Building InnovativeSubscription-based

BusinessesBUS-185

Lecture 2: The Subscription Business Model

Martin Westhead

Overview No standard

Concepts Recurring Revenue Lifetime Revenue Acquisition, Boost, Churn (ABC)

Modeling Revenue (easier – so start there) Leaky bucket Subscription Plateau Understanding Churn

Subscription Health checks Magic numbers The only three metrics that matter

Case Study: SendGrid

Optics check Which Month is better?

Now which Month is better? (same data)

Always start with $ Two problems with subscription numbers

Apples and Oranges cannot be added 3 bronze + 2 gold is like 3 inches + 2 feet

But even without the sum confusing to see them together

Summaries should present either: Dollars or % change (in dollars)

Subscription/Customer numbers ARE useful Just not recommended for summaries

Recurring Revenue Recurring Revenue

Annual (ARR) Monthly (MRR) Quarterly (QRR)

But there is a gotcha even with RR…Churn Rate of Annuals

is often not the same as

Churn Rate of Monthlies

So, even if annuals have lower MRR, can be worth more

Lifetime Revenue Customer Lifetime Revenue (CLR)

Subscription Lifetime Revenue (SLR)

All time expected revenue

Note : different from CLV

Multiple ways to calculate it…

Lifetime Revenue 1 Gold monthly

Recurring Cost $100 Churn 5%

Expected return is $100 in month 1 $100 – 5% month 2 $95 – 5% month 3 Etc. (see chart)

Total expected return is area of chart

$100 / 5% = $2000

More details: http://chargethru.com/profiles/blogs/weighing-up-the-true-value-of-a-customer

Lifetime Revenue 2

Use actual aggregated churn data

Build a retention model

Multiply retention by recurring revenue

Sum across the chart

Lifetime Revenue 3 Find average lifetime of Subscriptions

Multiply by Recurring Revenue

Used by Sendgrid (see later)

Exercise

Experiment with the three different approaches to modeling lifetime revenue What are the pros and cons of each? When would you use one over another?

Discussion Topic on Charge Thru

Modeling Revenue

Subscription Business

Acquire New Customers

Reduce Churn

Boost Revenue Per Customer

Notes:

Boost can be positive or negative Sometimes these are separated

(see SendGrid)

Alternatively Boost can be folded into Churn So Churn can be positive or

negative

Core revenue model: The leaky bucket

RecurringRevenue (RR)

Acquisitions

Boost: Up sell/Cross sell

A

C

Churn

B

The Math

B C

Rt+1 = Rt + At + Bt- Ct

t t + 1 time

A

B C

t + 2

Recurring Revenue Recurring

Revenue (RR)

Acquisitions

Boost

A

CChurn

B

Rt

Rt+1A

Natural relationships Churn naturally modeled as % of existing ($)

Boost naturally modeled as % of existing ($)

Acquisitions is usually* independent of existing ($)

Define:

B = Bt / Rt

C = Ct / Rt

Assume At is fixed At = A

*In a viral (referral-base) model A is % of existing

Rt+1 = Rt (1 + B – C ) + A

Constant Acquisitions

A

B C

t t + 1 time

A

BC

t + i

Recurring Revenue

t + i

Acquisitionsunchanged

Rt+1 = Rt (1 + B – C ) + A

Subscription Plateau

MRR for 2 businesses over 5 years Same acquisition rate (100

customers per month,

Same ARPC ($100 per month).

Red has churn rate of 2.5%

Blue has churn rate of 5%

Both businesses are starting plateau

But the 5% faster and lower MRR

“Water level equilibrium of the Leaky Bucket”

Understanding Churn Cancellations

Obvious, easy to quantify Learn what you can about why

Behavioral analysis Questionnaire

Overdue payments Failed payments Chargebacks / Paypal cancellations Covert cancellations Hard to quantify Establish a Dunnings (Overdue Enforcement) process Make sure you understand the scale of covert cancels

Industry average (SaaS) annual churn of 10-20%

More details:http://chargethru.com/profiles/blogs/churn-to-the-power-three

Subscription Health Metrics

Warning about modeling costs

Cost models are more business specific

Be particularly careful about projecting costs

Fixed costs can be changed

Variable costs can change with volume

Always be aware of your assumptions when you construct business models

“The” Saas Magic number Revenue growth per sales and marketing dollar

M = (QRRt – QRRt-1)*4 / SMt-1

QRRt: Quarterly Recurring Revenue for period t

QRRt-1: Quarterly Recurring Revenue for the period t-1

SMt-1: Sales and Marketing Expense for the period t-1

1.0 => $1 S&M leads to $1 ARR growth

Under 0.75 problems, over 0.75 accelerate marketing

Over 1.5 “call me immediately”

