Managing Director, Cloud Strategies
Guest author, Dave Key is Managing Director of Cloud Strategies, where he helps software companies transform to SaaS and SaaS companies perform at their highest possible level. Dave has built and supported large enterprise systems with both on-premise and Software as a Service (SaaS) platforms.
Growth is a good thing.
High growth subscription companies have higher company valuations, have a better market perception, attract better employees, and can dominate their market.
But at what cost?
Subscription companies need to spend money to gain new revenue before those costs are recovered by the profits from subscription revenue. Subscription companies need to measure growth efficiency
, return on investment (ROI) and internal rate of return (IRR).
Growth Efficiency
The cost of growth is measured by the Growth Efficiency Index (GEI), which is the sales, marketing and onboarding costs required to get $1 in additional annual recurring revenue (ARR).
The lower the Growth Efficiency Index the better, but of course, it all depends on the profits from new revenue. The present value of the new revenue stream, the sum of all your Customer Lifetime Values (CLV), is dependent on three things:
1. Profits
Subscription Gross Profits (the company’s profit margin after deducting the cost of subscriptions) show the incremental profits of recurring revenue. Recurring Profits are a better method of determining the net income stream generated by your subscriptions. Recurring profits are the profits from subscription revenue after the cost of providing the service and running the business, but excluding the cost of Revenue Acquisition.
Recurring Profit = Subscription Revenue – (COS + G&A + R&D)
The median percent Recurring Profit Margin of public SaaS companies is 47% based on the Cost of Subscription Services (COS), G&A, and R&D of 18%, 17%, and 18% respectively.
2. Churn
The amount of revenue lost per period, not the percent of customers lost, should be used for all financial analyses. Churn causes a loss of future revenue, lowering the CLV.
Companies serving markets where there is greater churn (such as B2C businesses) must have lower sales and marketing expenses, since their customers don’t stick around long enough to justify higher Revenue Acquisition Costs.
3. Cost of Capital
Companies with a high cost of capital will have a lower CLV, decreasing their ability to spend money on Revenue Acquisition. The cost of capital tends to decrease as your subscription company’s financial position increases.
ROI
The ROI of a subscription company’s Revenue Acquisition Costs is a function of the Recurring Profit Margin, the Growth Efficiency Index, Churn, and the Cost of Capital.
Aside from improving the Growth Efficiency, churn has the most significant impact on the ROI since it impacts the CLV. The graph below shows how dramatically churn impacts the ROI. To achieve your ROI target, you need to either raise the Growth Efficiency, lowering the Revenue Acquisition Costs (the “Investment” in ROI), or lower the churn (which raises the “Return”).
IRR
IRR is the percent returned each year from the Revenue Acquisition investment. This metric allows you to compare the value of the recurring revenue stream to other investments as an “interest” payment on the Revenue Acquisition Costs.
Conclusion
Building a subscription revenue stream is expensive. Businesses in the “Purchase Economy” had a simple measure of the ROI of their Revenue Acquisition Costs since the purchase revenue was realized immediately. In the Subscription Economy, the value of the subscription is realized over the life of the customer. By using ROI and IRR analysis of this future revenue stream, we can determine the Growth Efficiency required to meet these targets of the future profits against today’s Revenue Acquisition Costs.
We can determine how much can be spent on Revenue Acquisition while meeting the company’s ROI targets. By decreasing churn, the company can increase expenditures on Revenue Acquisition while maintaining the same ROI on these costs, enabling faster growth. Faster growth results in greater company valuation and market dominance.
For a more in depth discussion on GEI and the other metrics that matter in measuring the performance of your subscription business, check out last week’s on-demand webinar with Zuora’s Iain Hassall and me.