CFO

5 Questions for Tech B2Bs Considering the Subscription Model

By Megan O’Brien, Brainyard Finance & Business Editor
February 11, 2021
subscription model

In short:

  • The subscription business model has grown speedily in the technology space, often supplementing or outright replacing the traditional one-time-purchase model.
  • This growth has its roots in increasing preferences for access over ownership and services over products.
  • Prior to going all-in on the subscription model, companies should ask five questions about their value proposition, infrastructure and accounting practices, to name a few.

In 2012, Adobe announced that it would begin a new chapter in its history: the expansion to a $50-per-month subscription service called the Creative Cloud. The products that were previously sold separately as perpetual licenses — like Photoshop, Premiere Pro, Illustrator and After Effects — would instead be bundled together as a cloud-based subscription offering. The reaction to the announcement was remarkably frosty. In a survey by analyst firm Jefferies and CNET, 41% said they had a negative view of the Creative Cloud, compared to 32% who expressed a positive view.

In response, Adobe released a statement, saying, “We believe customers will see the added value of our new offering when it is available. It will become quickly apparent — via the continued addition of new products, services and capabilities — that Creative Cloud is the best long-term choice for customers.”

adobe

Image Credit: Macrotrends (opens in a new tab)

Analysts wrung their hands, wondering if this was a massive misstep for Adobe. But the move was actually indicative — or perhaps even predictive — of the subscription economy that has since been popularized across industries. The chart above shows just how good it was for Adobe, with its growth taking off shortly after its move to services.

However, as technology companies look towards the subscription model as a path to innovation, there are several questions to consider prior to making the shift.

Status Check: Current Health of the Subscription Economy

The pandemic hasn’t stunted the growing popularity of the subscription business model. Research suggests that overall, subscription companies continue to outperform their product-based peers by wide margins. Overall, subscription signups are on the rise, and while S&P 500 companies have seen sales contract at an annualized rate of -10% in 20Q2, subscription businesses expanded at a rate of 12%.

Unsurprisingly, revenue growth slowed among small SaaS businesses to 2.8%, as pandemic closures hit smaller businesses heavily. However, SaaS companies catering to multiple consumer types — consumers, small- and medium-sized businesses, and enterprises — reached record account growth.

zuora

Image Credit: Zuora (opens in a new tab)

Pros and Cons of a Subscription Model

Pros Cons
Recurring, predictable revenue stream Less upfront revenue than with larger, one-time purchases
Access to new markets Potentially high churn rates
Longer-term customer relationships and loyalty Difficulty converting customers
Opportunities to increase revenue from existing customers through upsell and cross-sell Complex billing scenarios that combine one-time payments with recurring fees, as well as usage-based plans with variable rates
Higher average customer lifetime value Management of subscription plan upgrades, downgrades, failed transactions and cancellations
Easier revenue forecasting Keeping track of various pricing plans, schedules, discounts and promotions
Potential competitive advantage Complicated accounting standards set by the FASB (ASC 606) and the IASB (IFRS 15)
Less prone to market ebbs and flows Susceptibility to big issues (A problem may affect an entire subscription cycle.)

Logistics of the Subscription Model

The trend toward subscription business models has proven resilient in the face of market-altering events. However, take a step back for a second. Like a bob hairstyle, just because there is hype doesn’t mean that you should immediately jump in and (figuratively) chop all of your hair off. Instead, there are several questions for companies to consider before making the leap.

1. What is our value proposition?

A product isn’t automatically subscription-worthy. Take Microsoft for example. With many of Microsoft’s offerings, the consumer has a choice between a perpetual license and a subscription. With Microsoft Office, they can pay a one-time licensing fee of $249 for commercial use on one PC or Mac and get Word, Excel, PowerPoint and Outlook. For $12.50 per month per user, they can subscribe to Microsoft 365 Business Standard and access the same apps with services and upgrades, like around-the-clock customer support, automatic feature upgrades and collaboration opportunities through mobile and web applications.

Now, if the Microsoft Office applications remained static, the subscription model likely wouldn’t make financial sense. After all, a user pays more than the ownership cost in under two years. No one wants to pay the same price monthly for a presumably depreciating asset.

“I think in the subscription model, certainly in the tech world, there need to be services happening away from [your product] that drive value,” said Will Temple, managing director of Meddbase, an electronic health records solution.

Transitioning to the subscription model means converting your standalone product into a service that continually delivers new value — from the servers you maintain.

“When a company offers you something but there’s nothing happening outside [the user’s] four walls, for me that defines the line [of opting for a one-time purchase as opposed to a subscription],” Temple continued. “I think it’s difficult to push for a subscription unless you’re seeing an actual service being provided outside of your environment.”