(Lars Leckie's Blog) http://larsleckie.blogspot.com/2008/03/magic-number-for-saas-companies.html

Joel’s SaaS Magic number Average customer rate of return

J = (ARR – ACS) / CAC

“ARR” is the average recurring revenue per customer

“ACS” is the average recurring cost of service per customer

“CAC” is the average customer acquisition cost

1/J time to profit per customer (Payback Period) J = 1 profit in first year. J >0.5 profit in under 2 years

No reference to Churn

(Joel York) http://chaotic-flow.com/saas-metrics-joels-magic-number-for-saas-companies/

The Only 3 Metrics that MatterRetention (%)

How much ARR you keep (1 – Churn)

Recurring Profit Margin (%) (ARR – Churn – Non-growth spend)/ARR

Growth Efficiency (ratio) Cost to acquire $1 of new ARR

Profit vs. Growth

Details: http://www.slideshare.net/Zuora/zuora-always-on20123-saas-metrics-that-matter-12301579

Industry BenchmarksBest

Practice Model

Retention 83% 86% 92% 90%

Recurring Profit

Margin

58% 47% 19% 50%

Growth Efficiency

0.75:1 1.26:1 2.15:1 1:1

SaaS Metrics Case StudySlides from Jim Franklin, CEO SendGrid Inc. (used with permission)

Metrics To Measure Growth Monthly/(Annual) Recurring Revenue

(MRR) Roll forward of MRR (Beginning+New+Increase-Lost-

Decrease) Monthly growth rates Churn analysis (cohort, by product, size, etc)

Customers Roll forward of customer count Monthly growth rate Churn analysis (cohort, by product, size, etc)

MRR = Monthly Recurring Revenue

Understand each as it relates to your business, products, geo, etc.

Customer Count

Understand each as it relates to your business, products, geo, etc.

Customer Retention/Churn

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 Month 13 Month 14 Month 15 Month 16 Month 17 Month 18 Month 19 Month 20 Month 21 Month 22 Month 23 Month 24

Customer 100% 99% 97% 96% 94% 94% 94% 93% 93% 92% 91% 91% 91% 91% 90% 90% 89% 89% 89% 87% 86% 86% 86% 86%Dollar 100% 103% 105% 110% 112% 115% 116% 115% 120% 124% 127% 130% 137% 138% 141% 141% 152% 162% 168% 168% 173% 161% 168% 182%

Cohort Analysis

Product/GEO/Vertical AnalysisCustomer % MRR %

Product 1 110 53% 4,000$ 17%Product 2 75 36% 6,000$ 26%Product 3 20 10% 3,000$ 13%Product 4 4 2% 10,000$ 43%

209 23,000$

Metrics To Measure Profitability

Customer Customer acquisition cost Lifetime value of the customer

Financial Statements Cash flows (direct method) Income statement

Employee Revenue per employee Cost per employee

Customer Acquisition Cost (CAC)

What does it cost to acquire a customer?

How many months of MRR does it take to recover your costs of acquiring that customer?

CAC = (Sales + Marketing +Deploy Costs)

# of Deals Closed

Sales Costs = $100,000

Marketing Costs = $150,000

# of Deals Closed = 600

$100,000 + $150,000 = $416 CAC

600

How long does it take to recover the CAC?

Payback Period = CAC/MRR per Customer

Average MRR Per Customer = $100

$416/$100 = 4.16 months

Rule of thumb: 12 months or less is good.

Lifetime Value of Customer

(Average Lifetime of a Customer * MRR/Cust)

- Cost of Revenue

- CAC

= Lifetime Value of CustomerLifetime of Customer = 36 mths 24 mths

MRR per Customer = $100 $100

Margin = 80%80%

CAC = $416 (4.16 mth payback) $1,600 (16 mth payback)

(36*$100)-$720-$416 = $2,464 (24*$100)-$480-$1,600 = $320

Rule of thumb: LTV that is greater than 3x CAC

is good

Class Exercise

…don’t leave it too late

Guest Lecturer

Celia HouseDirector of Product Management,MLS Listings Inc.