What does subscription finance entail?

Music, movies, SaaS services, cleaning products, education and more – our economy is seeing a massive shift towards a subscription-based business model dominant landscape rather than one dominated by traditional ownership.

Subscription business models entail offering a product or service and receiving capital using recurring payment platforms in order to continue providing that service or product. These subscription businesses prioritize customer retention over acquisition, and because revenue is recurring, they track it differently.

Effectively, as they concentrate on how money is generated and offer subscription billing for access to a commodity or service rather than a huge upfront one-time charge, their behind-the-scenes financial requirements follow suit.

When determining a valuation for a subscription business, leaders will talk about monthly or annual recurring revenue metrics, churn rate, and retention, as because their growth isn’t making more one-time purchases but sustaining long-term, profitable relationships. According to the Harvard Business Review, acquiring a new customer costs 5-25% more than retaining an existing one, after all.

Because of the way these companies measure growth, subscription based financial planning is fundamentally different from that of a traditional business. Let’s unpack why.

Why traditional finance doesn’t work for subscription businesses

Traditional financial metrics are backward-looking, whereas subscription finance is forward-looking. 

What’s that mean? Let’s illustrate it with a common subscription-based business model example: publishing exclusive content to a private community. 

Let’s say you’re a finance mogul who’s had a successful career. You want to train the next generation, so you start a private community where members get exclusive access to training and mentoring with you. You now run a subscription business. 

After a year of building your community and training others, you want to see how well your company’s done. With a financial model for a subscription business, what do you think is more important to you?

• How much you made last year from your customers
• How many customers you currently have

Sure, it’s important to know how much money the company brought in. You find this by looking at what traditional financial models include:

• Cash flow
• Gross profit
• Growth margin
• Cost of goods sold

These metrics are important but don’t reveal the full story. 

What if a dozen new members joined right at the end of the year? In traditional finance, you’ll only see their first monthly payment. But those members are worth much more. With each month, they’ll generate more revenue. This is their Lifetime Value (LTV). 

Subscription business models are commonplace with streaming services, phone plans, magazines, gyms, and learning platforms. But there’s more. 

Let’s start by introducing 2 financial models which both work great for handling subscriptions.

The self-service model

You will bring your customers with paid ads or SEO to your web, where they can read more about your product or service and subscribe. This model is great if you expect your customers to buy on their own, commonly when the price of the recurring payment isn’t too high or there is nothing to think about. For example, when you are selling things like pet products.

The inbound model

Your web traffic is converted into leads, which are then handled by you (or a sales team). Use this model if you expect to close deals using lead generation, lead nurturing, and a team to close sales. In most cases, whenever there is something tailored for your customer or a complex service, you need a person to handle the process of ordering and taking care of details that simply can’t be managed autonomously by software.

Using the inbound subscription model, you have to take into account hiring a certain amount of professionals that will handle closing new customers. Don’t forget to also include coaching costs in your expenses.

In either case, a subscription business’s success hinges on its ability to build long-term relationships with customers. If customers are no longer getting value, they’ll cancel.

Because subscription businesses fit within virtually every industry, it’s as if they’re becoming the norm rather than the exception. But this shouldn’t come as a surprise.

Benefits of subscription finance to businesses

On a macro scale, subscription businesses are enjoying their time in the limelight. Harvard Business Review sites a plethora of research showing that they are “consistently expanding five-to-eight times faster than traditional businesses.” 

Likewise, when customers purchase from you consistently, they spend more. Data from Amazon Prime members reveals that they spend $1400 a year, whereas non-members only spend an average of $600. That’s a whopping 80% difference. 

Amazon isn’t alone. CaaStle, a subscriptions-logistics provider, found that one apparel company’s “rental subscribers spent on average 2.5 times more than their traditional brand (non-subscription) consumers.” 

What can we garner from these studies? Clearly, there’s a convincing business case for subscription businesses.

But these benefits are not without their drawbacks. The most prominent headache? Accounting in the context of subscription billing.

