What Every CEO Needs To Know about Subscription Business

What Every CEO Needs to Know About Subscription Business
© 2021 MGI Research, LLC
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EXECUTIVE PERSPECTIVES - GROWTH STRATEGIES
What Every CEO Needs to Know About
Subscription Business
March 19, 2021
Subscription business models remain the holy grail
of the modern economy. Customers expect it, inves-
tors value it and companies are looking for ways to
leverage this concept. Of the companies created in
the last ten years, very few have achieved valua-
tions above $1 billion without some sort of a sub-
scription offering. Yet, despite all of the attention,
subscriptions are poorly understood and still repre-
sent only a small fraction of global GDP.
Subscription businesses may appear deceptively simple. After all,
how complex could it be to create an offering around some con-
tent or a service for $5.99 per month, set up a website and begin
to market to millions of potential customers with a hope to create
billions of dollars in new value.
A successful subscription business can create transformative value
by creating non-linear change in growth trajectory and a step-up
in valuation multiple. Still, many of the subscription start-up ideas
fail or achieve relevance. This is a complex endeavor, fraught with
risk and extremely sensitive to execution.
In this research report, we have compiled a simple guide to the
key concepts of a subscription business, including questions every
CEO should ask to track and grow a successful business.
Define the Relationship, Not Just the Pricing Model
To be successful in subscriptions, leaders need to take their thinking out-
side the box of any specific pricing model. Subscription business is not
about a $9.95 per month price model.
KEY ISSUES
• What are the strategic op-
portunities and risks in
adopting subscription busi-
ness models?
• How can organizations cre-
ate strategic differentiation
with subscriptions?
• What tools, data, process
and organizational models
are needed to create suc-
cessful outcomes with sub-
scriptions?
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Disclaimer: Information is furnished on an as is ba-
sis. No warranty, written or implied as to the accu-
racy of the data. Not responsible for typographical
or reproduction errors.
A key to success is to think about subscriptions as a recurring, ongoing customer
relationship that may include many different pricing plans and where the cus-
tomer value is delivered continuously.
This is in sharp contrast to a transactional relationship where, for exam-
ple, a company buys a batch of industrial commodities from a supplier
once.
A fixed cost monthly subscription is an example of a recurring revenue
plan. The full contract may look something like “$9.95 per device, payable
monthly in advance with no cancellation penalty”. Or it may look some-
what more complex like: “$9.95 per device, payable quarterly in advance,
for up to 1GB of data per device per month, $10 for each full or partial
GB of data above the monthly threshold, with a 30-day advance cancel-
lation notice”. The combinations and corresponding complexity can
snowball quickly – limited only by the imagination of marketing and pric-
ing experts. One only needs to think of a typical mobile data and phone
contract as an example.
On the B2B side of commerce, simple subscriptions are less dominant,
but complex recurring plans that allow clients to be charged based on a
Volume Purchasing Agreement with minimal commitments, plans priced
based on outcomes or prices varied dynamically – all of these are not un
usual.
The bottom line is that subscriptions are more about a recurring revenue
relationship with the customer than about any particular pricing model
like a fixed monthly charge.
Examples of new applications of subscription models are renewed liter-
ally every day – from digital entertainment and educational courses, to
personal products, boxes of the month, to support services, to food,
wine, beer and car subscriptions, concierge medical services, to private
jet charters, cloud infrastructure services and heavy equipment rental.
In best-in-class examples, the subscription relationship becomes the core part of
the product experience and offering. It is used to differentiate and entice, to
broaden the potential target base of customers, to sell into markets that were
Questions to ask:
• What is the target mar-
ket, how large is it, how
fast it is growing and
what are the growth
drivers?
• How does a subscription
offering create sustain-
able differentiation?
• Does it enhance the
brand experience?
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previously closed. And it is used to sell an outcome rather than ownership. It is as-
set-light and deflationary as it tends to broadly push down the price of access to
products and services.
Capture the New Spend
Consumers and business are now expecting that most products and ser-
vices will be offered either on a subscription basis or at the very least,
include some elements available by subscription. Subscriptions are shift-
ing expenditures from capital to operating budgets and also opening up
new buying centers.
Figure 1 - Adoption of Subscription Business Models – Massive Upside Opportunity for Growth
Establishing a subscription, as-a-service plan, can help organizations to tap into
potential new spending that is not available under traditional transactional busi-
ness models.
