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Subscription models are not a novel concept, in fact it can be traced back to its origins in 17th century England. Now, though, subscriptions are everywhere, from paying your phone bill to subscribing to your local gym or even for your monthly coffee delivery. Subscription models have also made their way into private equity, venture capital, and insurance. Are we living in the subscription era?

In this edition of Our Analysts’ Take we will analyse the impact that subscription models have on the world of corporate finance. We will split the article into 4 distinct sections: (1) the consumer subscription industry and special cases in corporate valuation such as Netflix and Spotify, (2) subscription credit lines in the private fund sector, (3) subscription metrics in venture capital, for SaaS firms, and finally (4) subscription as a disruptive model in the insurance industry.

Subscription Models: A Short History

Although the time when subscriptions were first used is not entirely clear, a consensus is that it was first used under the reign of King Charles I of England in the 17th century. The proposed idea was a patent fire insurance scheme which would provide compensation for any loss of property in case of a fire – a very common occurrence at the time. Due to miscommunication the idea took a few decades to catch wind, but by the 18th century it had been adopted by trading companies, charities, theatres, and publishers.

One of the most important moves was taken by newspaper publishers in the early 19th century. In the 1800s subscribing to newspapers was too expensive for the average person and so individuals preferred to buy single copies from newsstands. However, through economies of scale, mass publishing provided an opportunity for newspapers to advertise their subscription service to the general population. By the 1920s enough newspapers had established a firm identity with editorial principles and a loyal reader base from which to build a strong subscriber base that a substantial portion of revenues came from client newspaper subscriptions.

Subscription models continued to evolve throughout the 20th century. With the birth of the TV came the birth of Pay TV, a subscription in which Hollywood movies would be directly licensed from their studios and broadcast to homes without advertisements. This idea was pioneered by HBO in the 1970s but soon met competition with then conglomerate Blockbuster in the 1980s and 1990s. Blockbuster gained traction with their video, cassette and DVD rentals, but through a series of blunders throughout the 1990s such as turning down the rights to purchase exclusive DVD rental rights and missing out on the opportunity to buy Netflix in 2000 for $50m drove a period of sub-par performance and eventually to its bankruptcy in 2010. Netflix quickly seized the opportunity to make a name for itself in the video streaming industry and started out with a “pay-per-rental” model like that of blockbuster, but soon after decided to adopt an unlimited rental model which it still uses today, albeit without any physical DVDs.

Throughout the 2000s, in a period of high technological advancements, Software as a Service (SaaS) began to grow at great pace. Application Service Providers (ASPs), which gave users access to a suite of computer applications through a network, were the first to offer a subscription-based model for software. However, due to their niche, they were quickly overtaken by some of the largest software companies we know to exist today such as Salesforce and Dropbox.

An overview of subscription models

There are several types of subscription models, each one with its own advantages and disadvantages. The most popular types are: “Flat-rate model”, “Freemium model” and “Pay-as-you-go.”

The Flat rate-based businesses charge subscribers, who get access to all features, a single price for all goods or services purchased, which is typically monthly or annual. This model is commonly used for streaming services like Netflix or DAZN. Although flat rate pricing can be useful for early monetization, its lack of scalability and adaptability may restrict companies’ ability to grow. The “Freemium model” is slightly different as it offers a free basic version of the product or service, and charges subscribers only for premium features. An example of a company which uses this model is Spotify. Last, the “Pay-as-you-go model” charges customers based on their use of the service. This type of subscription model is mostly used among cloud storage services, as they charge customers based on the amount of data they store.

Businesses that adopt a subscription model are then confronted with the matter of pricing. Determining the appropriate price for a subscription offer requires additional considerations with respect to more traditional models because, by the nature of such a model, inflows of cash from customers are meant to be recurring. This means that firms need to set a price that maximizes this figure in the longer term – potentially a lower value, to maintain higher levels of loyalty. However, this model has a considerable advantage: prices are more dynamic, so firms enjoy the possibility of adjusting their offer based on users’ feedback, in addition to upselling or cross selling the subscription.

