A Deep Dive into the Subscription Business Model for Software

SaaS has been one of the most common software monetization strategies for consumer-based and enterprise software alike.

I can still remember back in 2012 when Adobe decided to switch to a subscription business model for the applications they sold.

Their stock valuation would indicate that this transition was a success, as the the inflection point to the "hockey stick" graph seems to coincide with this transition:

In this post I'd like to cover some key considerations around providing Software as a Subscription, both from the perspective of the ISV, as well as from the customer/end-user's point of view.

What Is a Subscription Business Model?

A subscription business model is a pricing and revenue model in which customers pay a recurring fee at regular intervals, typically monthly or annually, to access a product or service.

The rise of subscription box businesses has highlighted their popularity, recurring revenue stream, customer relationships, and projected market growth.

Instead of making a one-time purchase, customers enter into a subscription agreement that grants them ongoing access to the product or service for as long as they continue to pay the subscription fee.

What Are Key Characteristics of Subscription Business Models:

Key characteristics of a subscription business model include:

Recurring Revenue:

The primary revenue stream comes from the recurring fees paid by subscribers on a regular basis, providing a predictable annual recurring revenue stream for the business.

Subscription Tiers or Pricing Plans:

Subscription businesses often offer different pricing tiers or plans to cater to different customer segments or provide varying levels of features and benefits.

Choosing the right subscription pricing strategy based on the nature of the product and business goals is crucial. This allows customers to choose the plan that best suits their needs and budget.

Customer Retention and Engagement:

Subscription businesses focus on building long-term relationships with customers.

They strive to provide ongoing value and maintain high customer satisfaction to encourage customer retention and minimize churn (cancellations). Reducing churn rates and ensuring profitability are essential to make the subscription business model work.

Continuous Delivery of Value:

To retain subscribers, businesses need to consistently deliver value through their products or services.

This may involve regular updates, new content, exclusive features, or personalized experiences to keep subscribers engaged and satisfied. Additionally, the benefits of recurring revenue and the growing demand for subscription services due to factors such as digitization and the pandemic make subscription services an attractive business model.

Data-Driven Insights:

Subscription businesses often collect and analyze data about customer behavior, preferences, and usage patterns.

These insights help optimize marketing strategies, personalize offerings, and improve customer experiences.

Upselling and Cross-selling:

Subscription models provide opportunities for businesses to upsell existing customers to higher-priced plans or cross-sell additional products or services.

This can increase the average revenue per user and customer lifetime value.

How a Subscription Model Works:

A subscription is like a contract between a business and a customer.

The customer agrees to pay for a product or service for a specific period, and in return, the business provides that offering as long as the customer keeps making their recurring payments.

At the end of the contract term, the customer can decide whether to renew or cancel their subscription.

How to Build a Subscription Model:

Building a successful subscription business model involves several key steps to ensure its successful implementation.

Here's a high-level overview of the process:

Identify your Product or Service:

Determine what product or service you want to offer through a subscription model.

It could be digital content, software, physical products, access to a platform, or a combination of offerings.

Define your Value Proposition:

Clearly articulate the value your subscription provides to customers.

Identify what sets your offering apart from competitors and why customers should choose your subscription.

Pricing Strategy:

Develop a pricing strategy that aligns with your value proposition and target market. Accurately pricing subscription services is crucial, and using a subscription pricing table for multiple tiers can help in selecting the right subscription pricing strategy.

Consider factors such as the cost of delivering the product or service, market demand, and competitive pricing.

Subscription Tiers and Features:

Create different subscription tiers or plans that cater to various customer segments or offer different levels of features and benefits.

Consider what features or perks can be provided at each tier to justify the pricing.

Billing and Payment System:

Implement a billing and payment system that supports recurring payments.

Set up a secure and convenient method for customers to make their payments, such as credit card processing, direct debit, or digital wallet integration.

Customer Onboarding:

Streamline the customer onboarding process to make it easy for new subscribers to sign up and start using your subscription.

Create a seamless registration flow, provide clear instructions, and ensure a smooth transition from sign-up to access.

