SaaS Companies and Subscription Revenue Models

Every company can learn from SaaS (“Software-as-a-Service”), companies. My first exposure to SaaS companies was the first self-proclaimed “SaaS” company – Salesforce.com. This was early in my banking career around the time of Salesforce’s 2004 IPO. Today, Salesforce is a $110 Billion-plus market cap behemoth.

Every company – regardless of industry – should consider adopting a subscription revenue model either across the entire product portfolio (common with SaaS companies) or for certain products and services (the latter is gaining traction in the retail industry).

Subscription Revenue Models Enable Companies To Operate Strategically

Companies that leverage subscription/ recurring revenue models can take a long-term strategic approach to their respective business given the long-term visibility that recurring revenue models provide. This is a distinct competitive advantage vs. companies that have revenue visibility only in the short-term.

• Amazon: AMZN has strategically leveraged Amazon Prime’s recurring revenue stream ($3.4 billion of subscription revenue in the June ’18 quarter) not to mention the recurring revenue associated with AWS ($6.1 billion in the same quarter). For example, Amazon Studios can place long-term strategic bets in a way that other content production companies – Apple and Google included – cannot. Acquisitions such as the August 2017 Whole Foods acquisition serve to grow Amazon Prime membership, thereby growing Prime’s recurring revenue stream and Amazon’s long-term revenue visibility. A competitive advantage if there ever was one.

Subscription Revenues Carry Premium Valuations

There is also a financial advantage to recurring revenue/ subscription revenue models in that investors of all stripes – venture capital, private equity and public company institutional investors – value recurring revenues at a premium.

This explains the proliferation of various business models with abbreviations ending in “aaS” including “PaaS” (Platform-as-a-Service), “IaaS” (Infrastructure-as-a-Service) and the recently coined by Uber “MaaS” (Mobility-as-a-Service) each of which leverage recurring revenue models.

Subscription Revenue Models Are Aligned with Customer Interests

Subscription revenue models are aligned with customer interests in that they essentially match customer payments with value provided (usage). This is in stark contrast to the upfront license revenue model that was common 12-15 years ago in the software industry.

Under a subscription revenue contract customers pay a monthly subscription fee for the right to use the provider’s software. It is not uncommon for customers to pay 12 months’ worth of subscription fees upfront in exchange for a small discount. SaaS companies typically invoice customers based upon usage ($X per user per month).

Modern Day Subscription Revenue Models Offer Greater Customer Flexibility

Modern day subscription contracts offer a level of flexibility not found in legacy subscription agreements (made famous by mobile phone plans, auto leases and mortgage agreements) in that they often allow customers to cancel at any time without penalty.

All Companies May Benefit From Subscription Revenue Models

Which companies may leverage recurring revenue models? Any company with an e-commerce presence is a natural candidate. Any product or service that enjoys repeat orders from the same customer(s) lends itself well to a subscription revenue model. For example, Amazon’s effort around kitchen/ home goods. Order paper towels now for $8.99 or opt-in to a monthly subscription and buy now for $8.24.

Similarly, suppliers to hotels, offices and restaurants could provide enterprise customers with various subscription offerings for discrete goods and services or bundles of goods and services. Restaurants, golf community clubhouses, any company with an end-user relationship may get creative with subscriptions. Examples of companies that leverage subscription models:

• GM offers subscriptions to its Cadillac line (BOOK by Cadillac), which offers flexibility not found in traditional auto leases programs;
• Netflix;
• Amazon – for a variety of products and services;
• Shared office space provider WeWork offers short-term monthly subscriptions (in large part to tech companies).
• Razor blade companies seem to have caught on to the benefits of subscription models in recent years.
• Uber and Lyft offer subscriptions. The latter is experimenting.

It is less a question of “who may benefit from a subscription model?” and more a question of “how may we get creative in offering subscriptions to customers?”

Before Flipping the Subscription Revenue Switch

Before migrating to a subscription revenue model we offer some high-level advice: contemplate how the change in revenue recognition and operating cash flow will impact your business:

• Subscription revenue models can only begin to achieve full potential when accompanied by a robust e-commerce strategy that has CEO and Board-level buy-in.
• Over time you will maximize operating leverage under the subscription revenue model as you sign and retain customers. Customer renewal rates ought to sit at or above 90%.
• Less incentive to “close deals at all costs” under subscription revenue models compared to legacy upfront license revenue models. Less at stake each quarter given that you won’t recognize millions of dollars of revenue at deal signing. Thus, companies need to focus on retaining customers after closing deals.
• You will recognize less revenue and receive less cash upfront in periods when deals are signed as compared to upfront license revenue models.
• Cash inflows will not match revenue recognition for subscriptions where customers pay for 12-months upfront (12 months cash received upfront, revenue recognized pro-rata over 12-months, resulting in a deferred revenue balance).
• You will have to change your sales compensation plans and recalibrate operating expense levels in order to right-size the cost structure with pro-rata revenue recognition.

Below is our recent CEORater Podcast on the subject of Subscription Revenue models:

• Investing
• Investment Banks
• Leadership
• Software
• Strategy
• Technology