The subscription model would soon become the dominant structure for business of all kinds, said Zuora, a cloud-based billing company. However, the failure of accounting methods to keep up with subscription business models was increasing the risk of companies miscalculating their cash flow and running out of money, it added.
“The accounting system doesn’t say, ‘Customer A is going to keep on giving you a dollar.’ There’s no place to put that in the accounting system. It just doesn’t exist. And so people end up putting it in their spreadsheets,” said Tien Tzuo, CEO of Zuora. “More and more of what’s important to the company is not in the accounting system,” he added.
Accounting’s failure to keep up with subscription business models was making it difficult to value companies against conventional benchmarks. Wall Street analysts took a long time to understand the business model for Salesforce.com (Tzuo’s former employer) and many smaller investors still struggled to understand subscription accounting.
Cloud software companies such as Xero and Atlassian, which have burned through millions of dollars to fund meteoric growth, have calculated that investing in sales and marketing was sustainable given the margin on existing subscriptions, Tzuo said. “As long as their intrinsic recurring profit margin is strong, they are going to be okay and be a really, really valuable business,” Tzuo said.
Listen to Tzuo talk about how to value subscription companies, including Xero and Atlassian, in the interview below.
Subscription based business models have blossomed in recent years. The entire software industry is in the middle of shifting from one-off retail sales to cloud-based subscriptions. Professional services including the legal and accounting industries were also experimenting with fixed-price billing models sold on a recurring subscription.
Telecommunications companies had proven the success of the subscription billing model for many years and the model was now going mainstream, Tzuo said.
“What’s going to happen is that all businesses are going to have a service provider with a telco-like business model. A lot of things that they’re teaching today in business school are going to become obsolete in the next three to five years,” Tzuo said.
Companies that moved to the subscription model were forced to manually update spreadsheets to calculate their financial position. It was also challenging to recalculate revenue from customers who upgraded or downgraded their subscriptions mid-contract.
The combined overhead increased the time required to close the books every month and increased the risk of running out of cash, Tzuo said.
“We talk to companies [and they say], it takes me two weeks to do all my monthly bills and another two weeks to figure out my revenue commission, now you’re already done, into the next month,” Tzuo said.
Tzuo had met one company that switched from a licence model to a subscription model which used to book $100 and spend $100 each year under the old model. When customers began paying three year subscriptions upfront, the company spent the future revenue in the first year and ran out of money, Tzuo said.
The company should have created a cost management structure that aligned with the revenue stream, he added.
Tzuo recommended that companies moving to a subscription model separate their recurring revenue from their recurring costs and analyse a recurring revenue statement. “We match all our expenses to ARR (annual recurring revenue) versus the cash or revenue. That’s a much better way to go,” Tzuo said.
He also recommended recognising sales and marketing as an investment in future earnings. A company might justify spending $2 to earn $1 because of the recurring profit margin from each customer, Tzuo said.
Listen to Tzuo explain the failings of accounting and tips for running a subscription based business in the interview below.