Value Delivery and Continuous Improvement:

Consistently deliver value to your subscribers throughout their subscription period.

Regularly update your product or service, provide new content, and listen to customer feedback to improve and enhance the offering over time.

Customer Engagement and Retention:

Focus on engaging and retaining your subscribers.

Develop strategies to nurture customer relationships, such as personalized communication, targeted marketing campaigns, loyalty programs, and exceptional customer support. Exceptional customer service and effective retention strategies are particularly crucial for subscription companies.

Analytics and Metrics:

Implement analytics and tracking systems to gather data on customer behavior, usage patterns, and subscription performance.

Analyze these metrics to gain insights into customer satisfaction, identify areas for improvement, and inform decision-making.

Iterate and Optimize:

Continuously monitor and evaluate the performance of your subscription model.

Use the insights from customer data, feedback, and market trends to iterate and optimize your pricing, features, and overall subscription experience.

Why is the Subscription Business Model Sustainable?

The subscription business model is considered sustainable for several reasons:

Predictable Revenue:

Subscriptions provide a steady and predictable revenue stream for businesses.

Unlike one-time purchases, which can fluctuate and be less reliable, subscription models generate recurring revenue at regular intervals.

This predictability allows businesses to plan and allocate resources effectively.

Customer Retention:

Subscription models prioritize customer retention and foster long-term relationships.

By continuously delivering value and engaging with subscribers, businesses can build loyalty and reduce customer churn.

Retained customers provide ongoing revenue and contribute to the sustainability of the business. A low churn rate is crucial for profitability, making the subscription business model work effectively.

Scalability:

The subscription model has inherent scalability.

As businesses acquire more subscribers, revenue grows without necessarily incurring proportionate increases in operational costs.

This scalability allows businesses to expand their customer base and increase profitability without significant resource constraints.

Enhanced Customer Lifetime Value:

Subscription models often focus on increasing the customer lifetime value (CLTV) by offering upselling and cross-selling opportunities.

By providing additional features, upgrades, or add-ons, businesses can increase the average revenue per user and maximize the value extracted from each customer over their lifetime.

Customer Insights and Personalization:

Subscriptions generate valuable data on customer behavior, preferences, and usage patterns.

By leveraging this data, businesses can gain insights into their customers' needs and tailor their offerings to provide a personalized experience.

This level of customization enhances customer satisfaction and strengthens the sustainability of the business.

Continuous Innovation and Improvement:

The subscription model incentivizes businesses to continuously innovate and improve their offerings.

To retain subscribers and stay competitive, businesses must deliver ongoing value, introduce new features, and respond to market trends.

This focus on continuous improvement ensures the sustainability of the business in a dynamic marketplace.

Diversification of Revenue Streams:

Subscription businesses often have the opportunity to diversify their revenue streams by offering different plans, add-on services, or partnering with other businesses.

This diversification helps mitigate risks associated with relying solely on a single product or service, making the business more resilient and sustainable.

Customer Acquisition Efficiency:

While customer acquisition costs (CAC) may be higher upfront, the subscription model allows businesses to spread out the cost over the customer's lifetime value.

This efficiency in customer acquisition costs, coupled with the focus on retention, contributes to the sustainability of the business by optimizing the return on investment (ROI) for customer acquisition efforts.

How Do Consumers Benefit From Subscription-Based Software Licensing?

There are a few reasons why consumers would enjoy using software licenses as a subscription.

Significantly Lower Upfront Costs:

The greatest benefit for consumers when using SaaS is a lower upfront cost to use, since the entry point for a customer would simply be a monthly subscription rather than the total lifetime cost of the license.

If we take the example of Adobe Photoshop again, that meant people could immediately derive value from the software for $50/month for CS6, whereas the perpetual license cost $699, making it prohibitively expensive for many creatives.

Continuous Software Upgrades, Updates, and Patches:

Gone are the days where end-users expect rare software updates, or want to pay for them separately.

With a subscription business model, software vendors can offer a single application, and continuously upgrade it without having to worry about licensing different product versions.

That means less hassle for the customer, and they can focus on using the software as a service rather than figuring out how to upgrade to get the latest feature.

