The Subscription Trap: Why Recurring Revenue Isn’t Always King.

So, and we've got a couple stories from businesses that you have operated that have had good things and bad things coming about as a result of recurring revenue. So I'm going to let you riff on it a little bit. A couple of things I'd like to cover to be sure would be like hidden churn, cost of service, rate ratios, customer support, debt, and then cash flow timing and things like that.

Hey, everybody. Welcome to another episode of Business Lunch.

And we were trying to think of what to call this. I texted apparently some other person than Rich this morning. And I was like, hey, what do you think about calling this the Business lunch operating room or something like that, or operators only. So I'll just talk with you about it. Since some random person out there in.

The world never responded, it's probably my fault. I lose digital text messages all the time. No, I absolutely didn't get it. But I'm dying to know who did and what their thoughts are. So did you have options? I like the. What was the.

The operator room was the operating room.

I think that's operating room I like.

Because it's like, you know, a place.

Where urgent things happen and action takes place and we're talking about operators and.

Yeah. So very surgical.

Marinate on that and see what you think. But what I had sent over to you or now sent to someone else is an idea to talk about the subscription trap. So why recurring revenue is not always king. Because everybody, every entrepreneur, every buyer, every article I see now talks about something we've been talking about for over a decade, which is how recurring revenue can be a wonderful thing for a business. It increases the value. It starts each month or week or day with guaranteed income and sales. It smooths out the rough spots. It sounds like a perfect panacea. And therefore, Everybody should do 100% recurring revenue. Right?

All of it, all the time.

Yeah, yeah.

But except when you shouldn't.

What? Well, that's what I want to talk about today. So we've got a couple of stories from businesses that you have operated that have had good things and bad things coming about as a result of recurring revenue. So I'm going to let you riff on it a little bit. A couple things I'd like to cover to be sure would be like hidden churn, cost of service, rate ratios, customer support, debt, and then cash flow timing and things like that.

We need to talk about the innovation requirement as well.

Yeah, yeah, right.

I mean, that's a big one.

So I'm gonna let you start to riff on this.

Sure. So I mean look, subscription revenue is great. There, there is a, in theory, it's great to wake up at the beginning of the day and, and see a bunch of money in the bank account. It's great to know that at the end of the month that you're not starting from zero the next month. So we, I think we all know that the positive impacts of, of the subscription business, but should you be in the subscription business? Should 100% of your business be subscription based? Those are two very different questions. I think we over indexed as a, you know, as a society to a subscription based business about seven years ago, right? Seven years ago everything started going subscription. And then kind of about four years ago, subscription was a bad word, right? We started seeing things go subscription go away because the consumers just were over the forgetting that they subscribed to something and having all of these hidden charges and a lot of littles adding up to a whole lot every month. And not just consumers, but businesses also. Money was cheap, other people's money was free and it was a whole lot easier to sell higher ticket things leveraging other people's money. So that happened. But we've swung back a bit to subscription is kind of coming back in sort of this economy where people want to buy a lot of littles or pay over a long period of time. So it's fantastic. But you have to look and say what's my total addressable market? And of that total addressable market, where do I think the reasonably or where do I think the ceiling is that I can hit in a reasonable amount of time from a, from a paid user base? That is critically important because if you're going to sprint to a user base, a paid user base, and let's say that you're a lower dollar subscription, right? So we've got one of our portfolio companies that has been kind of in and out of the subscription business. And at one point we hit 10,000 paid subscribers very, very quickly. And I remember the celebration and it was a giant celebration. We were all very happy and had every reason to be. Now the month after that, it wasn't as happy because what we realized was just keeping up with Churn once we had hit that point was more than our average acquisition of new subscribers.

And how do you define churn? Just so everybody's on the same page with yeah, churn.