Experts in the sector advise businesses to first calculate the costs incurred – inclusive of all fixed and variable operating expenses – before determining the precise figure. The price of break-even, which should be regarded as an absolute lower bound, is then obtained by averaging the amount calculated across the estimated number of subscribers. However, more precise values are typically chosen by firms either based on their own value proposition or by analysing direct competitors. With the latter it is possible to obtain a reference value, whose relevance also depends on the adopted strategy and business model; prioritizing a broad and competitive market may result in lower and more aligned prices, whereas operating in a niche reduces the impact of competitor’s prices.
The way by which prices are established in most cases, though, is that of a value-based approach, carried out by an analysis of customers’ data to quantify the value perceived by final users. Despite being a more expensive process, both in terms of money and time, its result provides a more accurate representation of the value being generated. It can be viewed as the medium-run price to which the firm should aim after having increased its number of subscribers, possibly thanks to an initially lower and more competitive offer.

In the process of finalizing the subscription price, psychological biases are often taken into consideration. We’ve decided to analyse some examples, considering that their effect becomes particularly relevant for subscription pricing models since customers are asked to make ongoing payments over a long period of time.
A well-known example, the ‘left digit effect’ indicates that consumers tend to evaluate in a disproportionate manner the first-left digit of the price. (i.e., $19.99 is perceived to be significantly cheaper than $20.00)
According to the odd-pricing fallacy instead, customers are keen to interpret odd prices as good deals – $ 26.53 “looks better priced” than $27.50. Even simpler, a New York Times article reported evidence that shorter numbers appear cheaper; this can be achieved by avoiding showing null decimals or even the currency sign!

There are several benefits of the subscription-based model. One of the most relevant is that subscription-based businesses revenues are predictable and reliable since customers are billed on a recurring basis. Furthermore, this model typically enables businesses to gather information on customer preferences, which can then be used to better understand their needs and tailor products accordingly. Lastly, subscription-based businesses are usually characterized by lower costumer acquisition costs (CAC) thanks to the ease of offering free trials to potential customers. According to the Harvard Business Review, acquiring new customers costs on average 5 times more than keeping an existing one and so having this benefit will hopefully drive high growth rates and turn these new customers into longstanding and loyal customers.

On the other hand, subscription models also have some disadvantages. Over the last few years, the number of subscription-based businesses has increased significantly, resulting in stronger competition. To avoid this problem, companies must be able to stand out from others, by differentiating their products and their services, and by constantly innovating. Furthermore, the subscription-based model is characterized by high churn risk – the risk of customers not renewing their contracts. To avoid high cancellation rates, companies must develop strong relationships with subscribers and constantly develop and improve the product.

Case studies: the dangers of subscription models

Spotify dropped the bass

Spotify stock suffered an almost 80% valuation dip between 2021 and 2022 with a closing share price of $78.95 on December 30, 2022, compared to the record closing share price of $364.59 on February 19, 2021, symbolizing a drop in market cap from $69bn to $15.24bn. Spotify financial data of 2022 could be quite surprising: despite Spotify’s monthly active users (MAU) increasing by over 20% from 2021, hitting a total of 489m, with 205m paid subscribers, and its revenues rising from $11.4bn in the previous year to over $12.3bn, the well-known subscription-based company recorded a net loss of $462m.

This situation is due to initiatives taken by the company which were defined by Spotify CEO Daniel Ek as “too ambitious”. Over the past few years, the company has invested a very large amount of capital to expand the content on its platform, in particular Spotify acquired the two podcast distributors Podsights and Chartable in 2022 for a combined value of over $1bn. In addition, Spotify also placed a strong emphasis on its advertising by introducing a new advertising format that targets specific listeners based on their interests and demographics. These decisions were taken as a response to the extremely rapid subscription growth faced by Spotify during the Covid-19 pandemic. The company, to meet the soaring demand, decided to make these investments, sacrificing its profitability in the short-term. However, the economic downturn of 2022 caused a slowdown for both revenues and users’ growth, which were significantly lower than expected which represented a threat to the company’s medium-term stability. At the same time, expenditures increased as the number of employees grew from 6,167 in 2021 to 9,800 in 2022, representing a significant cost increase and a consequent fall of profit margin.