Adoption of Subscription
Business Models (XaaS)
Continues to Expand – but is
still < 1% of
global GDP
• “Expected” by Consumers,
Vendors, Investors
• Across audiences: B2C, B2B,
D2C, industries, company sizes,
and geographies
• Democratizes access to advanced capabilities
• Shifts spending from capital to operating expense
Start-Ups
• Provides a more frictionless market entry
Mature Companies
• Supports entry into new markets
• Boost growth
• Re-Energize Investor Interest
For Businesses
For Customers
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Enterprise software is a prime example of this trend. Historically, it was
enterprise software investments were funded out of IT capital spending
budget. IT budgets have been under pressure and barely growing in line
with inflation for the better part of the last twenty years. Yet, sales of
software-as-a-service (SaaS) aimed at corporate buyers and sold as a sub-
scription have been skyrocketing. Where does the money come from?
Typically, from business and finance operating budgets as well as from
spend shifted out of IT. The lower entry costs lowered barriers to adop-
tion for functional areas that historically did not have the ability to access
these tools. It also democratized access to world-class capabilities. With
the old enterprise license approach to selling software, only the largest
firms could afford first-rate software products. With subscriptions, the
access barriers have now been equalized and most companies – large or
small, can get access to the most modern set of software capabilities.
Few new companies today do not offer their products via some sort of a
subscription plan. For start-ups, subscription plans enable a more fric-
tionless market entry and the ability to build a beachhead without an in-
finite sales cycle. For mature companies, subscriptions offer an oppor-
tunity to enter new market segments, boost growth, increase revenue
predictability, and to re-ignite investor interest. Disney and Discovery Tel-
evision (HGTV, Food TV, et al) – are just two examples of a broader trend
of established consumer brands executing a direct to consumer (D2C)
strategy using subscriptions as a core element of the new offering.
Even with the current hype and adoption rates, the overall share of subscription
spend within global GDP remains quite modest. Based on its Global Analytics Model,
MGI Research estimates that in 2021 the worldwide spend on recurring revenue
plans across B2C and B2B will exceed $3 trillion of which about $750 bn or 0.85% of
global GDP forecast will be spent on subscriptions. A massive growth opportunity
for subscription models is yet to be realized.
Questions to ask:
• Does the subscription
business plan open
new markets?
• How large are these
opportunities and
how fast is the
growth?
• Why use a subscrip-
tion plan to enter
these new market
spaces?
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Create Real Value with a Subscription Business
With strong execution, subscription businesses can be tremendously scal-
able and extremely valuable. The table below illustrates a hypothetical
evolution of a subscription business and its progression through multiple
phases of maturity – from Proof of Concept to Growth and Expansion.
Table 1 - Subscription Business Valuation Scenarios
Subscription
Business Metrics
Proof of
Concept Pilot Production Growth Scale Expand
# of Subscribers 100 1,000 10,000 100,000 1,000,000 10,000,000
Monthly Revenue per Subscriber $100 $75 $50 $39 $19 $5
Annual Revenue, US$ Millions $0.120 $0.900 $6.000 $46.800 $228.000 $600.000
Subscriber Retention 100% 98% 94% 86% 84% 82%
Typical Subscriber Growth 500% 120% 60% 30% 20% 15%
Typical Revenue Retention 100% 110% 98% 94% 86% 82%
Typical Revenue Growth 500% 120% 60% 40% 30% 20%
Customer Satisfaction 50% 65% 70% 80% 75% 70%
Potential Revenue Multiple 5.00 7.50 10.00 20.00 15.00 10.00
Potential Value, US$ Millions $0.600 $6.750 $60.000 $936.000 $3,420.000 $6,000.000
In the illustration above, typical performance metrics and valuation mul-
tiples are applied to illustrate the potential for value creation. For exam-
ple, using valuation benchmarks of 2020-2021,
A growth stage subscription business with 100K subscribers paying $39 per month
as a fixed fee, with an 86% customer retention and 40% topline growth, trailing
revenues of just under $50 million, can command nearly $1bn ($936mn) in valua-
tion.
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Why are the valuation multiples so high for subscription-based busi-
nesses?
