Ah the allure of the subscription economy. Recurring revenue. Selling software as a service. The scale. The certainty, and…..the accounting! Uggh. Yes, there is so much to love about the new business models that are taking over software and e-commerce. But how to account for this remains somewhat elusive.
The systems for accounting for subscription-based revenue are still in their infancy. Many companies shifting to a subscription model still do not have a firm grasp on their metrics dashboard to drive decisions. And this is all happening while the sophistication of investors continues to rise, making the bar ever higher for companies to better command their data. This is no laughing matter. Your confidence (and investors) in your business is directly correlated with your command of your metrics.
As my friend who runs an M&A advisory company told me yesterday, “We still see a shocking amount of companies that are just not keeping up with the rising sophistication of the marketplace that is demanding more and more metrics.”
Here are the top 5 must have accounting metrics for running your subscription-based service.
1. Bookings vs. Revenue. If I sold you a year-long software subscription for $1,200 and collected that $1,200, that would be considered a booking. However, for revenue purposes, I could only recognize $100 per month. Therefore, my MRR (monthly recurring revenue) is $100 and that would be represented on my income statement. The balance sheet would capture the amount that has not been recognized.
2. Cohort Analysis. Every month you have a new group of subscribers that join your service. That is awesome. But understanding the behavior of each cohort is powerful because when you isolate a group of subscribers around a given time period, you can see if they are increasing or decreasing in value compared to others. Without breaking down your population, it is hard to assess improving service and customer acquisition value.
3. Lifetime Value (LTV). Knowing customer lifetime value is gold. It helps you
- understand how much you can spend on marketing to acquire them
- test customer messaging and targeting
- improve your understanding of what triggers certain people to buy
- prioritize customer support for the most valuable customers
There are a bunch of LTV formulas but the easiest one out there for software companies is:
Monthly Recurring Revenue / Churn rate (see definition below).
For example, if my monthly recurring revenue is $30 and my churn rate (the rate the people unsubscribe) from my service is 5%, that would imply that my LTV is $600.
E-commerce formula for LTV look a bit different and typically follow this sequence:
Average Order Value * Purchase Frequency * Average Customer Lifespan*Average Gross margin
4. Churn Rate. Churn rate is the pace at which your subscribers don’t renew. Companies with high churn rates are racing to fill a leaky bucket. The easy formula is:
(customers at the beginning of the period – customers at end of period) / Customers at beginning
Stemming churn rate is the battle for many companies who work hard to continue delivering value as the cost of churn is very high (i.e. it is a lot harder to acquire a new customer than to keep an existing one). Churn rates can be analyzed in aggregate and by cohort. The easiest way to calculate churn rate is:
5. Customer Acquisition Cost (CAC). How much are you paying to acquire a customer relative to the lifetime value of that customer? When you layer in your sales and marketing costs for a given period vs. the number of subscribers you acquired, what does that calculate to? It is critical to understand your CAC in detail as it will help you analyze the effectiveness of different channels for customer acquisition. And again, this is all relative to LTV. If your LTV is $100 and you spend $20 to acquire, that is great. If your LTV is $25 and you spend $20, that is danger zone to your margins in a big way. A good ration is 3:1.
We are scratching the surface here of relevant subscription economy metrics but this is the foundation of your dashboard. At Stride, we work with our clients to put these dashboards in place because the opportunity in the subscription economy is just too exciting to leave the accounting for later when, in fact, it should be the foundation for the most important business decisions that you will make.