Despite expenditures reaching such high levels, Spotify chose not to increase the price of its flagship subscription service and this decision strongly contributed to a significant pressure on the company’s gross profit margin. The company’s strategy is focused on increasing its Premium subscribers to increase its revenues, rather than raising its prices. Despite Spotify’s incredibly dominant market share in the music streaming industry, it is not free of competition and raising subscription prices could lead to a significant shock to its clientele especially with respect to the current cost of living crisis where people may decide to shift their spending to different services. The way Spotify is maintaining its pricing power is by differentiating themselves, which can be a challenge in the music industry, but Spotify achieves this by providing exclusive content to certain artists and podcasts and by constantly updating and curating their algorithm.

Twitter’s failed flight

After Elon Musk’s highly publicized $44bn Twitter takeover, the new CEO has made a series of changes to the platform, including various updates to its Rules and Regulations and account reinstatements, with the underlying idea of “Freedom of Speech”. One of the biggest – and most drastic – tweaks the social media platform made is the change to its users’ account verification process. In November 2022, blue verification badges, which were previously used to confirm the legitimacy of profiles of prominent public figures, were made available to anyone with a subscription to Twitter Blue, a premium $8 monthly subscription service that permits users to preview new features. This had the undesirable effect of many twitter users impersonating public figures, generating confusion and clutter on the platform, which led to an immediate suspension of the new update.

This move represents an attempt by Musk to increase subscription revenues in the hopes of offsetting a future fall in advertising revenues. Advertising income has been crucial for the social media platform as it made up more than 90% of revenues in 2021. According to Musk prospections, advertising would fall to 45% of the total revenue by 2028, generating $12bn compared to the total expected revenue of $26.4bn, while subscriptions would generate nearly 10bn. These projections are incredibly ambitious, considering that in 2021 total revenue amounted to $5bn representing a decrease of 40% from the previous year and subscriptions only generated around $500m (10% of total revenue). This drop is due to an advertiser exodus in which many advertisers left the platform due to concerns about content moderation.

Subscription financing in the private fund sector

Subscription credit facilities

The subscription model is paralleled in the private fund sector with the use of advanced lines of credit known as subscription credit facilities, or “sub lines.” As the name suggests, these loans enable private funds to access quick, short-notice financing, forestalling the need for traditional capital calls.

While these facilities were originally used as short-term bridge financing to cover working capital needs, the last decade has seen GPs across private equity, private credit, and real estate funds pursuing larger and longer-lasting fund-level credit facilities to finance investments, expenses, and other liabilities. In 2019, an estimated $400bn of funds sat in subscription credit facilities as limited partner agreements (LPAs) laxed, fanned by the low rates of the time. The recent tightening of macro conditions, however, has called the future of subscription financing into moderate uncertainty.

The impact of sub lines on the private equity sector

The benefits of subscription credit facilities are clear: they provide flexibility to GPs in the form of upfront liquidity for private funds. Managers draw on subscription facilities to quickly execute deals or add-ons, issue investor dividends, or clear expenses as they arise—then periodically pay down the credit through capital calls. Along with improving competitiveness in the bidding process and smoothing cash flow management, this tool lessens the administrative burden for investors by reducing the frequency of capital calls.

Of latent concern to investors, however, is the build-up of liquidity risk. A defining feature of subscription facilities is that the associated collateral is composed of investors’ unfunded capital commitments—with no recourse to underlying fund assets, lenders have claim on LPs’ committed capital, introducing systemic risk for LPs due to often sizable exposure to credit facilities. Lack of regulation may cause inadequate visibility into LPs’ total liability, including the obligation to meet larger, accumulated capital calls or the ability of lenders to recall lines in event of default.