Meddbase started in 2004 and found its subscription niche relatively simply. The opportunity was the custodial ownership of data for healthcare. In the UK, that’s a huge inherent risk — and health organizations consequently do not want to own the processing nor storage of data. Meddbase processes, manages and stores this health data and deals with retention, deletion backup and other tasks specific to data in the industry.

“Health organizations want [external] companies to deal with [the processing part of the data], so we got into that quite early on,” said Temple. “... We take it off of the organization and do it for them, so it’s a very obvious service we’re providing. There’s no way you would look at it and think that you would buy it once, because it’s a continual service.”

Thus, the question for your company becomes twofold:

  • Firstly, can your product be packaged with desired services?
  • If so, what compelling capability can your organization offer, or what pain point can you address?

As businesses contemplate the plausibility of reimagining a product to an “as-a-service” offering, it is critical to adequately define the value proposition that would convince customers to switch buying models.

Opportunities for product customization, valuable services (e.g., security, regulatory compliance and storage), consistent customer support and frequent upgrades can all prove the validity of a subscription versus a one-time purchase. Without an apparent differentiating value in a subscription, though, customers won’t adopt the new model — and could leave for a competitor.

Tips for Determining Subscription Value Proposition
Consult current customers. Identify customer pain points through discussions, surveys, feedback forms, etc. Some questions to ask:
  • What problem were you trying to solve when you initially came across our product?
  • What are the top three benefits you’ve received from our offering?
  • What are the top three things you’d like to see us offer?
  • How could we improve to better meet your needs?
  • Is our product integrated with separate products in your organization?
  • Which other roles or titles besides yours do you think would get a big benefit from our product?
  • What would you likely use as an alternative to our product if it were no longer available?
Analyze the competitive landscape. Consider your business and ask:
  • In the competitive landscape, are we the disruptor or the disrupted?
  • What are our competitors doing?
  • Is there something they aren’t delivering or that we can do better?
  • What is our competitive edge now? How/will that niche change with a subscription offering?
  • How will we define our differential? Are there verticals or micro-verticals we could own?
Talk to your sales team. As the group closest to the target audience, the sales team knows what customers value. Ask about prospects and current customers:
  • What are the pain points put forward?
  • What do they like/dislike about the product?
  • Do they compare our product with the competition? If yes, which aspect do they compare?
  • What gets customers to buy?
  • What is the toughest objection you handle?
  • What’s a common reason that prospects turn down the product?
  • What would keep them from turning it down?

2. Can we handle the working capital impacts?

In their book “Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business,” authors Thomas Lah and J.B. Wood refer to converting to a subscription model as “swallowing the fish.” Sounds pleasant, doesn’t it?

fish

As illustrated, “swallowing the fish” refers to the phenomenon of a revenue curve temporarily dipping below the operating expense curve before climbing back up again. At both small and large companies, conversion from upfront to recurring revenue generally results in a short-term revenue dip as the business loses licensing revenue and builds out the expensive subscription infrastructure. In addition, the timing of cash flow and revenue recognition can often be out of alignment with incurred costs. In fact, Adobe’s net income plummeted by over 64% when comparing Q1 2012 and Q4 2013, the former being when they launched the subscription version of the Creative Suite. Yet, Q4 2016 marked a 515% increase from its 2013 low. The subscription model’s high initial deployment costs mean companies need to prepare for a significant upfront investment.

macrotrends

Image Credit: Macrotrends (opens in a new tab)

You’ll also need to alert employees, the board of directors, analysts and other groups of the transition’s impact on working capital: Your revenue may look like it’s shrinking, because you’re no longer charging a higher one-time purchase price. For instance, instead of making $1 million through one-time upfront sales, you could be making that amount over two to three years. Yet, as revenue and costs come back into line in the end state, a company’s profitability can grow as scale and predictability have been built into the business model.

3. Can our operations support a subscription offering?

When asked to name just one best practice for companies beginning a subscription offering, Temple answered concisely: Invest in the customer and their loyalty throughout the lifecycle.

“My one piece of advice would be just don’t lose track of the renewal,” he said. “You see so many SaaS or B2B offerings that are service-related. And they focus so much on getting the customer in the door and moving to the next one that they forget about that renewal period.”

As customer interactions become less about a great product and more about excellent experience, the latter becomes the company’s differentiator. It can also be a barrier to entering the subscription model. That experience component cannot just be there when a consumer signs up and perhaps reinvigorated when the renewal period comes near. Instead, companies must have an infrastructure to support multiple customer touchpoints and facilitate a positive experience throughout the lifecycle. The business will need track metrics like customer churn — and understand the reasons behind the churn — to ensure longer and more engaged retention periods.

“The way the SaaS model works is gradually building up on those renewals,” said Temple. “That way, year-on-year, the revenues just carry through. But if you don’t support or pay attention to those revenues through that year, then you will lose them. And you’ll lose the advantages of the subscription service [model].”

anthony stames

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For many companies that are used to and built for the operations behind a one-time purchase model, the customer lifecycle associated with “as-a-service” offerings will present a significant change across all functions.

