Although recurring revenue businesses have been around for a long time, the trend toward a subscription economy has escalated rapidly in the last few years. IDC expects that by 2022, 53% of all software revenue will be purchased with a subscription model. Even the car subscription market is set to grow by 71% by 2022.
Many types of businesses are looking for ways to earn recurring revenue — and it has gone beyond business-to-consumer companies like Netflix and Dollar Shave Club. Business-to-business companies are also joining in, even those with products that last a long time. For instance, elevator-maker Otis offers Otis ONE, a subscription-connected elevator solution that offers predictive maintenance insights.
Subscription billing options should make it easy to manage all types of subscriptions, including integrating analytics to provide a more complete picture of the subscriptions landscape.
Promising, but there are pitfalls
Subscription business models are attractive, but there are two major pitfalls. At the top of the list is payment. Regardless of company size, there’s an ongoing need to convince customers to sign up long term.
Companies also need to accommodate new payment methods and ensure ongoing compliance with interstate and international tax laws. As a result, the payment process can quickly become painful.
As any company with recurring revenue scales, it becomes increasingly challenging to manage subscriptions, especially with homegrown systems, changing subscription offers and the complexities of converting customers from free trials to paid subscriptions. Subscription billing options should make it easy to manage all types of subscriptions, including integrating analytics to provide a more complete picture of the subscriptions landscape.
Businesses also have to keep in mind that every time they add more product categories or expand into new geographies, they need to tack on extra software code to change their operations and stay sales-tax-compliant. As they expand globally, this can become an obstacle to rapid growth and flexibility.
To keep the company focused and maintain growth without having to expend resources, subscription businesses need a specialized billing system so they can focus on customer acquisition and revenue growth rather than staying on top of billing complexity.
The CAC payback gap constrains growth
The second issue: How do businesses cover the funding gap between when customers sign up and when they pay? In the subscription economy, companies that would previously receive a customer’s payments all at once now earn revenue spread across a monthly or quarterly subscription fee.
This causes long cash-flow gaps — from as short as five to as long as 18 months — that prevent companies from reinvesting their profits into customer acquisition and product development. This can be a killer for startups and established enterprises.
There are thousands of articles and books advising companies on what they have to focus on to be successful. In the subscription world, one factor looms large: the cost to acquire customers (CAC) and the ability to monetize them, or customer lifetime value (LTV). CAC includes the entire cost of sales and marketing, divided by the number of customers acquired in that period. LTV is calculated by looking at the gross margin expected from a customer over the lifetime of the relationship.
It’s easy to see that business failure is inevitable when CAC exceeds LTV. Instead, CAC should be significantly less than LTV. Due to several factors, including churn, it can be difficult to strike the right balance between the two, and that can spell disaster.
The CAC payback period not only applies to cash-strapped startups, but also to bigger companies. Larger enterprises may have greater access to capital, but if they have a recurring revenue aspect to the business, then they face the same payback gap.
There’s also the issue of net retention rate (NRR). Once companies close customers, they need to find ways to encourage them to increase the consumption of products and services, either by increasing usage or signing on more customers.
Even if businesses can keep customer acquisition costs and churn rates low, they still often have to turn to investors and convince them to keep pumping in cash to fund growth — and the terms are seldom favorable. Many recurring revenue businesses have only two choices: scale fast and accept significant debt and dilution, or bootstrap and accept less available cash flow and slower growth.
Solving billing and cash flow problems at once
There are now new financial instruments that are integrated with subscription billing systems like my company, Chargebee. Together, they solve the problems of billing complexity while allowing recurring revenue businesses to scale without dilution. This allows business owners that want to get into subscription e-commerce to solve their payment woes and fund and scale their businesses and cover funding gaps at the same time, without turning to equity financing or debt.
Using these new financial instruments, businesses with any type of recurring revenue stream can trade contracts for upfront cash for up to the full annualized contract value, instantly. This enables companies to use their existing contracts to fuel growth and infuse capital into the business — without dilution or restrictive debt. The billing system gives customers preferred access to the trading platform and guarantees the best rates available as they trade their subscriptions for upfront capital.
These new financial instruments are uniquely different from alternative funding options: They are not a loan. They do not require a UCC-1 filing, and they are not expensive like a revenue-based agreement or merchant cash advance. Think of them as the Nasdaq, with a few differences: They are a software platform, and the assets traded are monthly or quarterly contracts.
Companies with recurring revenues trade their assets on the two-sided platform, with the buy-side comprising institutional investors (banks, hedge funds, etc.) bidding on those contracts’ annual value upfront. If a customer churns, then the company can trade another contract that is of equal value to the unserved portion of the original subscription.
With the subscription economy booming, companies need ways to take advantage of a subscription model without diluting the business with increased debt and equity capital or worrying about how to manage the increasing complexity of a subscription-focused billing model. New options allow businesses with recurring revenue to scale sustainably by supporting internal billing operations, as well as providing access to capital without sacrificing valuable equity.