Another consequence of delayed capital calls is the effective shortening of investor holding periods, leading to a positive effect on a fund’s internal rate of return (IRR), a metric based on NPV of cash flows used to measure performance in private equity. Not only does this improve a fund’s apparent competitiveness on a quarterly basis, but the condensed returns also result in GPs receiving carried interest earlier on, to the detriment of LPs’ pay-outs. As a result, debate has emerged regarding whether subscription credit should be construed as a legitimate fund management tool or a way for GPs to artificially inflate fund performance and boost personal profit.

Debate: “Inflated” fund performance and the push for transparency

The by-product of using subscription facilities to delay and aggregate capital calls is the distortion of key performance metrics that take holding period into account. Whether these associated distortions are systematically biased has been studied at length, producing critical insights into issues of transparency, agency, and performance evaluation within the PE sector.

A 2022 report by Carnegie Mellon professors James Albertus and Matthew Denes examines the impact of subscription credit lines on private equity fund performance and the potential for agency problems arising between GPs and LPs. The pair finds that the use of subscription lines was associated with a “significant” increase to the annualized IRR by 1.9 percentage points, and an even higher boost for younger funds and more levered funds. However, when evaluating the same funds through multiples-based metrics (MOIC/TVPI)—which indicate absolute return on LPs’ investments—the authors find no improvement. Performance decreased by a small amount, attributable to the repayment of fees and interest associated with the debt.

Albertus and Denes’ results suggest that GPs have potential cause to use subscription facilities to distort measures of fund performance sensitive to timing, including rates of return used to determine funds’ achievement of hurdle rates and ultimately the carried interest attributable to GPs. The finding echoes concerns expressed by the Institutional Limited Partners Association (ILPA) in their 2017 “Considerations and Best Practices for Limited and General Partners,” encouraging clearer partnership agreements and full disclosure of the terms of active subscription facilities among other calls for greater transparency.

Yet, conflicting results from a study on simulated funds by BlackRock, in collaboration with Technical University of Munich (TUM), showed that while there was a moderate improvement to IRR and slight penalty to multiples, the impact was not drastic enough to consider these facilities an instrument to obscure real results. The PE-backed research finds that sub lines created only a minor distortion to quartile rankings (2.4% of funds positively impacted) and a “negligible” impact on profit sharing between LPs and GPs. As such, the severity of the distortion from using sub lines may be overstated.

Whether intentional or not, the consequences of sub lines reveal that the private equity industry stands to benefit from increased transparency and communication between GPs and LPs, as well as an industry-wide shift against over-reliance on IRR in favour of greater consideration of other performance metrics such as ITT, TVPI, and MOIC.

Future of the subscription facilities market

The initial rise of subscription financing coincided with a prolonged period of low interest rates after the 2008 global financial crisis. Today’s rising rates environment casts doubt on the profitability of using sub lines. As of March 2023, a series of nine hikes by the US Fed has raised the target federal funds rate to the highest level since before the crash, and as the global monetary system attempts to rein in inflation, the cost of opening subscription lines is at an all-time high.

The Cadwalader European Fund Finance team found that for private credit managers, the 2023 rate environment has already started to encourage a more conservative approach to using sub lines, shortening the duration of facilities, and using the lines purely for “operational efficiencies.” On the other hand, PE sponsors tend to have more flexibility given higher target IRRs in the space, meaning the benefit of subscription finance outweighs, in many cases, the cost of rising rates.

Looking forward, as rates increase and stabilize, the subscription finance market is likely to shrink, if only moderately. While undeniably a helpful tool for fund managers, subscription credit facilities ought to be conceptualized within the broader scope of the private funds sector and the macro economy at large.

