subscription model, in compliance with relationship extended over time. As customers avoid the one-off large expenses, subscription economy continues to expand. The most popular subscription based businesses such as Netflix, Spotify or Amazon Prime are the best examples of this new model.
The subscription model requires firms to find new ways to engage with customers, focus on retaining existing customers and increase the customer life time, since their revenue stream is mainly based upon the relationship, not on one transaction only. This is why the traditional business economics and accounting principles fall short of explaining subscription models. The new approach needs to be forward looking and take expectations into account. Generally accepted accounting principles tend to focus on one kick transactions only when calculating profitability, and this leads to insufficient measure.
Subscription models have brought new key metrics for effective measurement, such as 'MRR, ARR, CLV, CAC' etc. These metrics are essential to assess the viability of these companies.
Key Metrics of Subscription Models
The metrics used for subscription based products are mainly about 'growth'. These metrics try to assess to what extent the growth is repeatable, scalable and lastly profitable.
MRR (Monthly Recurring Revenue):
It is mostly common for SaaS companies, since their products and solutions are subject to rent. It explains how much revenue is earned per each month.
ARR (Annual Recurring Revenue):
Although it is simply 12 times of MRR, the figures are subject to change due to churns or package upgrade and downgrades.
This metric explains the rate of lost customers. It can be calculated with the following formula, it is the division of the number of cancellations in given month by total number of customers: "number of cancellations in given month / total number of customers = churn rate"
Net New ARR:
This metric shows the growth of bookings, which is the critical indicator of success.
The formula is: "New ARR from new customers + Expansion ARR (package upgrades done by existing customers) – Churned ARR (due to customers lost) = Net New ARR"
CLV (Customer Life Time Value):
How much each customer worth for the company is understood with CLV. This metric is very useful when planning marketing or advertising budget to spend for each new customer and analysing customer acquisition cost (CAC). The calculation of CLV includes few steps:
- Firstly, Average Revenue Per Customer (ARPC) should be known. It is basically MRR divided by total number of customers. Let’s say the company has $100 MRR, and 5 customers. The ARPC is equal to $20.
- Secondly, average life time should be found. Knowing the churn rate, let’s say it is 10% (10 cancellations in a given month out of 100 customers) The average life time is found by dividing 1 to the churn rate: Av. Life Time= 1 / 0.1 = 10 months.
- Finally, Customer Life time Value is found as: ARPC x Av. Life Time = $20 x 10 = $200
This approach focuses on profitability of the company in the long run. If CAC < CLV, it can be said that the company is viable. Generally, CLV/CAC ratio indicates the profitability of the company, and it can be used among different customer segments to assess profitability of these segments. Generally accepted accounting principles aren’t enough when it comes to explain the negative cash flows within these firms despite growth. This is due to the reason that the customer acquisition cost (CAC) may be a burden for these firms in earlier phases. It takes time for the company to break even since the revenue is divided to months.
Finally, the nature of subscription models change the customer habits and traditional conduct of business. As subscription models, especially SaaS products gain bigger roles in our lives, financial metrics and analysis change. Investors and management teams should take these new dynamics into account when looking at growth and success of these companies.