Why Some Suppliers Worry About Subscription Business Models
Before we attack the list of challenges there is an important point to make: When it comes to being the CEO of a subscription business, it’s not a level playing field. There are companies who were born in a subscription model and companies who were born selling capital assets and are now pivoting most or all of their offers to subscriptions. Running the former is one thing, and running the latter is another. Why? The reason is simple: expectations.
Companies that grew up in the age of capital asset selling adopted the same financial model as any other company that built and sold hardware, software, or equipment to business customers. They sold the asset and recognized the revenue when that asset was delivered to the customer. That early revenue recognition was extraordinarily helpful. It locked in the gross profit on the deal, helped offset all the sales costs, and ensured optimal revenue rec for the current financial period. Virtually every manufacturer and software company prior to the early 2000s recorded sales in the same way financial markets had a simple time comparing the results of companies and evaluating the performance of a single company over time. Investors would then opt to buy stock in companies based on that track record. They liked what they saw and they expected even more of that performance in the future.
I think it was William Shakespeare who said “Expectation is the root of all heartache.” In the case of a CEO of a large, traditionally capital asset-based technology company, the adage certainly applies. Why? Because the shareholders who own the stock of that company have expectations of future performance that is largely based on past performance. But replacing capital asset transactions with subscription-based, ratably recognized revenue transactions is also replacing the financial model. The future performance will no longer look like the past performance. And here is the nasty bit: it looks worse.
The Fish Model
The problem works like this: You are a CEO running a company depicted on the far left side of the chart. Your revenues are stable and predictable. So are your costs. The white space in between those two lines indicates your profits—again, predictable. But now you want to start rolling out some form of subscription “as-a-service” offers because customers are clamoring for it, competitors are offering it, you want recurring revenues, which are all the things we have been talking about in this blog series. In short, you believe that if you can pull this off, your business can look like the far right side of the chart. Your revenue growth will be higher and your new digitally transformed, cloud-based business will operate far more efficiently and you will be able to take labor out of your operating model. Both revenue and profits will grow.
The problem is the fish in the middle. You see, when you convert from up-front revenue recognition transactions to ratably recognized, multi-year subscriptions, your comparable revenue performance dips. And as your faster, more successful new “as-a-service” offer cannibalizes your old model, the worse comparable revenues look. At the same time, you need to make investments to help your subscription offers become effective and be renewed successfully. You need to fund the creation of a Customer Success team. You need an Analytics team. You need to build data centers. You need…well, you get the picture.
So at the same time your comparable revenues are falling, your comparable expenses are growing and your comparable profits are declining. In short, the expectations of your value-conscious investors are no longer being met. It’s the right thing to do for the business. Your customers like it, investors will eventually like it, but for now when we are caught in the belly of the fish, heartache can ensue.
Challenges Businesses Face When Trying to “Squish the Fish”
This Fish Model problem is not as acute as it used to be for CEOs. The issue is a lot better understood by the financial community today but it’s still difficult nonetheless. At TSIA, we have recommendations on how to navigate the Fish, which we go into detail about in both of our most recent books, B4B and Technology-as-a-Service Playbook.
Companies who were born in a subscription model don’t have to navigate the Fish Model.
Getting to the new business model is trouble enough, but there is a second and potentially even more challenging obstacle to navigate. So far the XaaS business model has not proven to be very profitable. Even the largest and oldest pure-play XaaS companies are unprofitable on a GAAP basis. So its hard to explain to the board of directors (BOD) and your shareholders why you want to move to a model that appears inherently unprofitable. We will tackle that issue in a moment.
So here is why it’s not a level playing field. Companies who were born in a subscription model (aka, born-in-the-Cloud companies) don’t have to navigate the Fish Model. Their shareholders know and accept GAAP losses both today and for some foreseeable future. For their CEOs it’s just about one thing: growth. At least for now, the stock market is willing to trade off current losses in exchange for high growth and the promise of future profits. That makes running the company fairly one-dimensional.
But for CEOs of traditionally capital transaction-based businesses there are firmly entrenched, hard to change shareholder expectations. Most battle everyday with those expectations and try to meet them while pivoting to the new business model at the same time. They have one foot in the old world and one foot in the new, where they are milking the legacy franchises, trying to fund their nascent innovations and meet those “future guidance” numbers that were given years ago, all at the same time! That’s anything but a one-dimensional management challenge. Which job would you want?
So now you know why we are seeing a record number of CEO turnovers in the tech and industrial sectors. Oh and let’s not forget transportation and about a dozen other sectors.
Be Aware of These 2 Critical Tactical Issues
Tactically there are a few battles where the playing field is level. Two in particular should be a top concern. The first is how to sustainably and effectively compensate Sales teams who are selling subscriptions. I say “sustainable” because there are lots of companies who are laying on very heavy incentives for salespeople to get them to prioritize selling the new subscriptions offers instead of the old capital asset offers. Those heavy incentives are simply not sustainable. They accentuate the Fish Model problem and push back the break-even date of each deal. I use the word “effective” because you do need to consider new and different aspects of incentives when setting field sales comp in a subscription model. You want to balance the rep's desire for a lot of up front dollars with the reality that you need good, long-term deals. You want the reps to be vested in that notion. You want them to have some skin in the game past the initial contract signing but you don’t want them to get fat and happy living off renewals. It’s a balancing act, and one that TSIA has been studying.
You want to balance the rep's desire for a lot of up front dollars with the reality that you need good, long-term deals. You want the reps to be vested in that notion.
The second critical tactical issue that all types of recurring revenue businesses share is around ensuring high renewal rates. In a subscription business model, customer churn rates are at the core of success or failure. High renewal rates beget high growth and market share gains. High churn begets low (even negative) growth, high cost of sales, and poor market reputation. But fortunately, the keys to high renewal rates are becoming far more evident. TSIA has an entire best practices research channel for companies who are standing up or optimizing their Customer Success organization.
So, there is a lot for CEOs to consider as they the journey to a profitable recurring revenue business. What is certain is that there is a market for subscription versions of just about every type of offer. Sometimes BODs find themselves in the uncomfortable position of not being able to do what customers want because it means a period of financial transition that shareholders will not appreciate. But I would actually argue that is a no-brainer. If a CEO does not respond to the wants and needs of his customers, they shouldn’t be in the chair. It’s all a matter of explaining customer requirements to investors and navigating the world of recurring revenues smartly.
Read more posts in "The Digital Transformation Journey" series:
- "Navigating the World of Digital Transformation [Infographic]"
- "Customer Use Cases"
- "Customer Concerns About Subscriptions"
- "Supplier Benefits"
- "Supplier Keys to Success in Subscription Business Models"
- "Growing Customers Successfully"
About the Author
J.B. Wood is president and CEO of TSIA. He is a frequent industry speaker and author of the popular books, Complexity Avalanche (2009), Consumption Economics (2011), B4B (2013), and Technology-as-a-Service Playbook: How to Grow a Profitable Subscription Business (2016), and has appeared in leading publications, such as Fortune, The New York Times, and The Wall Street Journal. He works with the world's largest technology companies on strategies to extend their innovation platform beyond the lab and into the customer experience, particularly in the age of cloud and managed services.