A Subscription-Focused Business Model Almost Always Increases the Customer’s LTV for the Vendor:

From our experience, most software vendors that use LicenseSpring as tend to price their subscriptions in such a way that their perpetual license would be paid within 12 to 24 months.

That means, if the end user remains a loyal customer and regular user of the software beyond that amount of time, the ISV will extract more revenue from each customer in the long-run.

It's important for most software vendors to have the means to maintain and support their software, which usually means pricing the product in a way that can cover the cost of a team of developers, and infrastructure.

The Software “Market Landscape” Can Force All Vendors to Become a SaaS:

Sometimes, it's simply not possible to license your application using any other business model, since you would just be crushed by your competitors if you can't keep up with their engineering and their marketing budgets.

Let's say all of your competitors sell as a subscription, and use the higher LTV to ramp up their marketing and ad spend to gain more visibility toward prospective clients, and continuously increase the budget for R&D.

Competitors who cannot afford the marketing and the product development dollars will gradually become irrelevant.

I have seen this with many license managers that we used to consider competitors, that simply could not keep up without being a SaaS.

ISVs Should Be a SaaS if Part of All of Their Service Is Delivered Online:

Web services all inherently have some component that can justify recurring revenue, since their economics also have recurring costs (servers, databases, etc.).

Drawbacks to Prepare for With the Subscription Business Model:

Here are some key drawbacks to prepare for when implementing a subscription business model:

Churn and Customer Retention:

Customer churn, or the rate at which subscribers cancel their subscriptions, can be a significant challenge. Maintaining high customer retention is crucial to sustain revenue growth.

Businesses need to continually focus on providing value, addressing customer concerns, and improving the overall subscriber experience to minimize churn.

Revenue Predictability:

While recurring revenue is a strength of the subscription model, it can also create dependencies.

If a significant number of subscribers cancel or there is a decline in new sign-ups, it can impact revenue stability.

Businesses should anticipate potential fluctuations in revenue and have contingency plans in place to address such situations.

Initial Customer Acquisition Costs:

Acquiring new subscribers can come with upfront costs, such as marketing and promotional expenses.

Depending on the competitive landscape and target audience, customer acquisition costs (CAC) can be substantial, especially in the early stages.

Businesses need to carefully plan and manage their acquisition strategies to ensure a sustainable return on investment.

Pricing and Value Perception:

Setting the right pricing for different subscription tiers can be challenging.

If the pricing is too high compared to the perceived value, it may deter potential customers. Conversely, if it is too low, it might negatively impact revenue and profitability.

Striking the right balance and effectively communicating the value proposition is crucial.

Market Saturation and Competition:

As the subscription model gains popularity, competition in various industries continues to increase.

Customers have more choices, making it essential to differentiate your offering and continuously innovate to stand out.

Market saturation can lead to increased customer acquisition costs and a need for continuous improvement to retain customers.

Content and Offering Refreshment:

Keeping subscribers engaged and satisfied requires a consistent delivery of fresh content, updates, or new offerings.

This ongoing commitment can require substantial resources and investment.

Businesses must be prepared to continually invest in content creation, product development, and customer support to maintain a competitive edge.

Customer Support and Service:

Subscribers often expect responsive customer support and prompt issue resolution.

As the customer base grows, managing support requests and ensuring a high level of service can become more challenging.

Businesses need to scale their support infrastructure and processes to handle increasing customer demands effectively.

Regulatory and Compliance Considerations:

Depending on the nature of the subscription offering and the target market, businesses may need to navigate regulatory requirements and compliance obligations.

This can involve data privacy, security, financial regulations, or industry-specific guidelines.

Staying informed and ensuring compliance is essential to mitigate risks.

What Alternative and Complementary Business Models Are Out There?

There are many ways to license an application to customers, and often times a mix of tools are what is the most reasonable between customers and vendors.

Here are some of the most popular ones we see in our customer base:

Per-Use:

The software vendor meters the usage of the application, of some of its components, and sells "credits" which get consumed.

LicenseSpring is a sort of per-use business model since we charge based on API requests.

