Subscribed: Why the Subscription Model Will Be Your Company's Future - and What to Do About It

by Tien Tzuo

Subscription businesses need to constantly be optimizing revenue through pricing. In our experience, we see this philosophy reflected by companies that, generally, update their pricing at least annually (which means that they’re thinking about pricing constantly throughout the year). Why do you do this? Because pricing is the key growth lever behind the other seven strategies I just discussed. I can’t stress this enough—your subscription service could be sitting on vast amounts of unrealized value, simply because it hasn’t taken the time to test the market with new pricing strategies. You don’t need to guess anymore, but you do need to test.

Regrouping, Tyler and I realized that we weren’t explaining things the right way. We had delivered the plan using a traditional financial model, a pro forma income statement that was backward-looking and couldn’t show the return we would be making on our growth investments. Shame on us for assuming our VCs could do the translation without our spelling it out. We also realized that we needed better benchmarks. But to do benchmarking right, we needed to be able to use publicly available financial statements.

The guy who first formalized this system, also known as “the father of accounting” (they still have CPA conventions in his hometown!), was a Franciscan friar named Luca Pacioli. He was born outside Florence in 1447 and led a very full life. He was a brilliant, peripatetic man who taught and wrote in Venice, Bologna, and Milan. He wrote a treatise on magic that included the first instructions for card tricks, juggling, and fire eating. He gave lectures on Euclid. He wrote books about algebra, chess strategy, and geometric form and perspective. The latter was illustrated by his collaborator and roommate, Leonardo da Vinci.

we realized that this model may have worked fine for the last five hundred years, but it was entirely wrong for a subscription business, for three key reasons. First, the traditional income statement does not differentiate between recurring and nonrecurring dollars. It’s like saying there’s no difference between a dollar and a dollar that keeps happening every year for the next ten years. Recurring revenue is the cornerstone of subscription businesses, but traditional accounting concepts were never designed to recognize this fact. Second, sales and marketing is matched to past goods sold. It’s essentially a sunk cost. I’ll get into this later in the chapter, but subscription businesses need to think strategically about sales and marketing spend going toward driving future business. And finally, this is a backward-looking picture—it’s all about money already earned, expenses already paid, actions already taken. Subscription businesses are all about forward visibility: how much money I know I can count on over the next twelve months, so I can account, plan, and spend accordingly.

Every smart subscription business I know focuses on something called ARR, or annual recurring revenue. What is ARR? Simply put, it is the amount of revenue that you expect your subscribers to pay you every year.

ARR—Notice again that instead of starting and ending with income, now we’re starting and ending with ARR, or annual recurring revenue. Again, that’s because this income statement looks forward, not backward. Whereas a traditional statement says “you made this much revenue in the past quarter,” this statement says “you are starting the quarter with this much recurring revenue.” That’s a huge quantitative difference. ARR is known recurring revenue that you can bank on.

Churn—Sadly, not all recurring revenue actually manages to recur.

Recurring Costs—The first question is: What do we need to spend on to service that ARR? After all, your existing customers are expecting a service! Here is where we’ve rearranged some costs. We’ve pulled up COGS, R&D, and G&A to be “above the line,” in the sense that these are the costs you need to spend to service your ARR.

Recurring Profit Margin—Your recurring profit margin is simply the difference between your recurring revenues and your recurring costs. This number gives you the intrinsic profitability of your subscription business, as there is certainty in your recurring revenue, as well as certainty in the costs to service that revenue.

Growth Costs—So what about Sales and Marketing? Here lies one of the biggest differences between traditional and subscription businesses. In a traditional business, the cost of sales reflects how much I spent to get that dollar of revenue. But in a subscription business, sales and marketing expenses are matched to future revenue. Why? Because the sales and marketing I spent this quarter adds to the ARR, but the revenue I will see from that ARR growth will come in future quarters. In traditional accounting lingo, your sales and marketing now acts more like a “capital expenditure,” or capex. Essentially, these are costs you spend to grow the business, either from existing customers or from acquiring new customers. That’s why we call them growth costs.

why not spend all of the recurring profit on growth? Why not, indeed? If you believe you have a big potential market and have control over your churn, you can run this play year over year, and you’re growing by 30 percent annually. And when the time comes to finally start taking profits, you’re working off a much bigger recurring revenue stream. This is why a lot of subscription companies may “look” unprofitable, but they are actually awesome businesses. It’s also why I roll my eyes every time I hear an analyst complaining about the lack of profitability at companies like Salesforce and Box.

Here’s the key takeaway—it is perfectly rational for subscription businesses to spend all their profits on growth, as long as their bucket doesn’t leak.

All our department heads know that the best way for them to grow their budget is for them to contribute to growing our ARR. How are they using their resources effectively toward that single goal? When ARR grows, your budget grows.

Traditionally, 80 percent of a CFO’s job was to tell people what happened. To keep score. To track the budget. The other 20 percent was to interpret those numbers in order to direct resources, create forecasts, and manage strategy, to write the next part of the story. Today that ratio has flipped.