Venture Capital Investments in the Subscription Economy

Businesses operating with subscription pricing models can account for some specific features that are positively received by Venture Capital investors. VCs are attracted by the predictability and stability of recurring revenue, that originates from customer subscriptions and is tracked by the ARR – Annual Recurring Revenue. Sales that are predictable and systematic, rarely missing quarterly numbers by more than 10% or 20%, can reassure investors about the health of the business. In the case of more mature companies, they also provide a clearer idea of what the company could make in perpetuity, an important component of intrinsic valuation models.

Furthermore, the ARR metric can be used by VCs to mitigate the shortcomings of traditional valuation methods based on costs or profits indicators, that are often almost unapplicable to intangible assets such as software, by projecting future revenues. However, recurring revenue is not only an insight into future sales, but it also proves useful in assessing factors such as the impact of customer retention rates – all while providing a figure that can be easily compared across different businesses.

Lastly, the very nature of the model allows for better marketing opportunities aimed at upselling or cross-selling services. These derive from the possibility of adopting more targeted strategies, that are based on customers’ preference data collected through a consistent engagement with the product or service. Further advantages considered by VC investors are higher customer retention thanks to the inertia of the subscription, and overall easier pricing determination as companies only need to manage at most a few different tiers.

However, a necessary consideration needs to be made. Subscription-based businesses may sell products at a reduced price, betting to recoup the costs in the long term. This means that they expose themselves to the risk of client flight and that companies shifting mid-life to subscription pricing models may see their cash flow initially reduced.

The advantages have, in fact, contributed to the growth in popularity of such companies, a phenomenon that is reflected in the attention given by VC funds to new early-stages examples. According to data from PitchBook and CB Insights, Venture Capital funding of subscription-based companies continued its positive trend at least until 2021, with over $29bn raised. Not only did the total funding value increase, but also the number of companies by more than 250% from 2017 to 2021 when it exceeded a thousand. SaaS subscription-based companies confirmed their position for most VC capital received in 2021 topping other industry verticals in the subscription economy, with North America accounting for almost 70% of VC activity in the sector.

A notorious example of a VC-funded SaaS start-up operating with a subscription model is the messaging and collaboration platform Slack. Founded in 2013, it raised over $40m with seed funding led by Accel Partners, while over its 16 funding rounds managed to obtain $1.4bn with investors such as SoftBank Vision Fund and Andreessen Horowitz. It was then valued at $23bn with a direct listing on the New York Stock Exchange in 2019.

Despite finding a natural application in SaaS businesses, instances of the subscription pricing model that attracted relevant VC capitals are also to be found in more product-based industries. An example of that being the company Blue Apron, founded in 2012 and in the business of delivering meal kits to households under subscription plans. Testifying to the VC interest in the subscription economy, it raised a total of $423m over 11 funding rounds by the likes of Bessemer Venture Partners, First Round Capital, Fidelity Investments, and BoxGroup.

Subscription Models in the Insurance Industry

Insurance is an industry that has always stood out for adopting processes relatively like those of subscription models. Insurance asks for recurring payments whose prices and methods are determined by a mixture of long-term relationships with individual customers and incredible volumes of data. Following the dominance of smartphone apps in people’s daily lives and an ongoing digitalization of services, insurance companies may have to alter the way in which they provide their services for a growing tech-savvy audience. With retail subscription companies such as Spotify and Netflix offering a seamless user interface and other companies offering an increasingly personalized service, insurance companies seem to be lagging.

Because it is challenging to quantify risk, the insurance industry is inherently very complex. According to theory, the insurance provider must evaluate each client’s risk exposure and the potential damage that could result from their actions. By combining these two considerations, they must then determine the insurance premium that each client must pay.

The process of underwriting an insurance policy, which involves the insurer grouping risk units into a portfolio, is typically followed by the pricing of the premium that must be paid to be able to cover the losses resulting from the risk units in the portfolio. However, insurance companies must also have countermeasures in place because they are exposed to systematic, normal, and exceptional risks. As a result, insurance companies need a great deal of flexibility to implement countermeasures like repricing and risk loading. Consumers have been very frustrated by this in the past, particularly due to insurers’ opacity when raising premia and the high switching costs that consumers face when switching insurance providers.

