How do you measure the true value of a subscription business? A traditional GAAP financial analysis can’t measure the health of a subscription business because it doesn’t recognize the value of subscription revenue. Learn about how subscription businesses need to measure their performance and the three metrics that really matter.
Measuring the Performance of Your Subscription Business: The Three Metrics That Matter
1. Why Zuora : Zuora Provides a BluePrint to Succeed in
the Subscription Economy!
Measuring the Performance of Your
Subscription Business:
The Three Metrics that Matter
3. The Problem of Assessing
Subscription Companies
High growth subscription companies are
often “unprofitable”
Yet the markets value subscription revenue
at twice product revenue
4. Fast Growing, Money Losing, Highly Valued SaaS
Vendors
4
FireEye
Workday
Tableau
NetSuite
Marketo
Salesforce
Intuit
Microsoft
Oracle
SAP
Splunk
Adobe
-100.0%
-80.0%
-60.0%
-40.0%
-20.0%
0.0%
20.0%
40.0%
-25% 0% 25% 50% 75% 100%
%NetIncome
Revenue Growth
Companies moving to SaaS have
high valuations even with negative
growth.
Legends:
Size of Bubble =
Valuation/Revenue
SaaS
Mixed
Software
Only 30% of public SaaS
companies make a profit!
5. Financial Differences
Sale Subscription Annuity
Revenue Acquisition
Costs
Prior to Purchase Prior to Contract
Profit from Sale At Delivery Over Life of Customer
Revenue and Profit
Predictability
Large Profits, then nothing
until next sale
Greater Profits, but over the
Life of the Customer
Comparing financial results requires a different analysis
6. Revenue comes later with Subscription Companies;
Much later with High Growth Subscription Companies
$K
$20K
$40K
$60K
$80K
$100K
$120K
$140K
$160K
$180K
$200K
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
AnnualRevenue
Purchase versus Subscription
Annual Revenue – No Growth
Purchase
Subscription
100 New Deals/Year
$3K Purchase versus
$1K Annual Subscription
10% Annual Churn
$K
$100K
$200K
$300K
$400K
$500K
$600K
$700K
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
AnnualRevenue
Purchase versus Subscription
Annual Revenue – 30% Growth
Purchase
Subscription
100 New Deals/Year
$3K Purchase or
$1K Annual Subscription
10% Annual Churn
7. We need financial analysis methods to
value long term profitability of the growing
Subscription Annuity stream, not just short
term profit.
8. The Limitations of GAAP Financials
GAAP is backward looking not showing the
value of the recurring revenue stream
GAAP Income Statements do not give
insights into the health of a rapidly growing
subscription business
9. Subscription Financials Analysis Requirements
Build on GAAP standards
Recognize the future value of the Subscription
Recurring Revenue stream
Measure the Revenue Acquisition Costs against
the Recurring Revenue stream
Segregate the costs of Running the Business from
Acquiring New Business
10. *at a sustainable cost
Subscription Businesses are all about
Efficiently Building the Recurring
Revenue Stream*
11. 3 Metrics Measure Subscription Business
Efficiency
Churn
The revenue that is lost and must be replaced
Growth Efficiency
= Revenue Acquisition Costs/ New Annual Recurring Revenue
The cost to obtain a dollar of new subscription revenue
Recurring Profit Margin
= Subscription Revenue – (Cost of Subscription Services
+ R&D Expense
+ Administrative Expense
+ Acquisition Cost of Replacing Churn)
Profit excluding Costs of Incremental Revenue
12. Key Metric: Churn
Churn destroys the value of the
subscription revenue stream
Churn must be replaced raising
the total cost of Customer
Acquisition
Churn should decline over time
ChurnRate
Time as Customer
14. Key Metric: Growth Efficiency Index (GEI)
The company’s ability
to grow is constrained
by the cost of growth
The acceptable GEI is
a function of churn
The GEI should
decline with company
maturity
35%
104%
31%
111%
88%
152%
75%
154%
262%
111%
0%
50%
100%
150%
200%
250%
300%
Growth Efficiency of Public Companies
% Growth Growth Efficiency
* Pre IPO
15. Growth Efficiency Index Targets
GEI will be high during the early
company life
New Customer Acquisition is
Expensive
Customer Expansion is much less
expensive
Later Stage subscription
companies have lower GEI
Target GEI
~.5
~1.0
~1.5+
~2.0
B2C, High Churn
B2B, Later Stage
B2B, Growth Stage
B2B, Launch Stage
16. Key Metric: Recurring Profit Margin
Recurring Profit Margin is
the estimated profit with no
growth
Additional Sales &
