By Meredith Schmidt
Not too long ago, the word “subscription” really only referred to newspapers, magazines, and mail-order food and music services. Subscribing to something meant signing up for regular deliveries of a product — usually a periodical or other consumable (Remember the Harry & David Fruit of the Month club? It’s still around!) — for which you paid a regular, recurring fee.
Then the Internet came along and over time changed all of that. Smartphones and Web apps made it easy for buyers and sellers to manage subscriptions, which made subscription-based models viable for all sorts of businesses. Digital goods like software and media are obvious candidates for subscription pricing, as they’re cheap to distribute and update at scale. But when you think about it, you can conceivably build a subscription model around most anything these days — from cars to clothing — with the right economic conditions and business strategy.
Is subscription pricing right for your small business? Let’s explore.
Subscription Economics 101
Subscription-based revenue models hinge on balancing short- and long-term business goals. For example, Salesforce’s business model is built around software as a service (SaaS), a subscription-based model under which customers get access to our cloud-based software. When Salesforce started, our model stood in stark contrast to “on-premise” software sales. Remember the days when we had to buy software on CDs, install it on all of our workstations, and then repeat the process for each new application and update? Our SaaS model offered a new way for customers to buy and use software. The concept felt like freedom, and it sparked an entirely new business approach for companies of all sizes and industries, from subscription box startups Stitch Fix and Bark Box, to digital media innovators like Netflix and Spotify.
One framework we use to balance long-term growth and profitability goals is Subscription Economics. This is a framework which allows us to measure the economic value of every dollar of new business we acquire. In fact, many business schools teach Subscription Economics as a way to evaluate the underlying economics of a business — it’s similar to another popular concept called Customer Lifetime Value.
Calculating profits and losses
In a nutshell, the Subscription Economics framework allows us to bridge today’s investments with their long-term economic value, so we can optimize our business performance for the long haul. Subscription Economics uses four key metrics to illustrate a business’s economic drivers:
- Cost-to-book (CTB): All costs incurred to bring new business in the door (primarily sales and marketing).
- Cost-to-serve (CTS): Expenses incurred to service and maintain current customers (infrastructure, R&D, etc).
- Attrition: The reduction or loss of the annualized value of our business. In other words, what percentage of our revenue did we lose this year?
- Annual contract value (ACV): The annual contract value of a new or add-on sales opportunity, eg New business.
These indicators let us estimate how much profitability or loss we will eventually generate from any investments we make.
There’s a lot that goes into calculating profits and losses in our framework, but the key takeaway is this: Subscription pricing models can build predictable, long-term revenue your business can count on for planning growth. The revenue waterfall is a big part of how it works.
The Incredible, Predictable Revenue Waterfall
Small businesses, in particular, can really benefit from the stable, predictable nature of the waterfall model. Knowing in advance what at least a chunk of your monthly revenues will look like can give small business owners breathing room to plan for growth initiatives.
For instance, customers buy Salesforce products by subscribing to our services. We typically book contracts on an annual basis, and the revenue from each contract we book is spread across 12 months for accounting purposes. The more contracts we book, of course, the higher our monthly revenue will be. Same goes for monthly cash flow. When multiple contracts are signed, it sets up what we like to call a revenue waterfall, where monthly revenue keeps going up as each new contract comes on the books.
The more of those contracts we book early in the fiscal year, the higher our annual revenue will be, since we’ll have more months of cash coming into the business. Monthly and annual revenue figures are important to Salesforce since we’re a publicly traded company with investors to serve. But the predictability of monthly cash flow and the revenue waterfall is a boon to any business, as it lets you plan well in advance, and also enjoy some immunity from the financial ebbs and flows of “hot” and “slow” sales seasons.
Is the Subscription Model Right for You?
In a word, yes! You don’t have to change your core business, but it’s worth exploring how a subscription-based offering could help you grow. Apple is a great example: iPhone is one of the most profitable products in history, yet Apple spent the past several years building out a services business. Phone sales are now slowing down, but the services portion is growing year over year, accounting for a record $11.5 billion in the first fiscal quarter of 2019.
It’s interesting that small businesses and startups are leading the way in subscription pricing. Sure, the enterprise businesses are on board, but think about companies like ClearSky Data and Birchbox who’ve built thriving businesses on a subscription model. It’s their growth and success that have forced bigger businesses to include subscription models too.
You don’t have to be doing billions of dollars of business to reap the benefits of spinning up a subscription business. Just look at your core competencies from a new perspective: Can you start a premium subscription tier of carefully curated products or services with an extra personalized touch? What about packaging up your popular service offerings at a special monthly price?
There are always risks involved, but the upsides for subscription pricing are huge: Predictable revenue and cash flow, building long term customer relationships, and the potential to reach untapped markets. If you haven’t already, set aside some time to brainstorm how your business could spin off a product using the subscription model. You might be surprised at how many ideas you come up with.
As Executive Vice President and CEO of Essentials and SMB, Meredith Schmidt is responsible for creating products that help small businesses take advantage of the Salesforce Platform to grow their businesses. Meredith was previously the Executive Vice President in charge of global revenue operations at Salesforce, managing the sales operations, compensation, and product and enablement teams, reporting directly to the CFO. Follow her on Twitter: @MeredSchmidt.