Poor digital user experiences and insufficient claims processes have given rise to new entrants that are beginning to redefine the insurance industry. In the following paragraphs we analyse the successes of a few notable examples of new entrants that are disrupting the insurance industry with their unique subscription models.

Due to the high barriers to entry in the insurance industry, some of the new players have partnered with established insurers, one such example is Monzo, a UK neo bank that partnered with AXA and Assurant, two very established insurance providers. Monzo borrowed much of the language and pricing strategy of Spotify Premium for their young tech-savvy customers. Monzo premium launched in 2020 and bundled banking features and insurance in a single monthly payment. Through their huge volumes of customer transactional data, Monzo can gently nudge customers towards adjusting their policy as it needs change. For example, when purchasing products using their Monzo card which may need insurance such as a car, Monzo can suggest specific car insurance deals form its partners to their client. This move has proved to be beneficial for all parties involved as it has generated a new, younger customer base for AXA and Assurant, as well as enabling Monzo to enter a brand-new industry without having to learn the ins-and-outs of a brand-new industry.

Another example of an insurance company looking to disrupt the industry is the US Insurtech start-up, Lemonade. Lemonade used a machine learning-based approach to deal with customer registrations and claims which set them at the forefront of customer ratings and provided them with the possibility to run at very low operational costs. Lemonade opted to use a monthly (subscription) payment and a flat fee structure where any money left over after claims and fees would be donated to a good cause of the customer’s choice. However, Lemonade ran a loss ratio of 166% in 2017 which demonstrated one of the largest issues that Lemonade was facing – a lack of data. The loss ratio is calculated with the following formula:

 Loss Ratio = \frac{Losses Due to Claims + Adjustment Expenses}{Total Premium Earned}

A loss ratio of 166% means that the losses due to their claims and their adjustment expenses exceeded their revenue from premia by 1.6x. In general, an acceptable loss ratio is in the range of 40%-60% because most insurance companies don’t simply wish to break even on their claims but also have the capacity to set aside additional reserves in case of future systemic events. The main issue with Lemonade was that they didn’t have enough historical customer data to accurately derive fraud-detection and risk-prediction models. This likely led to excessive claims and insufficient premia and therefore to such a worrying loss ratio. Despite the bad performance in 2017, Lemonade has gradually decreased their loss ratio to 89% in Q4 2022 compared to 94% in Q4 2021 and shows hopeful signs for lemonade in the future as a player in the insurance industry.

Laka, another entrant in the insurance industry has developed a subscription model unlike any other, overcoming the issue of price inflexibility faced in other industries and by its competitors. Laka solely offers bicycle insurance but does it in an entirely unique way. Laka uses a variable pricing strategy where if claims are lower in each month, Laka passes this saving on to members through lower premia and vice versa. Through this, Laka incentivizes its customers to take greater responsibility for protecting their bicycles and cycling equipment and think about all customers before making claims. Laka’s early success has seen it receive $1.5m in funding from Porsche Ventures, the venture capital unit of Porsche AG in mid-2022. Later in 2022, Laka announced an insurance collaboration with British e-bike brand Volt.

Analysing the success of these three new entrants in the insurance industry one can’t help but see the possibilities that subscription models have in insurance. However, it is important to understand that the underlying risks for insurance companies still stand and these new companies must maintain high capability and ethical standards.

Specific KPIs for Subscription Businesses

Annual Recurring Revenues (ARR) and Monthly Recurring Revenues (MRR)

ARR measures the value of recurring revenues – meaning those originating from subscriptions and that are thus expected to be registered also the following term – normalized to a calendar year. Since the company expects to repeat such revenues, it acts as a gauge for the health of the subscription business, and it is used by investors in place of profit indicators especially for early-stage companies operating at a loss. Consisting of an annual measure and thus more focused on the long term than its monthly counterpart (MRR), it is a metric suited for reporting purposes and macro forecasting and can be useful to put occasional deviation in monthly revenues into perspective.