Investors love the predictability of subscription businesses, especially for companies
that sell plans based on a monthly price but charge for it up-front, often with a
multi-year agreement.
With prepaid subscription plans, companies have both higher
retention as well as a high visibility cash flow and a healthy bal-
ance sheet.
Still, the value of the business will never reach $1bn based
purely on the fact that it is using a subscription model. The
business needs to have a clear differentiation that includes
subscription as an integral part of its brand experience. The
other key ingredient for creating value is an outstanding set of
performance metrics.
Questions to ask:
• What does success look like?
• Who are the peer subscription busi-
nesses?
• What are the comparable recent valu-
ation benchmarks?
• What is the window of opportunity?
• What is the competitive landscape?
• What level of investment is required?
• What is a realistic plan for success?
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Beware of Hidden Complexity
Subscription business may seem deceptively simple. It starts with a sim-
ple idea, a marketing list, some messaging, and some tools. This initial
launch can translate into hundreds or perhaps thousands of subscribers.
Yet, many subscription business initiatives fail or at the very least, never
reach critical mass and are unable to differentiate themselves from the
competition.
SUBSCRIPTION MODELS MAY SEEM DECEPTIVELY SIMPLE
Figure 2 - The Hidden Complexity of Subscriptions
Subscription businesses resemble an iceberg – this giant mass of ice floating in the
ocean with the top, smaller portion visible and a much large, invisible portion hid-
den below the waterline. It may be instructive to think of subscription businesses of
being made up of two unequal parts: the concept as the portion above water and
the execution and continuous delivery, as the portion hidden under water.
Much of the complexity stems from the need to balance a variety of com-
plex decisions and execution.
• How to balance growth against need to maintain high level of
customer satisfaction?
“Great concept, but
what about execu-
tion?”
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• How to ensure that high level of customer satisfaction and strong
engagement translate into high rate of retention?
• How to create and maintain engagement throughout the life of
the relationship?
• How to eliminate friction with customers when it comes to bill-
ing, payments and collections?
• What are the compliance requirements when it comes to B2C
and B2B clients?
• What about revenue recognition?
• How to scale overall system performance as well as customer ex-
perience management?
And complexity increases as the scope and scale of the business expands.
A company launching a subscription business needs either internal exper-
tise in this area or needs to bring in qualified executive level talent with
a clear track record of success in managing a recurring revenue business
model.
Subscription Metrics Rule
Subscription businesses live and die by their metrics. Here are the mini-
mum subscription metrics every executive needs to understand.
Key amongst these:
Table 2 – Summary of Subscription Metrics
KEY SUBSCRIPTION METRICS
Retention Customer Lifetime Value Annual Recurring Revenue
(ARR)
Monthly Recurring Revenue
(MRR)
Customer Acquisition Cost
(CAC)
Revenue & Contract Value
Growth Customer Satisfaction Customer Engagement
The following table provides a more detailed look at the core subscription metrics.
Questions to ask:
• Do we understand the
top challenges – tech-
nical, marketing, finan-
cial, regulatory, etc.?
• Do we have the right
tools for the job – sub-
scriber management
technology, financial
systems, customer en-
gagement and experi-
ence tracking?
• Do we need to bring in
external resources to
fill in the gaps in the
talent pool?
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Table 3 - Subscription Metrics Details
Metric Definition Examples & Practical Aspects
Retention
(or its opposite –
Churn)
Retention comes in two flavors – Reve-
nue Retention and Customer Reten-
tion. Revenue retention measures for
current subscribers for every dollar of
revenue in the prior fiscal cycle, how
many dollars are retained. This number
can often rise above 100% as compa-
nies increased “same-account sales” ei-
ther with upsells, increased adoption
and/or price increases. Customer re-
tention measures how many accounts
from prior reporting cycle remain cus-
tomers in the current cycle. This is also
measured as a percentage and never
exceeds 100%. In many ways, cus-
tomer retention is more important
than revenue retention for it is proxy of
how healthy a subscription business is.
A customer retention rate below 82% is problematic and
an indicator of product and delivery flaws. [If it’s below
85%, that’s a red flag.] A retention rate above 92% is con-
sidered excellent and above 95% is outstanding. Subscriber
Churn that companies experience may come from variety
of sources and can be either voluntary or involuntary. Vol-
untary Churn happens when a customer, perhaps unhappy
with the offering or customer service or cost or lack of in-
voice transparency, decides to cancel the service. Involun-
tary Churn happens through the events that may or may
not be within the control of the supplier – e.g., in a B2C
scenario, the inability to process a payment say through a
credit card that is either expired or reached its credit limit.
