From streaming wars between the likes of Netflix, Disney+, Hulu, Spotify, and iTunes to convenient deliveries by those such as the Dollar Shave Club, Every Plate, and Stitch Fix — more and more businesses are migrating their products from single-purchase to subscription models, supplanting competitors along the way.
Welcome to the subscription economy.
The primary appeal of this recurring revenue model is the value of predictable recurring revenue. It makes more sense for entrepreneurs and investors alike who benefit from the value of predictable recurring revenue, particularly in comparison to one-time transactions
Putting this into perspective, it means that a $15 million dollar company with 80% recurring revenue can count on $12 million dollars at the beginning of every year, and far more stability.
On the other hand, this cannot be said for a $15 million dollar company with no recurring revenue. Each year this company starts the year at…. “$0”, estimating and predicting revenue based on past performance, but without the same contractually obligated revenue streams to plan ambitious growth.
Predicable Annual Recurring Revenue (ARR)
Subscription companies planning for success look carefully at ARR (Annual Recurring Revenue), scrutinizing revenue from customers for ongoing services.
This ARR is derived by taking the value of the subscription contracts for the total annual amount and adding it up as a true indicator of a company’s health. Every year begins with a predictable amount of future revenue.
It means greater customer retention and insights for marketing, and simple pricing models rather than individually pricing, shipping, and stocking a wide array of goods.
For business leaders, a subscription model means new ways to operate your company. It’s a shift of value from transactional to long-term relationships— so the traditional metrics no longer apply.
So how do we measure the health of a subscription model business? What are the KPIs and growth metrics? Is pricing or product-market fit the core focus? What does the go-to-market strategy look like? When is it time to invest, and when should we expect profits?
It comes as no surprise that these same questions are being asked by all businesses making this transition.
Key Metrics: The LTV/ CAC Ratio
In answer to the above, subscription models use the ratio LTV/ CAC to measure health. This is the lifetime value of the customer divided by the customer acquisition cost.
A couple of definitions will be helpful as we proceed. Lifetime customer value is calculated with the following inputs:
- Average Revenue per Account (ARPA): The average annual revenue per account in the initial year of a cohort. (Consumer businesses use ARPU or average revenue per user.)
- Gross Margin: The margin based on the revenue left over after accounting for the cost of serving customers—for example, the cost of operations, support, or customer success programs.
- Retention: The annual revenue retained from current subscriptions; the opposite of churn.
- Expansion: Any additional annual revenue earned from the current customer base through volume growth, cross-selling, or upselling.
With these insights on LTV/ CAC, it’s possible to see why this metric is key.
It reveals the true health of a subscription business, enabling a company to invest in acquiring new customers in return for growth, and measuring the return on investment.
As your subscription business matures, this metric will indicate when it’s time to invest, and when it’s time to focus on profit. For example, in most scenarios with an LTV/CAC ratio of 3 or higher, investing just $1 more in customer acquisition has a greater value than retaining that dollar as profit.
LTV/CAC is also a diagnostic tool, identifying operational opportunities, and allowing for fast and efficient improvements and iterations.
Finally, as a key metric, LTV/CAC will enable you to compare the performance of various subscription businesses regardless of their target market. Regardless of industry, investors and entrepreneurs will be able to prioritize portfolio investments with LTV/CAC ratio.