The pros and cons of a subscription model business
by November 24, 2023
Please note: This blog was originally published in 2020. It’s since been updated for accuracy and comprehensiveness.
If consumers are passionate about a product, chances are there’s a subscription business based around it – it’s easier than ever to get new and exciting Japanese snacks, beauty products or puzzles delivered to your door every month. And consumers aren’t just subscribing to receive fun stuff in the mail, a survey showed that 68% of them used subscription services for household staples like personal care products.
While there are clear benefits to running a subscription model business, there are also some potential downsides to look out for. To learn more about companies that utilize the subscription model for products, we spoke to industry expert, podcaster and author Robbie Kellman Baxter to discuss why this business model is attractive to startups, the importance of quality customers, and much more.
Recurring revenue is reliable, and attractive to investors
For a growing retail business using a subscription model, a reliable cash flow means having enough money in the bank to run the business, invest in projects and potentially have a higher valuation. “A lot of companies say to me, ‘I wake up in the morning and no matter how much money I made last year, I’m starting at zero and hoping someone buys from me today,’” Baxter says. “[With a subscription model], you know the money’s coming in.”
A positive cash flow can be a harbinger of growth to come.
Investors are attracted to businesses that are able to consistently bring in a positive cash flow based on recurring subscriptions because it bodes well for the company’s future. NetSuite’s look into cash flow analysis notes: “When operating income exceeds net income, it’s a strong indicator of a company’s ability to remain solvent and sustainably grow its operations.”
When investors see a company’s ability to grow, it’s an appealing prospect for a number of reasons. “Recurring revenue can lead to a higher valuation in the public and private markets,” Baxter explains. “If I want to sell a business to you, if I have a [loyal] subscription customer base, the multiple I use will be much higher – that’s true whether you’re trying to raise money, and it’s true if you’re a small business trying to sell your business. It’s also true if you’re a public company trying to get a better valuation for a share price.”
A loyal customer means a high customer lifetime value
Some investors have taken to using a customer-based corporate valuation methodology (CBCV) to evaluate the worth of a business using a subscription model. According to research conducted by marketing professionals published in the Harvard Business Review, the growth story the meal kit company Blue Apron released in their pre-IPO disclosures may have been overly optimistic. Their cost to acquire customers at the time was rising, which led the experts to believe that “any pullback in marketing spend would cause sales to drop in tandem.”
Their research at the time contrasted that with the meal kit service Gobble, which “sports a six-month dollar retention rate estimated to be more than 40% higher than Blue Apron’s” and has “done an excellent job retaining and monetizing their customers.” Around that same time, Techcrunch reported that Gobble has a “more loyal lifetime customer base than Blue Apron, Plated and other competitors at about $800 per year per customer.”
Gobble has been able to thrive by improving the value of its offerings (in their case, by selling food that’s faster to prepare and more delicious than their competitors) and reducing ad spend. The Business of Business noted that the company was profitable. And those loyal customers who come back month after month are another reason why the subscription model can be so alluring.
Figuring out your company’s Customer Lifetime Value is essential.
Baxter provides high-level strategy for companies pursuing a subscription model. She says businesses looking to succeed in this category should “want to build long-term relationships with the people they serve, and provide solutions to problems they face on an ongoing basis – or to help them achieve ongoing goals.”
Companies often try to sign up as many customers as possible by enticing them with free trials, Baxter explains. This could increase revenue in the short term if they stay on after the trial period ends, but has the potential to be a net-negative long term. “The [free product you send new customers] actually costs your company something, and if you aren’t confident the customer is going to stay past a certain number of months – even if you acquired them for the first month – you’re going to lose money on them,” she notes.
Baxter says companies must calculate both a reasonable cost per acquisition (CPA) and a customer lifetime value (CLV) that allows them to be profitable. “If you’re delivering a physical product, there are out of pocket costs, so you need to know how many months a customer is going to stay,” she explains.
