Measuring the Performance of Your Subscription Business: The Three Metrics That Matter
 

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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 ...

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.

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  • Rev 5/29/14 7:30pm
  • 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. <br />
  • 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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% <br /> <br /> Yet the financial markets see the value in the growing customer base and value them appropriately. <br /> <br /> 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. <br />
  • 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. <br /> That means the corresponding profit is immediate for the sale, and over the life of the customer for the subscription <br /> <br /> THIS IS THE MOST FUNDAMENTAL DIFFERENCE IN THESE MODEL <br /> <br /> 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. <br /> That means the corresponding profit is immediate for the sale, and over the life of the customer for the subscription <br /> <br /> THIS IS THE MOST FUNDAMENTAL DIFFERENCE IN THESE MODEL <br /> <br /> 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, <br /> <br /> Assess the value of the recurring revenue stream – the Customer Equity <br /> <br /> Gauge the efficiency of obtaining new revenue <br /> <br /> 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. <br /> <br /> Churn is what determines the long term value of the customer. <br /> <br /> Growth efficiency determines the cost to obtain new customers <br /> <br /> And <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> It is important to look at each component of the CLV of each customer to maximize it. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> It is important to look at each component of the CLV of each customer to maximize it. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> It is important to look at each component of the CLV of each customer to maximize it. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> It is important to look at each component of the CLV of each customer to maximize it. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> It is important to look at each component of the CLV of each customer to maximize it. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> <br /> 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. <br /> <br /> For more insight, Google SaaS Customer Lifetime Value for my article on the subject.
  • So lets start by looking at standard GAAP financial statements. <br /> <br /> These are the median expenses of public purchase software and subscription companies. <br /> <br /> 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. <br /> <br /> 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. <br /> <br /> BUT ITS STILL GAAP. <br /> <br /> Now we add in key metrics that are Subscription specific as footnotes. <br /> <br /> Then we benchmark these metrics with those in the pier group, particularly the three key metrics <br /> <br /> 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.

Measuring the Performance of Your Subscription Business: The Three Metrics That Matter Presentation Transcript

  • 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
  • 2. Measuring profitability of this business is easy …this one isn’t as clear
  • 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 
  • 13. Churn Targets More Customer Commitment  Lower Churn Customer Engagement (Use) predicts churn 0% 5% 10% 15% 20% 25% Churn Target Churn <10% <20% <25% B2B Enterprise B2C SMB B2C
  • 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
  • 17. Recurring Profit Margin Targets Recurring Profit Margins should reach 30%+ with company scale -15% -33% -6% -128% 55% 28% 57% 20% -150% -125% -100% -75% -50% -25% 0% 25% 50% 75% NetSuite Workday SalesForce Box % Operating Margin % Recurring Profit Margin
  • 18. Subscription Businesses are all about Efficiently Growing the Recurring Revenue Stream
  • 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.
  • 26. Contacts 26 Iain Hassall, VP Finance & Corporate Controller, Zuora Twitter: @iainhassall Email: iain.hassall@zuora.com Phone: +1 650-241-0658 Dave Key, Managing Director, CloudStrategies.biz Twitter: @DaveKey0 Email: dave@cloudstrategies.biz Phone: +1 949/887-4401
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