Marketing expenses will
fund growth 26%
16%
6%
-4%
-14%
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
140.0%
0% 10% 20% 30% 40%
EXPENSES
GROWTH RATE
COGS Sales & Marketing R&D G&A Profit
Recurring Profit Margin with
no growth
Sales Efficiency 1.0x
Subscription Businesses trade-off Profitability and Growth
19. 3 Direct Measures of Growth
• Increase in ARR
– Value of all Subscriptions contracts at a point in time
• Increase in Revenue
– Includes all revenue from the business
• Increase in Cash Flow
– Focuses on the cash generated from operations
– Should exceed the income from operations
The median growth of public and private SaaS companies is 30%
20. Customer Lifetime Value Predicts the Value of Subscriptions
• Customer Lifetime Value (CLV)
is the Predictive Measure of the
Net Present Value of the future
Subscriptions Gross Profits
• Customer Equity is the sum of
Customer Lifetime Values
When Customer Equity is growing rapidly, loses are defensible
Customer
Equity
Annual
Recurring
Revenue
Cost of
ServiceChurn
Cost of
Capital
Customer Equity = Total Recurring Revenue – Cost of Service
%Revenue Churn + %WACC
21. Target Revenue Acquisition Cost from CLV
• Revenue Acquisition Cost < 25% CLV
– Comparable to Product Sales
• Growth Efficiency Index < 25% CLV/ARR
– Equivalent measure based on GEI
22. Tying it all together in the
Subscription Financials
23. Contrasting Public Software & Subscription Profits
Subscription
Companies
Software
Companies
Revenue 100% 100%
Cost of Service* (30%) (33%)
Gross Profit 70% 67%
Operating Expenses
S&M (39%) (23%)
G&A (17%) (10%)
R&D (18%) (15%)
Total Op Ex (73%) (49%)
EBITDA (.3%) 19%
* Includes low margin professional services
Median Growth 26.0% 9.9%
Economic
Value/Revenue 8.0x 3.2x Source: SEC Software Equity Group,
Q1 2014 Software Industry Financial Report
Public Subscription
companies have over twice
the valuation ratios of Public
Software companies
24. Alternative Income Statement Presentation
Revenue 100%
Cost of Service -20%
Gross Profit 80%
Operating Expenses
S&M -40%
G&A -15%
R&D -20%
Total Operating Expenses -75%
EBITDA 5%
Revenue 100%
Cost of Ongoing Operations
Cost of Service -20%
S&M - Churn Replacement -10%
G&A -15%
R&D -20%
Cost of Ongoing Operations -65%
Recurring Profit Margin 35%
S&M - Incremental Revenue -30%
EBITDA 5%
Traditional Income Statement Subscription Income Statement
Yearly Metrics:Prior Current Growth
Revenue 100 130 30%
Ending ARR 115 150 30%
Revenue Churn 10% 10% 0%
Cost of Capital 10% 10% 0%
Customer Equity 576 749 30%
Growth Efficiency 1:1 1:1 0%
Yearly Metrics:Prior Current Growth
Revenue 100 130 30%
25. Summary
GAAP financials show the historical company results.
Growth in Customer Equity and Recurring Revenue measure the
company’s growth and future revenue.
Recurring Profit Margin of existing subscriptions should be
separated from the costs of new revenue.
Subscription Metrics of Growth Efficiency and Churn are the Key
Performance Indicators of cost effective growth.
The growth in the company’s Customer Equity measures the increase
in company value.
The issue is the time frame of the profits. Sell a product and you know your profit from that sale. When someone subscribes to product or service, the profits come in the future. You must assess the future revenue stream to value your future profits.
I talk to a lot of companies about their subscription business model, how they present it, and how they assess how they are doing. I work with both Subscription companies as well as venture capitalists and private equity groups that are assessing subscription companies.
I suspect in this group most of you are “believers” in the subscription model, but looking for new methods to assess how you are doing at each stage of your development.
The reason some vendors resist converting to a Subscription model is they don’t know how to make the transition, set appropriate benchmarks for success, or know how to manage the transition. This is the case whether it is a new “pure play” subscription company, a new division of a software company (like Microsoft Office 365), or providing an option of purchase or subscribe models.
The majority of SaaS companies are unprofitable from a GAAP perspective during their high growth period. The financial markets don’t seem to care about loses that much since they understand these companies are building long term profitability from an occurring subscription revenue stream.
