Subscription Models - "The Devil is in the Details"

Subscription Models

“The Devil is in The Details”

Understanding the nitty-gritty details that underpin a subscription revenue model and why taking a back-of-the-envelope (just keep it simple) approach in forecasting the subscription revenue stream can be perilous to start-up businesses. After reading the excellent cover story in Barron’s (December 10th, 2018) by Alex Eule on the prevalence of subscription-based revenue models being leveraged by start-up businesses in all industries, I thought it important to lend some of my learnings over the years in creating and analyzing subscription-based models.

Having experience in transforming both large consumer product companies and advising start-up businesses with subscription models, I have seen many take a far too simple approach to building out the revenue and assumption models associated with the subscription revenue portions of their businesses. This manifests into forecasted revenues not being achieved, cash flow requirements not being met (not a good thing for start-ups), and ultimately, and most importantly, unhappy investors.

A Financial model usually encompasses multiple summary reporting objectives for the business: Income Statement (P&L Statement), Balance Sheet Statement, Cash Flow Statement, etc.

Businesses that have both physical product sales and subscription sales usually prepare an Income statement with Product and Subscription Revenue broken-out separately. However, I believe there are three major areas where the detail assumptions need to be carefully reviewed and cannot be short-changed in developing a Financial model for a Subscription Revenue based business:

1. Active Subscriber Base (Monthly)

2. Churn Rates (retention/cancellation percentages)

3. Earned vs Deferred Revenue

Before getting into the specifics surrounding the aforementioned areas, we first need to discuss the overarching model structure. The best models should be structured and built from the Bottom – Up. If you are selling multiple products, multiple subscriptions, and/or membership plans (month-to-month, Annual, Biennial, etc.) your active base, churn rate, and earned revenue calculations will most likely be different by product sku and subscription plan.

For example, using an aggregated average churn rate by month for all membership plans will most certainly yield an unrealistic monthly active base. A good rule of thumb is to ask yourself, do my individual products or membership plans have different churn/retention rates that will affect my active base? If so, it would be best for the subscription model to be at product sku and membership plan level of detail.

Active Subscriber Base

Monthly recurring revenue (MRR) is the amount of fixed revenue retained every month. It is calculated by multiplying net users per month by the subscription fee. A critical factor in the calculation of the MRR is an accurate monthly forecast of the active base (net users per month), so understanding how the monthly active base is derived is priority number one.

Some businesses that sell a physical product and a subscription membership, and the product is sold through the retail channel, may require a closer review to ensure that wholesale sales of the physical product are not included the subscription active base. Delineating between wholesale and direct to consumer sales (eCommerce sales) is a necessity in determining and forecasting the monthly subscription active base. Since membership plans in most subscription businesses are sold directly to the end customer, physical product sitting in inventory at wholesale are considered product revenue but not included in the subscription active base until the subscription plan is activated by the consumer. Another important requirement when determining the monthly active base is not just providing the forecasting assumptions for churn/cancellation rates by month, but how the percentages or rates are applied in calculating the end-of-month active base. This is best discussed in the next section Churn/Cancellation Rates.

Churn/Cancellation Rates

There are two key elements in applying the forecasted churn rates or cancellation percentages in determining the forecasted active base for any month. First, a straight-line method should not be used (same percentage of churn every month against the sales/new actives for the same month). The more precise way to determine the impact that cancellations have in forecasting end-of-month actives is to utilize a cancellation rate by month (for as many months you believe represents the lifetime retention period) and applying that rate to the actual monthly cohort for that particular month. For example; The table below outlines active subscribers for January and February new actives of 100 and 90 respectively. The cancellation rates are 5% for the first two months as an active subscriber, 4% for the next two, and 3% for the 5th month, etc. The figures under each month for the January cohort represent how many subscribers of the January cohort would be retained in Feb – May, and similarly for the Feb cohort.

If we were to add additional rows representing new active cohorts for subsequent months (i.e. March, April, etc.) you can visualize a retention wedge forming until each cohort finally depletes to zero.

Earned vs Deferred Revenue

Ask any founder or CEO of a start-up business what keeps them up at night and they will tell you it’s making sure they have transparency and an accurate projection of their cash position at all times. Managing cash in a subscription model start-up has its own unique challenges. If your business offers multi-month or multi-year commitment membership plans and accepts the prepayment of its monthly fee for its services in advance for the entire commitment, the amount that received in advance of earning it is called Deferred revenue. According to the revenue recognition principle, it is recorded as a liability until delivery of the service is made, at which time it is converted into revenue.

The recording of earned and deferred revenue may not be a standard feature handled by your existing financial applications, customized software may need to be developed to accomplish this process. However, since your business is receiving cash in advance there is a desire to use the cash for operations (especially if the start-up is not well funded). When possible, my recommendation would be to keep that some percentage of the cash in reserve to help fund operations to service your customers through their subscription commitment, and to ease the burden on your exit strategy.

With subscription models becoming the “go-to” monetization strategy for start-ups and mature companies alike, and with investors understanding the potential it provides for company earnings growth, subscription models are here to stay. As Eule states in his article, “Subscriptions offer a way off the physical product hamster wheel. Recurring payments have changed the way that Americans consume software, music, movies, television, fitness, clothing, and food. Even tractor maker Deere is trying to sell subscriptions to farmers.”

There is obviously much more to building a full-blown subscription revenue model for a business, than what I have outlined here. Each subscription model has its own nuances and specific requirements that need to be addressed. I hope this short article at least points you in the right direction in realizing the complexity of ensuring the success of a Revenue and Cash forecast associated with a Business or Financial plan for a start-up subscription company and how important understanding the details in creating that model can be.

#IOT #SubscriptionModels #eCommerce #BigCommerce