Perpetual + Maintenance:

The software vendor grants the right for a customer to use their software forever, but pays periodically fees to have the right to upgrade their software to the latest version.

This model makes sense for companies that have major releases annually and minor releases that are relatively infrequent, or for vendors with software that is rapidly evolving, and the vendor wishes to charge for the new features and functionality.

Floating Licenses:

We see this business model requested often by end users, and is usually deployed for expensive software.

Floating licenses allow the end user to install the software on many machines with a restriction put in place on a number of simultaneous uses of the application.

One industry this is common in is access to a database, for example.

Time-Limited:

This is a business model where the license is set to expire on a fixed end date with no assumption that it will be renewed, and the software will no longer work after that date.

Six Metrics All Subscription Business Should Track:

Tracking metrics is crucial for subscription businesses to monitor their performance, identify areas for improvement, and make informed decisions.

Here are six key metrics that all subscription businesses should track:

Churn Rate:

Churn rate refers to the percentage of subscribers who cancel their subscriptions within a given time period.

It is essential to track churn rate to understand customer retention and identify any issues that might be leading to customer attrition.

By analyzing churn rate, businesses can take proactive steps to improve customer satisfaction and reduce churn.

Monthly Recurring Revenue (MRR):

MRR represents the predictable revenue generated by a subscription business on a monthly basis.

Tracking MRR helps measure the growth and stability of the business.

By monitoring changes in MRR, businesses can assess the effectiveness of their acquisition and retention strategies.

Average Revenue Per User (ARPU)

ARPU is the average amount of revenue generated per user or subscriber.

It is calculated by dividing the total revenue by the number of subscribers.

Tracking ARPU allows businesses to understand the value each subscriber brings and identify opportunities to increase revenue, such as upselling or introducing new pricing tiers.

Customer Acquisition Cost (CAC):

CAC refers to the average cost incurred to acquire a new customer.

This metric includes various expenses, such as marketing, sales, and advertising costs, divided by the number of new customers acquired during a specific period.

By tracking CAC, businesses can evaluate the effectiveness of their customer acquisition efforts and ensure that the cost of acquiring customers is justified by their lifetime value.

Customer Lifetime Value (CLTV or LTV):

CLTV represents the total revenue a business can expect from a single customer throughout their entire relationship.

Tracking CLTV helps businesses determine the profitability of their customer base and make informed decisions regarding customer acquisition, retention, and upselling strategies.

By increasing CLTV, businesses can enhance their overall profitability.

Subscription Growth Rate:

Subscription growth rate measures the rate at which a subscription business is acquiring new customers.

It provides insights into the business's momentum and market demand for its offerings.

Tracking subscription growth rate allows businesses to gauge the success of their marketing and sales efforts and adjust strategies accordingly.

Examples of Subscription Business Models:

Subscription business models can be found in various industries.

Here are some examples of subscription-based businesses:

Netflix:

Netflix is a popular streaming service that offers a subscription-based model for accessing a vast library of movies, TV shows, and original content.

Subscribers pay a monthly fee for unlimited streaming on multiple devices.

Spotify:

Spotify is a music streaming platform that operates on a subscription model.

Subscribers pay a monthly fee to access a vast library of songs, create playlists, discover new music, and enjoy ad-free listening.

Dollar Shave Club:

Dollar Shave Club is a subscription-based service that delivers shaving products directly to customers’ doorsteps. Subscription boxes are a popular and thriving type of business model that delivers curated products and physical goods on a recurring basis with monthly/annual charges.

Customers can choose from different subscription plans to receive razors, shaving creams, and other grooming essentials on a regular basis.

HelloFresh:

HelloFresh is a meal kit subscription service that delivers pre-portioned ingredients and recipes to customers' homes.

Subscribers receive a box of fresh ingredients and can prepare meals based on their dietary preferences and cooking skills.

Adobe Creative Cloud:

Adobe Creative Cloud offers a subscription-based model for accessing a suite of creative software tools, including Photoshop, Illustrator, InDesign, and more.

Subscribers pay a monthly fee to use the software and receive updates and new features regularly.