Why and How to Transition to a Subscription Business

Such benefits as predictable recurring revenue, easier borrowing, and strong cash flow are just for starters. However, there are risks as well.
Daniel McCarthy and Robbie Kellman BaxterOctober 2, 2018
Why and How to Transition to a Subscription Business

Most finance chiefs are probably already aware that subscription business models are the darlings of Wall Street.

According to Zuora’s Subscription Economy Index, subscription-based businesses are growing revenue nine times faster than the S&P 500. Some of the largest recent IPOs have been for subscription-based businesses: ADT, DocuSign, Domo, Dropbox, MongoDB, and Spotify, to name just a few.

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As has been widely covered in CFO and elsewhere, subscription businesses generate recurring revenue, which is more predictable and more durable. That makes the revenues easier to borrow against and the company more valuable to investors.

Robbie Kellman Baxter

The CFO of a subscription business also enjoys an enviable cash flow position. Such businesses often get paid in advance for a year’s worth of goods and services, and in some cases more.

These businesses foster more loyalty with customers. Interactions are more relational and less transactional because you are more incentivized to form long-term relationships, not just look for the next sale.

Most of those elements are well understood by now. What we cover next is what you should know to evaluate whether getting into the subscription business could be good for your company, weighing all the potential benefits against the potential risks and the things that will need to change along the way to make the transition successful.

More Plusses

One is data. A subscription business is typically able to collect more data about its customers because of the contractual nature of the customer relationship. That supercharges the company’s ability to tag and track customer behavior and engagement.

It also allows the company to more efficiently develop and improve products and services and to better anticipate when a customer might cancel or upgrade and to optimize for those moments.

Top-tier academics have been pushing the boundaries of what strategic insights you can learn about your subscribers through this data. Following are two notable recent examples.

“Customer-based corporate valuation” (CBCV) is an emerging, award-winning valuation framework popularized by Daniel McCarthy and Peter Fader, professors of marketing at Emory’s Goizueta Business School and the Wharton School, respectively.

CBCV is a method through which a company can project it future revenue and profit (and thus valuation) more accurately by driving those projections off of five customer-based drivers. Those drivers are customer acquisition, retention, order rate, basket size, and cost to serve the customer.

This greatly enhances the ability to evaluate new initiatives as well as benchmark performance over time and relative to peers. It provides a shareholder value-focused accountability mechanism for the subscription company’s chief marketing officer.

Second, an academic study co-authored by Raghuram Iyengar, another professor of marketing at the Wharton School, found that subscription programs are “more effective on customers with higher initial purchases than those with lower initial purchases.”

The study also found that customers “switch their purchases from the firm’s competitors and increase their share of wallet.”

These insights suggest that subscription companies’ membership programs will be more successful if tailored toward big buyers, especially those suspected of being even bigger buyers at competitors.

Potential Risks

Although the payoff is big for subscription transformations, there is a likely short-term cost: a dip in revenue.

Daniel McCarthy

Thomas Lah and J.B. Wood refer to this transformation as “swallowing the fish” in their book “Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business.” They call it that because the revenue curve dips below operating expenses before operating expenses decline and revenue increases.

It can be hard to swallow that fish, especially for the board of directors and shareholders, so it is crucial that they understand this process and have the right expectations.

This change must also be clearly and effectively communicated to the investment community, so their expectations are calibrated as well. Without the support of shareholders, it will be difficult to make the investments required for the transition to be successful.

Many CFOs are blinded by the power of the model without first checking to see whether their company can create subscriber value to justify the recurring fees. Others are nervous about leaving short-term revenue on the table by switching to a model that depends on the long term.

The hardest part is changing the culture. Every role in the organization will have to change, not just finance.

What Has to Change

There’s no way around it: the company will have to be customer-centric, not product-centric (or even worse, financial results-centric). Transformation must occur in every area, including but not limited to the following:

Product: The product team must focus on customer needs instead of just building cool things. That might mean spending less time optimizing the engine and more on the cup holders. While it might be less sexy to the engineers, it will be more sexy to customers (and, in turn, shareholders).

Marketing: The marketing team will need to spend more time communicating with existing customers, to encourage behaviors that will result in greater engagement.

In the “membership economy,” the moment of transaction is the starting line, not the finish line. Also, marketing will invest more in market analysis to understand the most promising target audience, identify lookalikes, and help onboard new subscribers.

Support: The company might need to transition resources from customer support into customer success. Customer support solves problems as they arise, when customers call to complain. Customer success is about proactively reaching out to make sure customers are happy and engaged.

Sales: The role of sales becomes easier as word-of-mouth and viral outreach replace the sales pitch, and compensation might become tied not just to the transaction but to retention.

The biggest challenge is cultural — how the whole team will work together to optimize customer lifetime value. Finance will no longer be a silo, but rather a key part of the customer-centric team.

It’s not enough for marketing to acquire new customers if those customers won’t stay and pay. Finance and marketing will need to coordinate with the sales and product teams, which will need to look to the customer success team for feedback on how satisfied customers actually are.

In turn, the customer success team must listen to the marketing analytics/data science team to glean insights into what subscribers value and the correlates of customer churn.

Ultimately, a subscription is just a pricing decision, not a strategy. The leadership team needs to have a strategy that works equally well for the company and the subscriber. Otherwise, it won’t work.

How to Get Started

At some point, you’ll have to let go of the monkey bars and rip off the band-aid. If you try to time it perfectly, you will probably miss your chance.

Balancing the potential loss of short-term transactional revenue with long-term subscription revenue requires a very clear vision of whom the membership will serve and what the nature of the “forever” promise will be. This promise is a commitment to handle something for the customer forever — continuously innovating, repackaging, and evolving to make sure the company is providing the best solution.

Build out that vision, from both the customer’s and the company’s perspectives, and about the value for each. It’s not enough to say, “We’re moving to subscription because it’s good for the company.”

Transforming to a membership model is tricky, so it is prudent to maximize the profitability of a successful transition. Start with a big vision and a small test of the first step to see if what you envision is possible:

  • What is our membership vision?
  • What is our “forever” promise?
  • What is our first offering?
  • What are the risks, and what small tests can we do to mitigate them?

Once the company has proven some of the key elements of its big membership vision and is ready to scale subscription across the organization, remember that getting the strategy right is the easy part. The hard part is changing the culture.

Nearly every industry — from software to media to consumer products to retail to manufacturing — is moving from ownership to access. Your company might be next. And your colleagues will be looking to you to understand how it will affect cash flow, expenses, and the company’s overall valuation.

So make sure you’re ready.

Robbie Kellman Baxter is the founder of consulting firm Peninsula Strategies and author of “The Membership Economy: Find Your Superusers, Master the Forever Transaction, and Build Recurring Revenue.”

Daniel McCarthy is an assistant professor of marketing at Emory University’s Goizueta Business School and founder of Theta Equity Partners. His specialty is a methodology for valuing companies by predicting what their customers will do in the future.