Why is CLV such an important data point to track for businesses with subscription models? HubSpot lays it out in their helpful guide: “CLV identifies the specific customers that contribute the most revenue to your business. This allows you to serve these existing customers with products/services they like and make them happier, resulting in them spending more money at your company.”
There’s plenty of opportunity to market to happy customers who’ve proven themselves loyal to the solutions you provide. But not every customer is equal in terms of their value to your bottom line. “[A new customer] who signs up because you gave them a huge bonus to join is less likely to stay than someone who came in because your company’s offering is valuable,” Baxter says. “If you’re really good at subscriptions, you’re looking at your data by cohort.” The analytics marketing brand Amplitude says it’s possible to use “cohort analysis to segment your customers based on their behavior, affinities, and propensities specifically to improve your marketing efforts.”
A company adopting a subscription model has the chance to grow with the help of motivated, lifelong customers who continually gain value from their subscription. But the business model isn’t without its pitfalls.
Potential downsides of a subscription model
McKinsey research suggests that losing customers is one of the largest issues facing companies that use subscription models: “churn can dramatically undermine [a company’s] viability, since the cost of replacing lost subscribers could not only make it difficult to meet their growth objectives but also quickly drain their cash reserves.” Their findings also state that “40% of e-commerce subscribers have canceled their subscriptions.”
But what are the reasons behind churn? Let’s get an idea by examining two types of popular subscriptions for physical products that are proliferating at the moment. One type is a curated package, Baxter says, citing companies that deliver anything from makeup samples to cigars. “You always get new things!” she notes. “It’s about curation, variety and discovery.” If a company consistently delivers things consumers love in their mailbox every month, in theory, they should be adding value each month. But humans are a fickle bunch.
“People get really tired of that – it’s exhausting,” Baxter explains. “They say, ‘I have this huge stack of whatever it is laying around. I found [samples] I like and I’ve been buying those, but I don’t know what I’m going to do with the rest of them. Or I haven’t gotten around to the products yet.” There’s a real risk that people won’t want to receive your products for an extended period of time, she says.
The other common type of subscription is for essentials: think contact lenses, pet food or personal care products. It may seem like if a customer is happy with the personal care product they’re receiving, there’d never be a reason for them to cancel. But people vary in their habits. “People consume products at different speeds,” Baxter notes. “If I have long, thick hair, I might use three times as much shampoo as my husband who has short, fine hair. Both of us get a new bottle every month, but his bottle is half full at the end. He’ll get annoyed because he has too much. He says, ‘I’ll cancel for a while and come back later,’ but he may forget to come back later.”
There are, of course, ways that companies can counteract these potential problems. “A lot of companies are providing different amounts of product or allowing you to pause when you’re full up,” Baxter says. She cites the clothing site StitchFix, which formerly used a subscription model to deliver apparel to your home. Now, their site promotes a “delivery of curated pieces whenever you’d like” and that “there’s no subscription required.”
Even though Blue Apron has been seen as a cautionary tale for subscription model businesses, the entire meal kit sector saw growth at the beginning of the COVID-19 pandemic. The Washington Post reported that in 2020, “the U.S. meal-kit market surged by 68.5 percent, reaching $5.8 billion, a greater increase than any recent year, according to Coresight Research,” though growth appears to be slowing again as dining options are becoming more available. Regardless, Blue Apron continues to innovate with how they market to their highest value cohorts, all in an attempt to reduce churn and become a long-term solution for their customers.
If you’re offering products on a subscription basis, managing compliance is key
There are multiple factors to determine if your company’s subscription boxes are taxable, including the types of products in the box and where your company’s offices and warehouses are located. That’s why we’ve written this informational blog post to act as a first step in figuring out your potential sales tax obligations.
Keep in mind that if you’re selling products on a recurring basis to the same customers in the same states each month, it may lead to sales tax liabilities in those states. It helps to have a partner in managing sales tax compliance to make sure you’re staying ahead of your potential obligations.
Ready to automate sales tax? Sign up for a free trial of TaxJar today.