Who are my subscribers? Try asking SAP or Oracle how many active subscribers you have at any one time, and they’ll be stumped. The concept simply doesn’t exist in their universe. Systems of record for orders, accounts, and products? Sure. But ask your ERP how much upsell business you’ve done, or how many customers have renewed in the past year, and you’ll get a blank stare. ERP is simply not built around customer-centric transactions. And unless you can monetize customer relationships over time, you’re dead in the water.

Subscriptions are an ongoing dynamic cycle of actions: renew, suspend, upgrade, downgrade. So the subscriber actions on the inner circle of this diagram need to inform the business systems on the outside.

It turns out that being a “customer-focused company” is a simple concept that is, in fact, very difficult to realize. It requires a cultural change. Product cultures are built around thinking and organizing like assembly lines: stay in your lane, do your job, then pass it on to the next person. That no longer works. Subscription cultures are about making sure your customer continues to succeed with your service over time, and translating that ongoing value into revenue. And why is creating that subscription culture so hard? Because the same organizational structures that worked in the past are now hindering the future. Organization is the biggest thing holding us back—just

The business was scaling nicely. But like so many businesses, we were starting to get siloed. Increasingly, our departments were arguing, and we would argue about who should do what—instead of what was good for the customer,

What’s PADRE? Well, it’s our way of visualizing our company as an integrated organization composed of eight subsystems, all tied to the customer.

We start with Pipeline, which a consumer-focused subscription company might call positioning. The key goal of the pipeline subsystem is to build market awareness and translate that into demand. You do that by getting the marketplace to understand your story: who you are, why you exist, what you do, what benefit you provide. You’re also not just addressing potential customers, but the people who influence them: journalists, analysts, the adjacent vendors they interact with, etc. The idea is to get an interested (and, ideally, well-informed) potential base of subscribers to engage with the company: visit the website, download the app, talk to your salespeople or resellers.

Then we have the Acquire subsystem, which encompasses the so-cal...

Only once a company becomes a customer and enters into a contracted subscription relationship with us can we actually start creating value.

Deploy. How do we get our customers up and running as quickly and efficiently as possible?

Run. As a subscription company, you succeed or fail based on how well and how long your subscribers take advantage of your service. Anything you do that doesn’t feed into the customer success flywheel is detrimental to the growth and value of your business.

Expand. You want three things out of your subscribers: retention, growth, and advocacy.

PADRE is also supported by three core subsystems that manage the “back of the house”: People, Product, and Money.

This is a perspective that transcends departments, roles, and org charts. It’s an enduring way of looking at a subscriber-focused company. Things change all the time around here. That’s natural. Priorities shift. People arrive, people leave, working groups form, projects finish. As we grow larger, we start specializing, and things by definition get more complicated. The organization may start to grow and branch out in all sorts of unexpected and unusual ways, but these eight subsystems stay the same.

And here’s the most important part—the only way these individual subsystems can succeed is with cross-functional coordination.

PADRE permeates everything we do at Zuora. We build all our metrics around it, which we share with the whole company: pipeline coverage, sales numbers, new logos deployed, retention statistics, expansion rates. We teach it to all our new hires as part of the onboarding process. We build our operating cadence around it—weekly, quarterly, and annually. Every week, all the managers get an eight-slide deck (one for each subsystem) that shows where we are, with red/green/yellow flags to indicate hot spots. And as we’ve grown and started segmenting our customers, we’ve created “Franchise” PADRE reports by geography and customer size.

Once a quarter, as a management team, we’ll drill into one of the eight subsystems.

PADRE is an operating framework, but perhaps more important, it’s a way of formalizing a culture. A culture built around always keeping the same intuitive customer insight that we enjoyed as a small company.

Once upon a time, we used to know the people we bought from—the butcher, the baker, the blacksmith, the farmer. We used to know the people we sold to, the neighbors in our village. All that knowledge got lost a long time ago, when the Industrial Revolution ushered in the product era. But it’s coming back in a big way. And in the process, we’re getting rid of a lot of stuff we never really needed in the first place—planned obsolescence, the landfill economy, the whole concept of ownership itself.

It’s also a much happier business. Why? Because subscriptions are the only business model that is entirely based on the happiness of your customers.

Subscription business sales have grown substantially faster than two key public benchmarks—S&P 500 sales and US retail sales. Overall, the SEI reveals that subscription businesses grew revenues about eight times faster than S&P 500 company revenues (17.6 percent versus 2.2 percent) and about five times faster than US retail sales (17.6 percent versus 3.6 percent) from January 1, 2012, to September 30, 2017.

Size matters in the Subscription Economy. The subindex made up of $100M+ constituents has been the highest performing since its inception in 2014. In contrast to start-ups, these larger companies have more resources, more distribution, more new acquisitions, more channels to grow. As a result, they benefit from the network effects mentioned earlier in this study.

For start-ups, the real challenges appear to lie after the initial submillion-dollar “honeymoon” growth period. As seen in the figure below, the $1 million to $20 million revenue band has the most challenging growth rate.