Challenges of subscription billing

Subscription billing is the process of automatically charging your customers on a recurring cadence. Without automation, billing gets complicated quickly. Don’t fool yourself into thinking that canceling a customer’s membership in the middle of the month is as straightforward as flicking a switch. Complex adjustments like these might disrupt downstream systems and have an immediate impact on revenue recognition. 

This holds especially true if every update made by the client is handled manually — and there are also more challenges you need to face. 

You must be able to swiftly adjust changes in the customer relationship and evaluate how this will affect the performance of the business. However, the primary functions of the old-world financial system revolve around tracking raw materials. They aren’t particularly strong engines for recurring billing. They aren’t clever enough to adjust to subscription changes in real-time and recalculate any schedules that are affected.

Without a platform that makes subscription billing easy, accounting mistakes may occur way more often than you’d like — which should be never. Let’s investigate four challenges of subscription billing that the right subscription billing tool can mitigate, starting with taxes.

Tax compliance

Even when subscription sales teams and their tax colleagues are well aware of the complexity of sales tax compliance requirements, meeting those obligations can be extremely challenging. On the podcast, Tax Matters by Vertex, Joe Cicman, a Forrester Senior Analyst, stresses the importance of having frequent conversations with your tax professional when changing your business to a subscription-first model.

“Talk to that tax expert early and talk to them often. Expect that they’re not going to have a 15-minute conversation about this and be totally motivated the next day to rework everything in the organization. So, be patient… It takes intentional planning. It’s not a switch to be flipped.”

Cicman stresses that transitioning to a subscription billing model is challenging. But ensuring you’re on top of your tax obligations is almost impossible when done manually. If you operate an ecommerce subscription business in the US, for example, you’re obligated to abide by various tax laws depending on what state your customers are in. 

Fortunately, tax automation can help to simplify things. Even better, many subscription management solutions include seamless connections with tax engines that may be simply programmed to automatically manage worldwide sales tax calculations while staying up to date on applicable rates and standards (including those related to sales tax exemptions and tax holidays).

Fraud management

If managing taxes is frustrating, then dealing with fraud is downright infuriating. Chargeback fraud and card-not-present (CNP) fraud all impact revenue and operating costs, while account takeovers are on the rise, with online merchants experiencing attacks every month.

To mitigate these risks, having a sophisticated platform that watches your back is critical. They can use payment gateways that support recurring billing, double-check that credit cards are authorized, and use a dunning tool to chase up and reclaim failed payments. 

Accounting and financial reporting

Successful subscription-based business models will give subscribers promotions for upsells, cross-sells, and other offers that add value to their membership. Although effective marketing techniques, they can make subscription finance complicated. Recognizing this revenue and processing a high volume of transactions requires sophisticated analytics tools.

The best way is to introduce an example. ExcelTemp, a fictitious subscription business that provides Excel templates.

1. ExcelTemp Inc develops a new offering. It allows customers to download this template and other spreadsheets.
2. As part of the sign-up procedure, ExcelTemp charges a monthly membership price of $19.99 as well as an extra $100 setup fee.
3. ExcelTemp charges the consumer $19.99 at the beginning of each month. The company will continue to give access to the service as long as the consumer continues to pay.

ExcelTemp made $119.99 on its first day. The funds are now in their bank account. However, because the company has not yet supplied the whole amount of services to that consumer, based on most revenue recognition standards, not all of this money can be recorded as revenue. If ExcelTemp decides to discontinue the service tomorrow, the user will have paid $19.99 for 30 days of access and got only one day.

Subbly’s built-in analytics platform shows you all your key metrics so you can understand how your business is performing and what you can (or can’t) count as subscription revenue.

Credit invoices and audit trails

In accounting, what is a credit invoice? It’s the new document that was provided as an addition to the original invoice. It is beneficial to both buyers and sellers since it ensures that the records are correct.

They are sent when a company owes a consumer money (think of credit notes as the opposite of an invoice). When a client downgrades or cancels their plan before the end of a billing cycle, you must alter the following invoice amount to reflect the change.

Credit invoices, or credit notes, are a much better alternative than manually creating a negative purchase invoice every time you’re dealing with returns or cancellations.