The core problem with subscription model finances is the cost of the customer acquisition happens before the revenue stream begins, and the time to recoup the customer acquisition costs can be substantial.
We’ll give you the insights that the financial markets see in the value of the growing subscription revenue stream and assess if the growth is worth the cost of that revenue acquisition.
Subscription businesses generally grow faster, but from a backward looking financial perspective lose money. In fact, the median growth for a software company was xx% while the median growth for a public SaaS company was xx%
Yet the financial markets see the value in the growing customer base and value them appropriately.
Many software companies are moving to provide Subscription offerings. Companies such as Adobe and Intuit see short term loss of revenue from this transition, but the market values them higher than pure software companies.
The cost of revenue acquisition occur up front for both the sale and the subscription, the revenue is immediate with the sale, and over the life of the customer for the subscription.
That means the corresponding profit is immediate for the sale, and over the life of the customer for the subscription
THIS IS THE MOST FUNDAMENTAL DIFFERENCE IN THESE MODEL
With this revenue over the life of the customer, the revenue stream is much more consistent. In each quarter, the majority of the revenue is from the existing customer base and just incremental revenue from new subscriptions. With the purchase model, you start over each quarter.
The cost of revenue acquisition occur up front for both the sale and the subscription, the revenue is immediate with the sale, and over the life of the customer for the subscription.
That means the corresponding profit is immediate for the sale, and over the life of the customer for the subscription
THIS IS THE MOST FUNDAMENTAL DIFFERENCE IN THESE MODEL
With this revenue over the life of the customer, the revenue stream is much more consistent. In each quarter, the majority of the revenue is from the existing customer base and just incremental revenue from new subscriptions. With the purchase model, you start over each quarter.
So how do we augment our financial models to do decent financial analysis of Subscription companies?
So we know the problems with GAP…
The answer is to build on GAAP,
Assess the value of the recurring revenue stream – the Customer Equity
Gauge the efficiency of obtaining new revenue
Determine the profitability of the business without growth – we separate the profit of the steady state business from the cost of growth which is adding shareholder value.
So the attributes of a healthy subscription business is that they grow efficiency, and that recurring revenue stream is profitable over the life of the customer.
The metrics for maximizing the Customer Lifetime Value, and the Subscription Business Efficiency are encapsulated in the “3 Key Subscription Metrics that Matter” first proposed by Zuora.
Churn is what determines the long term value of the customer.
Growth efficiency determines the cost to obtain new customers
And
Recurring Profit Margin is what is the profit from the existing customer base
Since the Customer Equity is a predictive metric, it can only be derived based on past results and management judgment.
Since it is predictive, it is not guaranteed, but also should not be ignored because it is the core of the value of a subscription company. In fact, if you estimate the Customer Equity of large Subscription companies such as Salesforce, this value can explain a great deal of their high market valuations.
It is important to look at each component of the CLV of each customer to maximize it.
The gross profit is crucial to ensure that the company retains most of the gross profit from the subscription. The Cost of SaaS Services should be below 20% as is achieved by major SaaS companies including Salesforce, NetSuite, and Workday.
Churn is the most significant determinant of the long term value of the customer. If churn is high (greater than 10% for B2B, greater than 20% for B2C) the revenue will diminish quickly.
Cost of Capital must also be taken into account. To have a realistic assessment of customer value, you must take into account that revenue down the road is worth much less than money today. Use a realistic cost of capital value in the calculation.
increasing the recurring revenue is key, and this is inherent in a Subscription , “Land and Expand” strategy of upselling and cross selling into the customer base.
These factors in the Customer Equity are both necessary to gain a reliable estimate, but also guide the most important aspects of maximizing the customer value.
For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
Since the Customer Equity is a predictive metric, it can only be derived based on past results and management judgment.
Since it is predictive, it is not guaranteed, but also should not be ignored because it is the core of the value of a subscription company. In fact, if you estimate the Customer Equity of large Subscription companies such as Salesforce, this value can explain a great deal of their high market valuations.
It is important to look at each component of the CLV of each customer to maximize it.
The gross profit is crucial to ensure that the company retains most of the gross profit from the subscription. The Cost of SaaS Services should be below 20% as is achieved by major SaaS companies including Salesforce, NetSuite, and Workday.
Churn is the most significant determinant of the long term value of the customer. If churn is high (greater than 10% for B2B, greater than 20% for B2C) the revenue will diminish quickly.