ARR finds an important application when it is analysed in its different components – i.e., revenues from new customers, renewals of current customers, revenue variation from service upgrades or downgrades and use of add-ons – as it provides further information tailored to subscription businesses with respect to what can be measured with traditional accounting measures.

Moving to more technical aspects for the calculation of ARR, the total contract value of a subscription needs to be divided by the number of relative years. However, besides this simple operation, it is important to remember that ARR does not includes one-time charges or trials offered at discounted price, as these can’t be considered recurring. Further, it is possible to normalize subscriptions with terms that have a duration of less than one year, but this could introduce inaccuracies, as shorter contracts can often be cancelled. In the case of businesses with mainly short-term subscriptions it is then preferrable to consider monthly recurring revenues or MRR.

MRR is conceptually equivalent to ARR, but revenues are normalized to a monthly basis. Again, it is a useful metric for gaining insights on sales and cashflow dynamics or to explore opportunities to upsell or down-sell the service to customers, according to the value they are extracting. Different measures of MRR, highlighting various aspects of the business and drivers of revenues, can be calculated.

Gross MRR indicates the total amount of monthly revenue from all subscribers, without considering any discount or adjustment. It can be useful for evaluating the business from a more general perspective, excluding any occasional or non-recurring event. Net MRR provides the actual amount of revenue generated, by considering any needed adjustments or discount offered. New MRR counts recurring revenue that only comes from new customers acquisitions. It can be a handy tool to track growth projections of the business. Expansion MRR counts recurring revenue that only comes from upselling or cross-selling; it can measure the efficiency of the company in its pricing offer or marketing strategies. Churn MRR considers the impact of lost customers on monthly revenues. Lastly, it can be useful to calculate the Net Growth rate of MRR to grasp a general sense on the direction of the business, particularly considering customers subscribing or unsubscribing.

We find it necessary to make further considerations on the differences between monthly and annual recurring revenue KPIs. Despite measuring a similar metric, they slightly differ in terms of use. First, ARR is usually adopted by B2B businesses which tend to have subscriptions with multi-year terms and generally lower volumes of transaction but with higher value. That is because, as stated above, normalizing to one-year contracts with shorter duration – as is usually the case in B2C subscription businesses – could introduce mistakes and reduce forecasting capabilities.

Second, ARR is generally perceived as a valuation metric since it is believed to offer a more complete picture of revenues that reduces any eventual seasonal differences for companies with complex subscription models. MRR, instead, is mainly looked at as an operating metric, since its shorter-term nature makes it more useful in daily activities, and it is better suited for promptly evaluating the impact of market conditions, competition and changing regulations.


Churn is an important KPI for subscription businesses, as abnormal levels could seriously threaten the outlook of the company. It provides an indication on the number of customers who do not renew their subscriptions: this can be either voluntary or involuntary, but since the latter is usually caused by mere payment failures or system glitches it is of less interest to the business and can more easily be fixed.

There exist two ways of measuring it, both expressed as rates, that are in most cases complementary. Customer Churn is the ratio between the number of lost customers in a fixed period and the total number of customers; it provides a clear indication of the number of lost clients independently from the revenue they accounted for. Calculating the inverse of customer churn, it is possible to determine the average customer duration.

Alternatively, Revenue Churn considers the same ratio but in terms of lost recurring revenue; in case of a monthly period, it is called Churn MRR. Expressing the Churn rate in terms of revenue is particularly useful for companies which offer more complicated subscriptions plans organized at different price tiers, since simply counting the number of customers may provide a distorted picture.

Good or acceptable churn rates also depends on the average size of clients; companies working with small- or medium-sized ones can aim at a range of 3-7% monthly according to experts and industry averages, whereas those working with large corporate clients will need to reduce the figure close to 1% – obviously this is dictated by the higher costs of finding new customers and a generally lower number of targetable ones.

