What Are Subscriptions?
Remember when you stopped renting movies from Blockbuster and decided to subscribe to Netflix? In both cases, you watched a movie in the comfort of your home. You switched from paying when you rented (or bought) to paying a monthly fee, a subscription. Same outcome, different pricing model.
A subscription is a periodic payment for frequent usage or benefits.
In 2000, Salesforce pioneered a new way to deliver business software, a subscription. They called it Software as a Service or SaaS. Instead of buying a CRM or sales management software package, companies could subscribe to the functionality.
Salesforce’s success prompted other companies to look into subscriptions. Since that time, companies like Adobe and Microsoft have shifted their product offerings from perpetual license to subscriptions. Most software companies today are at least exploring how to offer subscriptions if they haven’t already made the shift.
The subscription craze isn’t limited to software. In Atlanta you can subscribe to Porsche. Rent the Runway allows you to subscribe to designer clothes. Harry’s Razors lets you subscribe to your shaving consumables. Burger King is now offering a subscription for coffee.
Although not precisely subscriptions, companies like Uber and Lyft and products like AWS act a lot like subscriptions. Officially, these companies sell per use, but the recurring revenue characteristic of these businesses makes managing their pricing and packaging very similar to subscription businesses.
Why are all of these companies moving to subscriptions? The easy answer is it’s a better business model, but let’s explore why. Subscriptions are better for both the buyer and the seller.
First the buyer. Buyers get to try the product with a relatively low upfront investment, which means a lower risk. How many times have you bought something, only to never really use it? (They do make treadmills to hang your clothes on, don’t they?) Instead of committing to purchase something, buyers simply pay a monthly fee for the benefits. This reduces the upfront risk to the buyer. They try something and if it isn’t worth it, they cancel.
Also, products tend to be better. Before, when you bought a product, companies only cared if they could convince you to buy the product. They didn’t really care if you used it. With subscriptions, they care if you use it. Buyers who don’t use tend to unsubscribe. With subscriptions, sellers listen to their market more, fix problems and add features. Their desire to make sure you use their product, not just buy it, means they simply build better products.
The real reason subscriptions are taking off is the benefit to the sellers. The biggest reason of all, subscription companies have 4 to 10 times the valuations or market capitalization than traditional companies. There are reasons for these high valuations:
- Lower customer acquisition costs
- Higher lifetime value of the customer
- More predictable growth
- Business planning
Customer acquisition costs tend to be lower because a customer can get into the product for a short time without making a huge commitment. For example, you can cancel your Netflix account any time you want. Your Netflix bill is less than what you used to pay for one DVD. Because your risk is lower, you are more likely to try Netflix to see if it’s really worth it. Hence, it’s easier and less expensive to get you to subscribe.
The lifetime value of a customer tends to be higher because companies have to serve their customers well to keep them subscribing. The better they serve them, the longer they stay. Companies focus more on creating products and features buyers want and use. When subscribers use the products, they are less likely to churn. Netflix tracks which shows are the most popular, and then they create original content to satisfy that exact same viewing preference. They are focused on keeping subscribers happy and paying.
There are many more reasons that both buyers and sellers prefer subscriptions, but the key point is that companies are moving to subscriptions at a rapid rate. Unfortunately, most companies don’t truly understand how subscription pricing works.
What’s different about subscription pricing?
Although there are many differences between traditional and subscription businesses, the two biggest are where revenue growth comes from and how to use pricing to enhance that growth.
In traditional business, a company builds a product and sells it. Once the customer has paid, the seller is out looking for new customers. Subscription is different. Subscription businesses need to focus on three revenue buckets, acquisition, retention, and expansion. Or, win, keep, grow.
- Acquisition (winning new customers) is just like with a traditional business. Sales and marketing focus on finding and converting potential buyers. This is the customer acquisition cost and as pointed out above, it’s a little easier in subscriptions than in traditional businesses.
- Retention (keeping customers paying) is new for subscriptions. Customer churn is a measurement of how many customers canceled their subscriptions. If a customer cancels too quickly, the seller often doesn’t make enough money to cover the customer acquisition cost. Sellers focus on retention by making sure they are winning the right customers, by systematically onboarding customers when they first join and by monitoring and assisting customer usage of the product. The last two are often done with a new department called customer success, (something traditional businesses didn’t really care about.)
- Expansion (growing customers and getting them to pay more) is the most powerful revenue bucket for long term company growth. Yet it is also the least understood and most often ignored. It is also the bucket where a deep understanding of pricing strategies has a major impact. The most successful companies grow their current customer spend by 40% or more per year.
The pricing metric that makes the most sense is the one that makes the most sense to your buyers.
The second big difference with a subscription business, especially SaaS business, is the pricing levers you can use.
- Market Segment: A crucial lever that exists in traditional business, but is not used well, is choosing the right market segment. When a seller clearly specifies the right market segment, the customer acquisition cost tends to go down and the lifetime value of a customer goes up. The right market segments value your product more making it easier to sell and users that love your product. As sellers focus in on the right market segments, they often have the ability to raise prices on that segment.
- Pricing Metric: The second powerful lever, especially for SaaS businesses, is a pricing metric. What will you charge for? The key concept behind a pricing metric is the more value someone gets from your product, the more they should pay. As a buyer grows and uses more, they should pay more. A great example of this is Slack and how they charge based on active users. As a company grows and hires more people who use Slack, they pay Slack more money. User-based pricing, the most common pricing metric, is easy to implement but often not the optimal choice when looking at how buyers receive value.
- Packaging: The third pricing lever is packaging, which is usually the hardest to get right. Look at pricing for your favorite subscription companies. Many offer good, better, best pricing. There are many reasons why this is a brilliant pricing strategy. The fastest growing and most profitable companies frequently tweak and test their packaging and pricing.
Subscription business models provide big benefits for both buyers and sellers, but the business is not as well understood. Pricing is about understanding what decisions buyers are making and how they use price when making those decisions. Nobody says subscriptions are easy, but they can absolutely be worth it.
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