Cost of Capital must also be taken into account. To have a realistic assessment of customer value, you must take into account that revenue down the road is worth much less than money today. Use a realistic cost of capital value in the calculation.
increasing the recurring revenue is key, and this is inherent in a Subscription , “Land and Expand” strategy of upselling and cross selling into the customer base.
These factors in the Customer Equity are both necessary to gain a realizable estimate, but also guide the most important aspects of maximizing the customer value.
For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
Since the Customer Equity is a predictive metric, it can only be derived based on past results and management judgment.
Since it is predictive, it is not guaranteed, but also should not be ignored because it is the core of the value of a subscription company. In fact, if you estimate the Customer Equity of large Subscription companies such as Salesforce, this value can explain a great deal of their high market valuations.
It is important to look at each component of the CLV of each customer to maximize it.
The gross profit is crucial to ensure that the company retains most of the gross profit from the subscription. The Cost of SaaS Services should be below 20% as is achieved by major SaaS companies including Salesforce, NetSuite, and Workday.
Churn is the most significant determinant of the long term value of the customer. If churn is high (greater than 10% for B2B, greater than 20% for B2C) the revenue will diminish quickly.
Cost of Capital must also be taken into account. To have a realistic assessment of customer value, you must take into account that revenue down the road is worth much less than money today. Use a realistic cost of capital value in the calculation.
increasing the recurring revenue is key, and this is inherent in a Subscription , “Land and Expand” strategy of upselling and cross selling into the customer base.
These factors in the Customer Equity are both necessary to gain a realizable estimate, but also guide the most important aspects of maximizing the customer value.
For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
Since the Customer Equity is a predictive metric, it can only be derived based on past results and management judgment.
Since it is predictive, it is not guaranteed, but also should not be ignored because it is the core of the value of a subscription company. In fact, if you estimate the Customer Equity of large Subscription companies such as Salesforce, this value can explain a great deal of their high market valuations.
It is important to look at each component of the CLV of each customer to maximize it.
The gross profit is crucial to ensure that the company retains most of the gross profit from the subscription. The Cost of SaaS Services should be below 20% as is achieved by major SaaS companies including Salesforce, NetSuite, and Workday.
Churn is the most significant determinant of the long term value of the customer. If churn is high (greater than 10% for B2B, greater than 20% for B2C) the revenue will diminish quickly.
Cost of Capital must also be taken into account. To have a realistic assessment of customer value, you must take into account that revenue down the road is worth much less than money today. Use a realistic cost of capital value in the calculation.
increasing the recurring revenue is key, and this is inherent in a Subscription , “Land and Expand” strategy of upselling and cross selling into the customer base.
These factors in the Customer Equity are both necessary to gain a realizable estimate, but also guide the most important aspects of maximizing the customer value.
For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
Since the Customer Equity is a predictive metric, it can only be derived based on past results and management judgment.
Since it is predictive, it is not guaranteed, but also should not be ignored because it is the core of the value of a subscription company. In fact, if you estimate the Customer Equity of large Subscription companies such as Salesforce, this value can explain a great deal of their high market valuations.
It is important to look at each component of the CLV of each customer to maximize it.
The gross profit is crucial to ensure that the company retains most of the gross profit from the subscription. The Cost of SaaS Services should be below 20% as is achieved by major SaaS companies including Salesforce, NetSuite, and Workday.
Churn is the most significant determinant of the long term value of the customer. If churn is high (greater than 10% for B2B, greater than 20% for B2C) the revenue will diminish quickly.
Cost of Capital must also be taken into account. To have a realistic assessment of customer value, you must take into account that revenue down the road is worth much less than money today. Use a realistic cost of capital value in the calculation.
increasing the recurring revenue is key, and this is inherent in a Subscription , “Land and Expand” strategy of upselling and cross selling into the customer base.
These factors in the Customer Equity are both necessary to gain a realizable estimate, but also guide the most important aspects of maximizing the customer value.
For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
So lets start by looking at standard GAAP financial statements.
These are the median expenses of public purchase software and subscription companies.
Note the much higher growth and valuation of Subscription companies. Also the expenses are higher as a percent of current revenue, because the revenue is deferred.
But this doesn’t tell us what is good or bad over the long haul.
We can see the core profitability by still using GAAP, but separating the Recurring Profits from the Cost of acquiring new revenue.
BUT ITS STILL GAAP.
Now we add in key metrics that are Subscription specific as footnotes.
Then we benchmark these metrics with those in the pier group, particularly the three key metrics
So we can see if our core business is profitable, if we are growing efficiently, and if the company’s Customer Equity is increasing a appropriately to our spending.