Subscription Finance

What is Subscription Finance?

Subscription finance refers to the financial services and arrangements designed specifically to support growing businesses that generate recurring revenue. The subscription model has grown in popularity due to the increasing prevalence of subscription-based services (in particular, SaaS products).

The subscription economy — where traditional businesses are moving toward subscription-based models — has become increasingly prevalent over the last two decades. There are several reasons behind this:

• Subscriptions create longer-lasting relationships between brands and their customers.
• Buyers want the flexibility to use products without spending a fortune or owning them forever.
• Companies can test pricing and product features on customers without risking a poor sales year.
• Recurring revenue is more predictable, so it facilitates accurate forecasting and more scalable business models.
• Advancements in technology eliminate the need to own software licenses (the sheer abundance of tools makes that impossible, anyway)

SaaS products are the primary driving force behind the subscription economy. Out of the $1.5 trillion subscription market, cloud-based services account for 45%. Maintaining software is expensive, difficult, and doesn’t scale. Cloud-based technology updates automatically without any effort from the customer.

Could you imagine having to purchase a Netflix license for several hundred dollars, then installing updates every month or two? Fortunately, cloud services have eliminated the need for traditional technology maintenance.

Since today’s consumers have become so accustomed to the convenience of subscription-based services, plenty of other types of businesses have followed suit to meet customer demand.

Synonyms

• Recurring revenue model
• SaaS financial model
• Subscription business model

Key Elements of SaaS Subscription Finance

Financing Based on Predictable Revenue

The core principle of subscription finance revolves around recurring revenue (as opposed to one-time sales). Subscription businesses track revenue monthly (MRR) and annually (ARR). MRR and ARR represent the predictable revenue a company expects to receive each month or year, respectively.

These metrics are forward-looking, while traditional revenue measurements are backward-looking. Subscription finance also factors in churn — the rate at which subscribers stop using the service — and annual contract value (ACV).

Accounting for Recurring Subscriber Payments

Subscription finance also includes sophisticated financial reporting and accounting practices. This is because subscription-based business models often involve complex transactions. They offer promotions, upsells, cross-sells, and varying subscription tiers. In the case of B2B SaaS products, there’s sometimes a usage-based component as well.

Accurately billing customers, then recognizing and processing this revenue requires advanced tools. Under ASC 606 and IFRS 15, revenue is only recognized when it’s “earned.”

Most subscription companies use a pay-as-you-go model or bill customers upfront for a month’s worth of access. This means they won’t “earn” the revenue until that billing cycle is complete, despite it being in their account.

So, for every customer, businesses recognize revenue the following month (or, in the case of annual subscriptions, in 1/12 increments throughout the year).

This adds difficulty when preparing financial statements and, ultimately, presenting that data to investors and stakeholders.

Addressing Cash Flow Management

Although subscribers pay for their services on an automated schedule, the time you receive a cash inflow and the time you have to handle your company’s expenses or investments probably won’t align.

Subscription financing options can bridge the gap between the time you collect revenue and the time cover your expenses. That way, you can stay liquid while investing in product development and market expansion (more on this below).

Growth Capital Funding

Subscription companies can (and do) access traditional forms of financing, like loans and venture capital/debt. But, in recent years, alternative financing options have emerged specifically for subscription businesses.

A unique aspect of subscription finance is revenue-based financing (RBF), which is a funding option based on a subscription company’s future revenues. Lenders assess the value of a company’s current subscriber base, acquisition/revenue retention figures, and revenue projections. Then, they provide cash upfront.

This model is generally less risky for the borrower because they can reasonably expect business to carry on as usual. It would be quite strange for tons of customers to churn at half their average lifetime without a dramatic change. In fact, that almost never happens.

For subscription businesses, this means the funding process is often simpler and quicker compared to traditional debt or equity funding. The repayment is tied to the company’s revenue, making it a flexible option for businesses with strong recurring revenue streams.

Risk Mitigation

Subscription finance providers use risk mitigation tools and services to address the challenges associated with customer churn and defaults. Their strategies primarily focus on predicting and preventing churn from happening in the first place.

These include:

• Credit insurance
• Risk-sharing arrangements
• Churn prediction models
• Cohort analysis to identify at-risk customers
• Automated payment reminders and account monitoring systems
• Customer success strategies to improve retention rates

Recurring Revenue Valuation

In the eyes of investors, businesses with recurring revenue are insanely valuable…more valuable than any other kind.

According to data from Aventis Advisors, the median SaaS valuation between 2015 and 2023 was 5.1x revenue. And one-quarter of companies were sold higher than 9.7x revenue.

Other data suggests that SaaS companies are typically valued between 4.0x and 8.0x EBITDA. That’s several times greater than any other type of company.

