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

by Tien Tzuo

After the rug got pulled out from beneath them in 2008, a lot of businesses and investors realized that they were playing their own version of Hollywood economics: Pour tons of money into developing a product, then pray for a hit. If it doesn’t work out, you’re out of luck. These companies had no visibility into their finances. They had no predictability in their forecasts. They started every quarter with nothing in the bank and had to crawl all the way up to hit their number. That’s not how it works with subscription revenue. A $10 million company with 80 percent subscription revenue starts every year with $8 million in the bank. If stock valuations are forward-looking predictions, then subscriptions are forward-looking revenue models.

And when you finally discover your customers, it changes everything about your company. It affects every role. With a subscription model, suddenly your development team is spinning up new services based on usage data, as opposed in response to the loudest voices in the room. Your finance team is getting ahead of churn and test-driving new ideas. Your customer service team is proactively advising, as opposed to reacting to, tickets with scripts. Your marketing team can tie pricing to value, so they can come up with creative new packages and services. You’re no longer hamstrung by back-end processes that can’t adapt and scale. There are no more strictly linear, bucket brigade–style operations. Your organization is fluid but cohesive, recurring and responsive, and above all, relentlessly centered around your customer.

The subscription model gives us predictive revenue—that’s something that no commercial carriers have. They don’t know if a flight is going to be profitable until the door on the airplane closes (and they still have to fly at that point!). Because of subscriptions, we know exactly how much revenue we’re going to generate at the beginning of every month. So we can scale our operation effectively, because we know exactly how much flying we’re able to execute. That kind of insight is basically magic in the aviation industry. No one has been able to do that before.”

THE FISH MODEL To understand why traditional software companies were facing such a steep uphill climb, you have to understand the Fish Model. In their excellent book Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business, Thomas Lah and J. B. Wood refer to this transition period as “swallowing the fish,” as the revenue curve temporarily dips below the operating expense curve before climbing back upward again: The fish is what happens when a traditional company starts to shift its revenue mix from an asset purchase model to a subscription model. In this scenario, the company experiences a string of quarters where top-line revenues shrink as revenues from large, pay-up-front deals are replaced by recurring subscriptions without the big up-front payment. At the same time as revenues dip, the company must make investments in many of the new capabilities and structures that are required for profitable XaaS. The traditionally profitable and stable mix of more revenue than costs on the left side of the chart is replaced with a tumultuous period of costs exceeding revenue. So, a fish: As Lah and Wood note, management teams chasing after quarterly numbers generally don’t like the look of that fish. They would just as soon avoid it altogether. There are boards and investors to consider, not to mention the fact that as traditional unit-based companies, Wall Street measures them on strict GAAP-realized profits, not growth rates based on deferred revenue. When...

Today the entire software industry is following Adobe’s lead. In February 2015, for example, Autodesk announced the transition from perpetual licensing to pay-as-you-go subscription plans. By August 2016, Autodesk’s stock jumped to an all-time high following record increases in cloud subscriptions as their “customers and partners embrace a model that has greater flexibility and a better user experience,” according to Autodesk’s then-CEO Carl Bass. And why did Microsoft, which has been public since 1986, see its stock hit an all-time high in July 2017? Because it rode the shift to become a successful SaaS company with its “Commercial Cloud” business nearing its fiscal 2018 goal of a $20 billion annualized revenue run rate and its Office 365 Commercial business beating out its traditional licensing business in revenue generation. There are countless examples of software companies that have successfully made the shift to subscriptions and subsequently driven higher valuations and more shareholder value: IBM, Symantec, Sage, HP Enterprise, Qlik. Another big reason? IT buyers prefer opex to capex. Historically software companies have preferred capital expenditures (capex) for technology investments, as this afforded them the ability to take advantage of amortization and depreciation of the capital investments over a period of time. But as technology shifts to the cloud, there’s a complementary shift happening in favor of opex over capex. Operating expenses bear the advantage of...

Over the course of the entire lifetime of a subscription business, do you know how much time the average management team devotes to planning their pricing? According to business intelligence platform ProfitWell, the average amount of time a company spends per year on pricing is less than ten hours. That’s nuts, especially considering the huge impact that pricing has on your bottom line—it can be much more impactful than similar amounts of effort spent on acquisition or retention.

INTRODUCING THE SUBSCRIPTION ECONOMY INCOME STATEMENT 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. It is the revenue that recurs, as opposed to the revenue that gets booked only once. Every quarter, subscription businesses look at how much their ARR has grown, using the following formula: Based on this formula, Tyler and I constructed a Subscription Economy income statement, one that better reflects how we thought about the business. This is what we presented to the board sixty days later. Since then we’ve shared this model with countless other companies, as well as a number of financial analysts who cover subscription businesses. Given the formula above, a Subscription Economy income statement should look more like this (revenue in millions): ARR $100 Churn (10) Net AA 90 Recurring Costs Cost of Good Sold (20) General & Administration (10) Research & Development (20) Recurring Profit 40 Sales & marketing (30) Net Operating Income 10 New ARR (or ACV) 30 Ending ARR $120 Let’s break this down. 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...