In the case of B2B subscriptions, this can happen during a
merger, a change in accounting systems or staffing. Com-
panies can guard against both kinds of churn by being pro-
active and deploying advance warning and management
tools to minimize leakage. Strong retention affords compa-
nies with a unique target base of upsell opportunities – at
CAC that is typically well below that of any first-time cus-
tomer.
Customer Lifetime
Value (CLV)
The total value of payments that a
company can expect from a customer
over an expected subscription period.
Let’s say your firm offers an online, subscription-based
weight-loss program priced at $39.95 per month. If a typi-
cal subscription period is 20 months, then CLV is
$39.95x20= $799.
Annual Recurring
Revenue (ARR)
Subscription revenue from a single cus-
tomer over a 12-month period.
Monthly Recurring
Revenue (MRR)
Subscription revenue from a single cus-
tomer over a 1-month period.
Customer Acquisi-
tion Cost (CAC)
The fully loaded cost to acquire a single
new customer, including all sales and
marketing costs, salaries, tools, over-
head, etc.
CAC is often compared to CLV through a ratio of CLV/CAC.
Any CLV/CAC ratio above 4 suggests a pretty decent busi-
ness opportunity and anything that is below 3 is potentially
problematic. A ratio of 1 indicates a worthless business
model. For example, in the weight loss subscription exam-
ple above, the cost to acquire and on-board a single client
could be $85, so a CLV/CAC ratio would be $799/$85 =9.40.
Revenue & Con-
tract Value
Revenue is the GAAP-recognized reve-
nue and Contract Value is the annual-
ized total value of subscription con-
tracts.
These two metrics are often close - but almost never the
same as contract value is typically recognized ratably over
the life of the agreement.
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Metric Definition Examples & Practical Aspects
Growth In addition to Revenue and EBITDA
Growth, every subscription business
needs to track Subscriber Growth and
Contract Value Growth.
Referring to the Growth in Contract
Value, there is a concept of Net Con-
tract Value Increase or NCVI, that has
been in useby a number of mature sub-
scription businesses over the last forty
years and with great efficacy to overall
financial results. NVCI nets out new
wins and losses in subscriptions and
creates a common orientation vector
for the entire company. In fact, many
successful subscription businesses
have tied sales compensation to NCVI
performance.
Not all growth is good all the time. Uncontrollable growth
that leads to a poor customer experience can have a very
negative impact on Customer Satisfaction, Engagement
and eventually results in a sharp drop in retention. Compa-
nies need to balance growth, service delivery and reten-
tion, but if the choice is between increased growth or
higher retention, then retention wins as it leads to cus-
tomer loyalty and higher profitability.
Customer
Satisfaction
This metric is the over-the-horizon ra-
dar of any subscription business and
should be measured and triangulated
to other metrics. Whether measured
through a simple survey, a complex in-
ternally developed index or an NPS
(Net Promoter Score), this is the pre-
dictor of the renewal rate and overall
health of the subscription business.
In a recurring revenue model, customer satisfaction stems
not only from the delivered service or content, but from a
holistic overall customer experience – this includes billing
transparency, this includes customer self-service and abil-
ity to change or cancel the service without waiting on hold
for 40 minutes. The subscription is the experience and is an
integral part of the product. Companies that have high cus-
tomer satisfaction scores in their subscription business,
tend to invest into tools, platforms and integration needed
to make the overall experience frictionless and transpar-
ent. Such companies tend to focus on proactive subscriber
management as a persistent process. The leaders in this
area provide a lot of self-service capability to their sub-
scriber base in terms of being able to change service com-
ponents, seasonally suspend or re-activate services, utilize
a variety of billing plans and payment options.
Engagement Without engagement there is no re-
newal and without renewal there is no
subscription business. Any way a com-
pany measures engagement of its sub-
scribers with its offering – hours
watched, articles accessed, consulta-
tions scheduled – these measurements
are some of the most important ele-
ments of subscription success.
Engagement levels and change should be triangulated to
changes in product, pricing, packaging, marketing cam-
paigns, technical issues, as well as external factors such as
competition, weather and other exogenous events.