An audit trail is a collection of records that help in proving the accuracy of your financial accounts. Auditors work backward, matching all of your financial statements to all of the actions that lead to the financial record. This allows them to notice contradictions in the statement immediately.

A good subscription billing platform will handle invoicing and customer management. It will send bills to customers, make it easy to process transactions, and send receipts. It will do all this while ensuring the right amounts are charged and any changes to their subscription are reflected.

Having a platform that handles these essential steps ensures you’re offering a seamless and trustworthy experience for customers. You also have the peace of mind that you’re mitigating the above challenges.

Now, let’s move on to a more detailed look at subscription-based performance metrics so you know what you need to track in a financial model for a subscription business.

Subscription finance metrics to track 

For businesses running on a subscription model, there’s no shortage of metrics you can track. But to accurately forecast your business, prioritize the below in your financial statements or reporting:

Monthly Recurring Revenue (MRR)

Monthly recurring revenue is the average monthly revenue you earn for each subscriber, multiplied by the total number of subscribers. It doesn’t include one-off sales or promotional offers. MRR is a great metric to forecast how much revenue you’ll bring in each month, which is key to cash flow management.

Annual Recurring Revenue (ARR)

Similar to MRR, annual recurring revenue multiplies your MRR across 12 months. This gives you a helpful benchmark for annual reporting and performance forecasting. Do note that ARR also shouldn’t include promotions or free trials as this would inflate the results. This metric only forecasts recurring revenue.

Average Revenue Per User (ARPU)

This metric is useful if you have different tiers of customers like starter or premium subscription newsletter subscribers or students on your subscription course. To find this number, divide your MRR by the total number of customers you have. It will tell you what an average customer spends monthly. You can use this information to inform marketing and upsell promotions. 

Customer Acquisition Cost (CAC)

Can you afford to acquire the customers you have? This is what CAC reveals. If you’re spending more dollars on marketing and sales than you’re getting from customers, that’s not good. You want more revenue than customer acquisition costs. To calculate your CAC, add up all the costs incurred to bring in a customer. Then divide it by the number of customers brought in during that period.

Churn Rate

Churn is the number of customers that unsubscribe. It’s inevitable that some will. And to gauge the impact that has on your business, start with a meaningful time frame, say a month, quarter or year. Take the number of unsubscribes you had in that period and divide it by the number of subscribers you had. Then convert it to a percentage by multiplying it by 100. Conversely, subtract that number from 100, and you’ll have your retention rate. 

Customer Lifetime Value (CLV) or Lifetime Value (LTV)

Customer Lifetime Value is the total amount the average customer spends throughout their relationship with your business. It’s how much they’ve spent since signing up. To calculate this, divide your ARPU by your churn rate and multiple it by 100% to get the dollar amount. 

Payback Period (PBP)

This number is the amount of time it takes you to pay off your CAC. It’s your breakeven point. To find this number, divide your CAC by the difference between the total revenue from a customer and the average cost of goods sold COGS.

These are some of the most important KPIs for your subscription business. Without them, you’ll find it hard to track what happens not just when a subscriber signs up and begins engaging with your brand, but throughout the rest of the customer journey.

In summary

There are tremendous benefits to starting a subscription business. It’s proven that recurring, automatic payments generate much more growth than chasing after more and more one-time purchases. But our accounting and finance teams’ approach needs to change to gauge this new and profitable model. 

Subscription finance manages the complexity that recurring billing imposes on financial models. The traditional way of measuring a business’s success looks backward at performance. But for subscription businesses, we need forward-looking financial models. We need metrics like monthly recurring revenue that tell us where we’ll be in 6 months. Or lifetime value that reveals how much the average subscriber generates for our businesses. 

We also need sophisticated platforms that automate financial operations like important billing processes and mitigate the risks. Tax compliance, fraud management, reporting, and invoicing are all challenges without the right subscription platform. 

To effectively manage your subscription finance, get started with Subbly for 14 days free. It takes minutes to get started, and it’s built for subscription-first companies like yours.