SaaS companies are practically guaranteed to continue generating a stream of predictable revenue. It’s easy to calculate customer lifetime value and make educated assumptions about customer acquisition cost, churn, and future growth.

All of these factors make SaaS companies the most attractive investment prospects.

Focus on Customer Retention

Long-term relationships are the priority. It costs $X to acquire each customer and $Y to run a subscription business, but your recurring subscription fee is only a fraction of that.

To break even, you have to retain your customers long enough to pay off your customer acquisition initiatives (this is called CAC payback). To turn a profit and run a sustainable operation, you have to generate at least 3x as much subscription revenue as your acquisition costs. In other words, your LTV:CAC ratio needs to be at least 3:1.

If you have a customer churn problem, you can’t break even. If your customers like the service enough to stick around for several years, you’ll have one of the world’s most scalable businesses (assuming your cost structure is on-point).

That’s why subscription businesses are obsessed with customer retention. Unlike traditional businesses, the sale doesn’t end at the transaction.

Pricing Strategy

For basic subscription services, like a meal delivery box or streaming platform, pricing is straightforward. They use a flat-rate pricing model — customers pay a fixed fee for unlimited access or a set number of deliveries per month.

For complex SaaS products, it’s not so straightforward. They use a combination of…

• Tiered pricing (a baseline rate for each product tier)
• Usage-based pricing
• Per-user pricing (a per-seat rate for each user)
• Custom pricing (for enterprise customers)
• One-time fees (for implementation, consulting, etc.)

…so it’s difficult to set and optimize prices for product value, price sensitivity, and simplicity. But, based on your needs and usage, you’ll always know the maximum amount you could potentially owe.

Subscription finance options take these pricing models into account when determining funding amounts and repayment terms. The flexibility of subscription billing means businesses can adjust their prices and still have predictable revenue for repayment. This allows for more agile growth and planning, without the need to constantly secure new rounds of funding.

Subscription Finance Metrics

To secure financing, subscription businesses need to look closely at the following metrics:

Monthly Recurring Revenue (MRR)

Monthly recurring revenue is the month-to-month running total of your subscription income. It gives you an at-a-glance look at your revenue performance.

When you zoom out, you can analyze month-over-month revenue figures to see how much you’ve grown. You can even look at several months to spot trends.

MRR is the most basic metric for subscription finance. It shows potential investors the success of your short-term growth and retention initiatives. And it speaks to your company’s real-time financial performance.

Annual Recurring Revenue (ARR)

Annual recurring revenue is the zoomed-out version of MRR. You’ll use it for macro forecasting, long-term trend analyses, and annual reporting.

Investors love ARR because ARR growth demonstrates your ability to grow sustainably. While MRR highlights your company’s capacity to retain subscribers and grow your subscriber base through sales, marketing, and customer success initiatives, ARR looks at the big picture. It also puts a good or bad month into perspective.

Customer Lifetime Value

Customer lifetime value measures your subscribers’ value to your business over the entire time they keep their subscriptions. By looking at lifetime value, you can see the average amount of revenue each customer generates before they churn.

Lifetime value is used in subscription finance to help businesses better understand exactly how much money they’re making off of each customer, compared to the costs of their customer acquisition strategies (and running the business in general).

Annual Contract Value

Annual contract value shows how much you can expect to make from each of your yearly subscribers each billing cycle. This metric is used in subscription finance to understand how much the typical customer will spend on your service in 12 months.

Churn Rate

The churn rate is one of the most critical metrics for subscription businesses. If your churn rate is too high, you won’t be able to keep up with customer acquisition costs and growth. As such, churn rate is crucial when securing subscription finance as investors will want to see that your business has a solid plan for keeping retention rates high.

In general, companies shoot for net negative churn. That means their expansion revenue outpaces any contraction or churn. This is a sign of healthy growth and often leads to larger funding rounds, as investors are confident that businesses in this situation can sustain themselves long-term (and have a great product).

Subscription Management Best Practices

To positively impact your company’s financial performance and ultimately secure funding, here are seven practical tips for subscription management:

• Continuously benchmark your company’s performance against relevant industry peers to set realistic improvement targets and understand your competitive position​​.
• Efficiently manage customer acquisition costs and actively reduce churn rates to maintain a healthy balance between new customer acquisition and retaining existing customers​​.
• Prioritize customer retention over acquisition in your subscription business model to increase the lifetime value of each customer and support stable and predictable revenue streams.
• Implement self-service functionality so subscribers can upgrade themselves without having to talk to sales.
• Understand that subscription management is broader than just recurring billing. While recurring billing is an essential component, subscription management also includes managing subscription plans, providing easy subscription modifications, offering loyalty benefits and discounts, and nurturing your customers through content and a positive ongoing experience. 
• Implement usage-based pricing models to align your revenue with customer value.
• Integrate your subscription management system with secure payment gateways to streamline the payment process and enhance operational efficiency.

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