Suppose a digital media streaming entertainment company
defines its own engagement index (EI) as hours of content
watched per month per subscriber. Let’s say, the average
value of EI is 8 hours per month of content watched. If EI
suddenly goes down to 3 or goes up to 14, the executive
team should have a clear understanding of why a dramatic
change took place.
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Overall, the understanding of individual subscription metrics and the in-
terplay between them is a basic required qualification for any manage-
ment team contemplating a recurring business model. Companies need
to have the tools and processes in place to persistently collect, summa-
rize and analyze subscription metrics. In order for metrics to work in sup-
port of the strategy, organizations need to maintain data hygiene – en-
sure that the data used for decision making is monitored for cleanliness
and accuracy (see MGI Research note Mediation 2.0 – Taking on the Data
Challenge in Agile Billing) This is especially critical during early stage
launch when companies may not have statistically significant number of
KPI data points.
Subscription Benchmarks – What does success look like?
Once the executive team is fully conversant in subscription KPIs/metrics,
it is important to outline what a footprint of a successful recurring reve-
nue business looks like. Table below illustrates a spectrum of business
cases from Bad to Acceptable (OK – there is hope), to Better (there is ac-
tual progress) to Best (this business can be worth real money). As evident
from the illustration below, metrics alone do not determine success. Ra-
ther, it is a combination of KPIs and contractual terms such as the length
of subscription term, cancellation clauses and penalties if any, as well as
a combination of growth and retention.
Table 4 - Subscription Business Benchmarks
Subscription Benchmarks Bad OK Better Best
Subscription Term Month-to-Month Quarterly Annual Multi-Year
Cancellation Any Time 30 Days Annual End of Term
Subscriber Retention <82% 82-86% 86-94% >94%
Annual Subscriber Growth Negative 0-5% 5-15% >15%
Annual Revenue Growth <10% 10-20% 20-40% >40%
Questions to ask:
• What key metrics do
we need to track?
• Do we have a persis-
tent process in place
to collect, analyze
and share subscrip-
tion KPIs?
• Do we have the
right tools in place
to manage subscrip-
tion metrics?
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A “Bad” scenario is one with month-to-month subscription terms, no can-
cellation guardrails, subscriber retention below 82%, negative subscriber
growth and very modest revenue growth.
By contrast, a “Best” scenario is one with multi-year subscriptions (typi-
cally pre-paid annually), cancellation clauses that are tight and corre-
sponding results of high (>94%) subscriber retention, solid subscriber
growth (>15%) and high revenue growth (>40%).
If any of these factors were used to describe the state of a subscription
business on a standalone basis, it is easy to come to erroneous conclu-
sions.
Bottom Line
There are 10 points that every CEO needs to know about a sub-
scription business:
1. Adoption of subscription business models continues to
grow but is still less than 1% of global GDP
2. Subscriptions can dramatically enhance the value of an of-
fering and the overall business
3. Subscriptions can create strategic differentiation
4. Subscriptions are more about a recurring customer rela-
tionship than about a $9.95 fixed monthly charge
5. A common misperception is that subscription business
models are simple to execute. They are not, especially for
mature organizations looking to add a recurring revenue
model to an existing business model.
6. Metrics and benchmarks are key to the success of a sub-
scription business
7. External talent and best practices can reduce risk, acceler-
ate time to market, and ensure sustained success
8. Continuous customer engagement – not the price - is crit-
ical to the long-term success of a subscription business
9. Operating a subscription business requires a careful bal-
ance between growth, engagement, customer satisfac-
tion and retention
10. Subscription businesses can expand your total addressa-
ble market (TAM)
EGRES:
DEFINITION OF
SUBSCRIPTION SUCCESS
Subscription success can be ex-
pressed in five variables that
MGI Research calls
EGRES:
• Engagement
• Growth
• Retention
• Experience
• Satisfaction
Questions to ask:
• What is a benchmark of
success for our subscrip-
tion business?
• What are best in class
companies doing in this
space? How do we com-
pare?
• How does current perfor-
mance compare to best-
in-class benchmarks?
What can be done to close
the performance gaps?
• What best practices
should be adopted?
• Where can we get an inde-
pendent review of our cur-
rent state and strategy?
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