Moving to subscription pricing? Prepare investors for a short-term revenue drop

October 30, 2019

Published by: serena

Subscription-based pricing models attract companies because they come with a predictable cash flow, which leads to higher investor valuations and easier access to debt. They also generate more data than transactional models, which helps you tweak products and services to keep customers happy. 

Now that SaaS applications and cloud-based platforms make the transition to subscription pricing realistic, there's little reason for companies to hesitate before going this route. But you have to prepare for a short-term downturn in revenue, higher customer acquisition costs, and inquiries from nervous investors who worry how long the transition will take, executives specializing in recurring revenue models say.

"If you want to make this happen and keep your job, you have to be able to show long-term value, even if, temporarily, it's not going to look like that," Daniel McCarthy, assistant professor of marketing at Emory University, said in a webinar last week.

Infrastructure in place

Subscription applications like Zuora and Ordergroove and online platforms like Amazon Web Services and Google Cloud create an infrastructure that makes subscription pricing feasible for many companies, McCarthy said.

Customers are pushing businesses in this direction because they like the choice and flexibility subscriptions give them, and upfront costs are lower because they're not paying the entire purchase cost as they do in a transactional model, said Chris Hemenway, director of solutions consulting at RecVue. 

Adobe is a prime example of a company that moved from transaction to subscription licensing. About seven years ago, it unbundled the elements of its creative suite —  Photoshop, Illustrator, Premier Pro, and so on — and made them available individually, on a subscription basis, in the cloud. "Previously, you had to buy all the elements as part of their suite," said Hemenway. "Now, under their cloud-based model, you can pick discrete services on monthly, quarterly, or annual basis."

Over time, companies tend to sell more services and generate more income per customer using the subscription model, but your income will almost certainly drop over the short-term, since your new customers are only paying the subscription amount rather than the full price when they come on board, and that's something executives have to make sure investors understand before the transition begins.

"You can think of it as a J curve," said Robbie Kellman Baxter, founder of Peninsula Strategies. "You need to set expectations for that dip in revenue and have a long enough transition time that you can see the revenue coming back, at some point. You want some interim metrics, like engagement, that can be early indicators that your model is working."

Experiment with metrics

McCarthy recommends tapping the data the new model generates to track metrics — what he called a customer-based report card — that show success even while revenue is playing catch-up.

"I would track the number of customers acquired, period by period, how that breaks down into payment plans, purchase frequency, validated models of lifetime customer value, 12-month retention, different measures of retention points," he said. "Track every period and make sure you're comfortable with where these are trending."

Keep tinkering with your metrics, because your ability to identify what your best customers want, and will want in the future, leads to renewals. 

"Experimentation is key," McCarthy said. "Constantly run randomized controlled studies. Put a system in place to track leading indicators of churn, things like net promoter score, other measures of happiness, and engagement of your customers. Capture all of that on a regular basis, and if things don't come in as expected, you can very quickly jump on that."

Once the data comes in, share it across the organization — not just with the CEO and board — because, for the subscription model to work, all functional areas of the organization — finance, operations, product, marketing, technology — must work together to match product and services and their delivery to what customers want. "This isn't a business model that works in silos," Kellman Baxter said.

One company she worked with, she said, appeared to have a good customer acquisition team but a poor customer retention team. "It turned out the acquisition team was pitching a feature that could only be used once, so customers were signing up, using the one feature, and then canceling. They were going after the least valuable kind of customer, which looked like a retention problem but was really a product and acquisition problem."

Simple, transparent pricing

To make the transition successful, you have to get your subscription pricing right. That means keeping your model simple and being transparent about how you derived the amount. 

From the customer's perspective, "I need to understand why I’m being priced the way I am for these services," said Hemenway.

Kellman Baxter recommends pricing not just for customer acquisition but for engagement and retention. "Make sure your pricing attracts and maintains your best customers," she said. "If your offering requires a lot of upfront investment, once they've gone over that hurdle, they're very likely to stay for a long time."

Make it easy for customers to either reduce their product use or leave, because if they feel they can do those things without penalty, they're more likely to trust you and return when the time is right.

Hemenway calls this pricing for the downsell journey, not just the upsell journey. "What's often overlooked is just allowing customers to consume less of the services you offer," he said. "If you over-purchase out of the gate, or you're just not consuming as much you signed up for, getting something from that customer is dramatically more valuable than getting nothing. So, follow usage pattern, and look for those slight drops; you can reach out with an offer to downsell, as opposed to a new promotion."

Hemenway pointed to a California law that took effect a few years ago. It requires any subscription-based service, whenever it emailed customers with a price increase, to include an opt-out at the bottom of the email. Companies were concerned that the requirement would lead to a flood of opt-outs but the opposite occurred: people overwhelmingly stayed with their service. "Customers not feeling trapped was actually a retention strategy," he said. 

Netflix has been good at this, Kellman Baxter said. "When raising prices, they always have a cancel button in the email," she said. "It shows a level of integrity and trust. Consumers behave like a member."

That applies to business-to-consumer models, like Netflix, as well as business-to-business models, she said. 

RecVue was a sponsor of the webinar,  What CFOs Need to Know About Creating and Sustaining a Recurring-Revenue Business.

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