“It’s very much a complete shift in your business,” said Temple. “You have to recognize you’re becoming a services company, and not a distributor or a seller.”

funnel

Image Credit: Startup Talky (opens in a new tab)

Creating a successful subscription model won’t happen just by selling different things. It will require your organization to sell differently.

A subscription is a pricing tactic. By itself, it’s not a strategy,” Robbie Kellman Baxter, author of the books “The Forever Transaction” and “The Membership Economy,” told Harvard Business Review. “To build a recurring-revenue business, an organization needs to change how the product is designed, move from customer support to customer success, and keep the customer’s long-term wellbeing in mind across every functional area.”

Sales, marketing, finance, product development and the back office, to name a few, will see immediate impacts.

Sales:

The sales organization will face a major overhaul as its go-to-market strategy shifts to reflect the recurring revenue model. A business will need to be prepared to communicate that change in strategy, provide ongoing training and introduce new measures of success for the sales team. Additionally, it’ll need to prepare to rethink compensation and incentives as sales goals shift from gaining business to gaining and retaining business. Sales-team metrics should shift away from number of deals closed and move toward volume of usage, number of users, time users spend using the offering, and annual contract value or churn rate, for example.

According to Kellman Baxter, the length of the customer relationship is the most significant shift. The sales team will need to be invested in not only the initial transaction but also the ongoing relationship with each customer. The moment of transaction is the starting line, not the finish line. As those closest to customers and responsible for explaining the benefits of the model, sales teams will likely require a larger investment of time and resources to ensure they’re understanding and embracing the subscription offering.

Marketing:

A longer customer lifecycle means the marketing team will need to spend more time communicating with existing customers to encourage behaviors that will result in greater engagement. Like sales, marketing will need to make a shift to focusing on retainment, not just attraction. Companies will need marketing teams with the capacity to: enact a strategy that identifies the new target audience, successfully onboard new subscribers, promote customer satisfaction, and identify best practices in acquisition and retention that will build a strong recurring revenue stream.

The marketing team’s new goals will include ensuring that customers fully use and engage with the offering by tracking metrics like feature use, time spent in the tool, and the number of employees using the system. They can then make sure customers are aware of other advantages the system encompasses and cross-sell or upsell.

Cross-Selling vs. Upselling
Cross-Sell: Sales tactic in which customers are invited to buy offerings that complement or supplement the purchase they’ve already made.
Upsell: Sales tactic in which customers are invited to purchase more expensive items or upgrades. Unlike cross-selling, in which customers are sold related products, upselling encourages the purchase of a higher-end product than the customer already owns.

Finance:

No more silos for the finance team. With customer satisfaction being paramount, the finance function, just like marketing and sales, is intimately involved in customer relationships. All functional areas, both front- and back-office, must work together to match product, services, pricing and delivery to customer desires. Additionally, the subscription model presents some complications to a company’s financial reporting ore on that later). Businesses will need to make sure their finance team can collaborate well and has the infrastructure and savvy to handle a new financial model.

Product development:

For the subscription model to succeed, the product development team will need to consistently evolve the product to ease customer pain points and meet their needs. Changes only every year or two won’t cut it.

“You can’t move into a B2B SaaS model without expecting a change, enhancement or something pushed out that demonstrates value on a quarterly basis at least,” said Temple.

Make sure your product development team is willing — and more importantly, able — to consistently create new features and improvements, to prove the worthiness of the recurring revenue pricing model.

Back-office:

Back-office logistics can comprise a significant hurdle between your current business model and your future subscription business model. Pricing, billing, collections – all of these operations are more complex relative to a subscription model. For instance, you will generally be billing more frequently under a subscription model, with customers able to modify their services easily. And if your process has a significant manual component, then scalability is a concern. Without automation, a business may need more personnel instead.

The subscription model impacts a company’s external infrastructure, as well. It changes both how a business sells a product and the prospects to whom they sell. These shifts raise questions about the role of channel partners and resellers. Companies need to decide which role they want these partners to play in the future and how that role will change. They need to find ways to keep their partners engaged, well-informed and incentivized.

In order to successfully roll out subscription strategy, businesses will need to ensure that their functional teams have the knowledge and capacity to handle that longer customer lifecycle with a focus on retention. For some, that may mean upskilling and redeploying current employees. For others, it may require hiring new talent. Without preparation and buy-in, the subscription model is rendered just a different way of pricing, not a comprehensive strategy.

4. Do we have the needed technology infrastructure?

Technology’s importance in facilitating a subscription model is twofold.

