SUBSCRIPTION FINANCE
The Fundamentals of Subscription Finance
What is Subscription Finance?
Subscriptions are replacing the traditional product sales models, and are fundamentally changing the face of businesses, industries, and the job of the CFO in the process. CFOs long-accustomed to product-centric, single-purchase transaction businesses need to get smart on the shift to businesses built around long-term recurring revenue relationships that are becoming the hallmark of the 21st century.
The Subscription Economy is becoming pervasive for a variety of reasons. Customers are demanding a more flexible consumption model. General Managers have the flexibility to test pricing and bring new functionality to consumers at an accelerated pace. Executives are realizing this allows for a longer lasting relationship with their customers. And investors recognize that, if executed well, Subscription Economy companies have fantastic revenue and return models.
Traditional finance is broken.
As a finance professional, if you haven’t already participated in the shift to subscription, you need to know that you will soon. When you do, you need to be aware of a critical difference: finance as you know it is broken. Double-entry bookkeeping – the cornerstone of accounting for 500 years – cannot capture the dynamic, ongoing revenue relationships that are the foundation for the subscription business model.
The fact is that a company with a subscription business model is fundamentally different than a product company.
- You need to value one-time revenue very differently than recurring revenue.
- You need to measure your business across multiple dimensions of time – not just the past, but the future as well.
- You need to manage complex changes that can create chaos in downstream processes, such as mid-month subscription cancellations that can result in credits or refunds thereby impacting revenue recognition.
As a result, the shift to the Subscription Economy can wreak havoc on finance departments that are not prepared to handle recurring revenue. Why? Because every accounting system in existence today – including ERP – was built around the rules of double-entry bookkeeping. That means your accounting system is still great as a general ledger, but nothing more than that.
CFOs and their teams are in pain because it takes longer for them to close the books. Many revenue teams are drowning in spreadsheets with a row for every customer – spreading revenue across a multitude of columns. This has forced some CFOs to maintain one set of GAAP books to please auditors and another to run their business.
On the executive side, CEO and board members demand insights into more than just balance sheets and income statements; they need insights into forward looking metrics, like ARR, Churn, and ACV. At Zuora we have to rely more and more on non-GAAP off-balance sheet accounts to explain our success. In addition, despite a growing awareness of these recurring revenue models many Wall Street investors don’t fully understand the subscription business model and often fail to value subscription businesses correctly.
The market is moving towards subscription businesses.
Recognize that making this shift may not be by choice. The Subscription Economy is here to stay, and you need to adapt. Customers from all walks want more control over their relationships with vendors, brands and service providers. With widespread internet access and the proliferation of mobile devices and social networks, more and more customers are taking charge. The customers want you to serve them how, where and when they want. Will your company be ready?
At Zuora, every single employee lives and breathes this model. In fact, this guide is compiled by some of our brightest finance experts and an excellent starting point for understanding how this unique business model will forever change the world of business and how to adapt, not react, to the evolving role of the finance executive. Read on.
Ready to take the next step? Talk to one of our experts today.
The basic subscription finance equation.
Whether you’re two guys in a garage launching a new business or a large enterprise shifting to a recurring model, the Subscription Economy will turn your business on it’s head. Instead of focusing on tracking products shipped to random customers at random intervals, your business strategy must now be focused around offering innovative services that breed long-term relationships. So instead of being about single, discrete sales, the Subscription Economy nets down to monetizing and retaining relationships for a predictable recurring revenue.
But you’ll need to change the way you measure your business when you shift from the old world of chasing after each and every dollar to this new world of monetizing relationships. Here is the basic equation behind all subscription-based businesses:
ARRn + ACV – Churn = ARRn+1
ARR / MRR
Annual Recurring Revenue, or ARR (Monthly Recurring Revenue / MRR), is the amount of revenue you expect to repeat. It’s that simple. Note that this does not include one time revenue, it only includes revenues that recur. And with that said, ARR is different from revenue. Revenue is a backwards looking number while ARR is a forward looking number — emphasis on “Recurring” in ARR.
The problem? Well, your traditional financial statements only show revenue for a past period and have no concept of recurring, forward looking revenue. But for Subscription Economy companies, because of ARR, they can actually start each fiscal year knowing what their revenues are going to be for that year. In the formula above, we call this Starting ARRn.
Churn
ACV
Annual Contract Value (or ACV) is your new revenue brought in by new customers or customers upgrading or renewing their existing contract. You invest in sales and marketing to drive new revenue, because ultimately this increases your ARR.
If you add up all of these metrics, you not only have a complete financial picture of your subscription business, but you also have your recurring revenue for next year or your ending ARR.
So, by now you get the subscription business model. ARRn – Churn + ACV = ARRn+1, right? But how do the ERP financial systems you have in place today support a new model based on fostering and monetizing relationships?
But tracking recurring revenue is a forward-looking process. So, when it comes to tracking metrics for subscription businesses, traditional systems just can’t account for the whole picture. Sure, financial metrics like bookings, billings, cash and revenue were tracked in the old world of commerce, but they were backwards-looking and focused on one-time transactions. Let’s look into some of their limitations.
The Subscription Economy is about committed relationships, not one-night stands.
Recurring revenue is the output of a committed long-term customer relationship, where both the customer and the vendor hold up their part of the bargain. A committed relationship needs constant attention, whereas a one-time purchase is casual, transactional.
Thus, businesses need to account for recurring revenue differently from one-time revenue. But traditional financial systems don’t know how to differentiate between a one-time transaction and a recurring customer relationship, and so they tend to just lump the two together and treat them the same.
In the Subscription Economy, relationships will evolve over time. People, customers and businesses — the only thing constant is change. Their needs and their wants will indefinitely constantly change as they mature and as their environments change. Your relationship will have to evolve to service the needs and wants of your customer.
This means you need to be able to iterate on your pricing and packaging. And do it quickly — before your customer goes elsewhere. But this can result in quite a burden for the finance team. Every tweak to pricing or bundling can mean an entirely new sku (or stock keeping unit) in your system, or make things very difficult if there are multiple time periods in play.
In fact, because traditional finance systems do not know how to spread a series of changing transactions over time, they limit you to simple debits and credits. And if your ‘system’ is a spreadsheet, well good luck tracking the business impact resulting from these changes — things like bookings, billings, cash and revenue – across multiple dimensions of time.
Decisions in relationships will have downstream effects.
Don’t let yourself think that when a customer decides to cancel their subscription mid-month that it’s as simple as flipping a switch. Complex changes like this can create chaos in downstream processes and will have a direct impact on your revenue recognition. Especially if every notable change the customer makes is managed manually.
You need to be able to quickly adapt to changes in the relationship and automatically calculate how this will impact the account, as well as the business. But the core functions of old world financial systems are around tracking raw goods. They are not powerful rule engines. They are not smart enough to adapt to subscription changes in real-time, and re-calculate any schedules impacted by those changes.
Limitations can be painful for everyone.
Every department in your company will feel the impacts of the limitations offered by traditional finance systems — and this pain ripples far beyond the CFO’s office.
- The accounting teams struggle to close month-end books on time.
- Revenue managers are drowning in spreadsheets.
- CMOs are prevented from implementing new packaging and pricing because of the burden it places on the finance team.
- CEOs are having a hard time explaining their success to Wall Street.
- And, last but not least, CFOs are forced to maintain one set of GAAP books to please auditors and another to run their business.
The Journey to Usership
The playbook for modernizing monetizing, and scaling your subscription business
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– Rahma Samow
Head of Siemens Healthineers Digital Health Global
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