Lifetime Value and Customer Acquisition Costs

Customers’ Lifetime Value (LTV) gives the company a measure of the average revenues generated by each customer through subscriptions. It is therefore positively impacted by the price level but negatively dependent on churn rate – i.e., higher churn reduces the average length of the relation thus reducing the total amount spent by customers.

Customer Acquisition Costs (CAC) estimates instead the average cost endured by the company to acquire each new subscriber. This metric needs to be carefully compared with the churn rate, as high values of both may lead to a loss-taking business.

Ratios for Subscription Businesses

LTV/CAC ratio

Both LTV and CAC are KPIs that can be calculated also for traditional business models, but in subscription-based ones they find a crucial application. A common way to reason with their values is through the LTV/CAC ratio. By applying it to different segments of the business, it can provide management with information on where to focus optimization efforts; instead, it can give investors a general overview of the efficiency of the company and how its services or products are perceived by the market.

BCG reports that venture capitalists usually consider values greater than 3 – meaning that for every dollar spent on a customer this will return three dollars – as a sign of a healthy business that could benefit from further investments and growth. Otherwise, a business is either to be considered flawed or on some special occasions better to be run for profit-taking rather than aiming at growth – i.e., the costs and risks necessary to promote growth are not sufficiently rewarded by customers.

Burn Multiple

Lastly, we wanted to provide a highly considered capital efficiency metric for subscription businesses. This multiple indicates the impact of each dollar invested on Annual Recurring Revenue (ARR).

To calculate it, the following formula is used:

Burn ratio = \frac{Net Burn}{Net New ARR} = \frac{Cash Revenue – Cash Expenses}{Expansion ARR + New ARR – Churn ARR} [/latex}

A lower Burn Multiple is the manifestation of an efficient company, and it generally must be preferred by investors, although only values below zero indicate that the company is cash flow positive (obviously, this is only when the negative sign is dictated by the numerator). It must be remembered however, that due to its ‘revenue nature’, it can’t be calculated for pre-revenue start-ups.

This measure is a great complement to previously reported KPIs, such as LTV or CAC, because differently from those it accounts for costs in every area of the company – not only sales and marketing ones - and thus enables investors to evaluate the company with a wider perspective.

It is true that the history of Venture Capital funding is full of examples of unprofitable companies with high burn rates – e.g., Uber, WeWork to name a few – but in a climate of higher interest rates and economic downturn we don’t see the idea of “growth at any cost” being as strong as it used to be. Capital efficiency and the ability to make profit need therefore to be once again at the centre of focus.

VC investor David Sacks – a key figure of the early-stage success of PayPal – has provided some of his thresholds to evaluate the Burn Multiple, rating as great and amazing values under 1.5x or 1x respectively while suspects of possible inefficiencies needs to be addressed when the multiple is higher than 2x – particularly after the 3x level.

Exceptions for higher acceptable values can be made for companies still at their seed-stage since sales are generally low and R&D is high or if a company embarks in a higher level of expenditure to reduce future competition and increase prospects of revenues. However, both these examples can only be temporary, and the multiple should eventually converge towards usual levels.


It is clear to see that the subscription model has had a substantial impact on the way finance and business is carried out today. Subscriptions provide software companies with the possibility to generate continuous revenues, reduce hassle for consumers, provide easy liquidity for private equity and many more positive impacts.

It’s not all clear sailing for subscription-based companies though. These companies must constantly innovate and develop their product to maintain their subscribers as well as focus on their performance metrics to reassure sceptic investors.

It will be important to keep an eye out on the development of these subscription models. It is not uncommon for people to have many subscriptions at the same time, and as much as this provides ease and comfort for consumers, companies will inevitably try to find ways to boost their profit margins and take advantage of the unsuspecting consumer.

Overall, subscriptions are likely here to stay and we may see more innovative uses of the model in the future.


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