The first component is simply logistical: The complex nature of a recurring revenue model means your business cannot be manual or reliant on systems that don’t have the needed capabilities. Companies with ERP systems need to ensure their system is capable of managing recurring revenue. On the sell-side, a CRM system should have the capabilities to automate the majority of the subscription and renewal management process, as well as accurately track customer information like billing, rewards and feedback. Trying to force systems without those capabilities to fit the subscription model can result in inaccurate forecasting, revenue leakage and improper revenue recording.

Companies without those capabilities may want to consider investing in a subscription management system and integrating it with their finance system. A subscription management system can support multiple pricing models, gauge consumption-based billing, automate renewals and schedule changes to subscriptions and more, overall ensuring smooth subscription management and accurate reporting.

The second component of technology’s role in the subscription model is a more of an opportunity in the form of data.

Michelin has become a rather surprising entrant into the data, analytics and as-a-service space. Smart tires in airplanes track the number of landings to determine when they need to be replaced. In Formula E racing, connected tires allow for more efficient air-pressure monitoring. Meanwhile, the subscription model allows Michelin to provide new services based on a company’s tire use. For instance, mining vehicles carrying large loads are prone to increased heat in the tires and costly failures. Michelin’s IoT-enabled sensors help mining operators monitor tire temperature and pressure, so they can reduce their speed when tires start to overheat.

B2B technology companies have the same opportunity. Effective data compilation allows for similar customization that not only promotes loyalty, customer satisfaction and engagement but also renders a switch to the competition — even when cheaper — an inefficient choice. The ability for companies to see how customers are using the product allows them to tailor their offering to deepen loyalty. While this process isn’t unique to subscriptions, the longer relationships associated with subscriptions give you more opportunities to perform it.

This data collection also helps with sales, Temple said.

“When it comes time for renewal, you know what [customers] have been using your product for — and not using it for — so you can either upsell, cross-sell or alert them to other ways they might use the product,” he added. “Giving back value [through analysis of] those metrics is fairly vital.”

Companies will also need to rethink how they measure success in data and analytics collection. Because subscription businesses are all about recurring revenue, traditional KPIs like average order value aren’t as indicative of health and performance. Instead, you’ll need to have the capabilities to track more relationship-based costs like churn rate and customer lifetime value.

Subscription KPIs to Consider
  • Customer Lifetime Value (LTV)
  • Churn Rate
  • Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR)
  • Renewal Rate
  • Average Revenue Per Account (ARPA) or Average Revenue Per User (ARPU)

The ability to analyze and act on this information will give your company an advantage in a subscription-based world. A strong data strategy can help you anticipate customer needs, present customers with timely, personalized offers and deliver a richer, more engaging experience.

A strong focus on customer success and a data-driven culture can require a big shift in mindset — and your company needs to be prepared to make that change.

5. Can we meet the accounting standards for a subscription model?

Contemplating a business model shift warrants a quick consult with a CPA. Subscription-based buying models require different accounting and reporting practices than a one-time purchase model. According to 2019 research from CFO Magazine, 48% of businesses with a recurring revenue model struggle to handle accounting and reporting challenges.

Both the U.S. Generally Accepted Accounting Standards (GAAP) and the International Financial Reporting Standards (IFRS) have relatively new standards around revenue recognition — and they get more complex regarding subscription revenue. Both state that revenue cannot be recognized until it is “earned.” For a one-time purchase, this is relatively straightforward: Revenue is recognized once the product is delivered to the customer. However, subscriptions fundamentally change the nature of the interaction between the business and the customer: Instead of a one-off transaction, companies with subscription offerings see smaller payments over a longer period of time.

For example, let’s say a consumer signs up for a software subscription which costs $12,000 for the year and has a one-time setup/training fee of $250 — both due upfront. As soon as the training/set up is complete, the company can consider that $250 “earned.” However, even though the customer already paid for the subscription service, it hasn’t yet been delivered and thus can’t be recognized as revenue. Instead, the revenue is recognized on a pro rata basis with $1,000 being recognized each month as the service is rendered.

Because revenue is segregated from billing, unlike a traditional one-time purchase, and can vary based on factors like pricing plan, billing cadence, when a customer signed up and even days in the month, the accounting and financial reporting process is much more complex. If your system isn’t equipped to handle new ASC 606 standards — where revenue is only recognized when certain performance expectations are satisfied — you’ll need more manual steps. This increases the risks of getting it wrong, again underlining the importance of a subscription management system and a team equipped to handle it.

The Bottom Line

Subscription business models are all the rage right now, for good reason. As both the business and consumer realms lean toward access over ownership, a subscription model can generate new sources of revenue and innovation. Before jumping into the deep end, though — à la my impulsive 2018 bob haircut — ensure it’s a fit for your team, offerings and business as a whole.

Mark Bianco

For more helpful information from the Brainyard and our friends at Grow Wire and the NetSuite Blog, visit the Business Now Resource Guide.


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