And Churn is, is just the, the paid members leaving every month. And Churn is broken down, you talked about hidden churn. So there's voluntary churn, meaning I want to cancel. I am Voluntarily canceling. And then there's involuntary churn, which is that hidden killer of the subscription model. Involuntary churn is credit cards expire, credit cards decline. And depending on your billing system, there are hard coded rules that you have no control of that says there's a max number of attempts on this and then this invoice won't be billed anymore. Or there's a max number of attempts on subscription invoices and after those are failed, we just cancel the subscription invoice or the subscription itself. So there's the, the voluntary churn that you're having to constantly add value to keep people. And then there's the involuntary churn which you're having to look at it like what credit cards are expiring. Does my system have the ability to auto update credit cards? Does it have the ability to trigger alerts when credit cards are expiring? And do I have campaigns that are outreaching to have people on the phone calling customers? Do customers know? Because depending on, you know, whether you're a breakage model, which typically a breakage model subscription is a lower dollar subscription, like a Netflix, right? You don't at the end of the month look at your Netflix and go, well, I only watched 10 movies and, and four episodes, so this didn't roi, I'll cancel it. You think of Netflix like if I'm bored one day and I want to watch this show and I didn't have Netflix, then I'm going to feel real dumb because I canceled Netflix to save whatever Netflix is now, right? That's a breakage model. A consumption model is more of the, if I don't use it this much every month, then I feel foolish. It didn't ROI and I'm gonna cancel. What's that?

Gym membership.

A gym membership, right? Gym memberships fall into consumption model a lot. Like if I don't go into the gym at least this many times a month or a week, then it doesn't make sense, right? So you're having to deal with all of these things just to maintain membership. And in the beginning, when you're building that subscription membership, it's fine because if you have owned media, if you have an email list, right, you're launching something, the velocity of new subscribers and membership growth is high. Then you figure out maybe paid acquisition or referral acquisition, and you're just compounding. But when you hit that ceiling, and at some point you're going to hit a ceiling of total addressable market maxing out each of these acquisition channels. Now you're trying to offset churn through new channel acquisition. And that becomes a very dangerous game to play when you're losing more members than you know how to gain.

Right?

That's when the subscription model goes bad.

And this is the innovation challenge.

Well, the innovation challenge is, comes along with depending on, you know, if you're Netflix. The innovation is that look at Netflix budget for show acquisition and new show creation. That budget has gotten crazy because as competitors came into the streaming market and those competitors started either acquiring the rights of shows by merging or getting network rights or you know, buying the rights to we show friends over here now and we've got this. Netflix is having to keep those users by adding more content old and new. So the innovation challenge at Netflix is how do I constantly create new shows and movies or acquire old shows and movies? I have to innovate by adding here. If you're, you know, if you're in a, you know, the education space, right? Then you're having to innovate. If you're on a subscription model by creating new education every month, if you're in the physical product space and it's a consumable like a auto ship, then usually it's good news because it's a consumable and ideally the end user is using it. So they're running out and you just have to ship it again. That works as long as they don't stop using it. And then they get three, four or five of them and they go, this is dumb, I have too many. Right? But that innovation engine means how do we constantly create something new to deliver every month to our paid members. And if you miss a month, then your churn goes up so you lose more members and that gets you closer to that ceiling of where do we hit that point where we have where we're losing more members than we know how to gain every month. So that's just. Yeah, go ahead, go ahead, you can finish. I was gonna say that I think that kind of gets into a bit of your cost of service ratio, right? What does it take to. To what does it take to fulfill or service a subscription based or a recurring revenue based business model? It kind of depends on what your deliver deliverables are, but also what the tech stack is, what customer service support requests are. Unfortunately, what we've seen in our portfolio of companies, the lower the dollar amount of that subscription when you're living in the breakage model, the higher the number of customer service requests per member are. So you get less money per member and they need more support per member. So that's one box that you know, okay, well the, the cost of service ratio is going to go up in customer support, so it needs to be lower in innovation or fulfillment or technology because I'm overly indexed to supporting those members. Even if it's just billing issues, you just, you have a lot more members as well to make that model work. It's a lot of littles. So in the 10,000 members, if each of them has one and a half support requests a month, or even just the active members have one and a half support requests a month, that's a lot of support requests. So that ratio gets really, really skewed pretty quickly.

Is that something that you can AI ify to make it make a little bit more sense?

For sure. I think that's one added advantage that we have right now is leveraging AI in those frontline support. Right. You can build in chatbots within membership platforms to where the, the first line of support is a far more interactive and prescriptive chatbot than we used to have. In the member portals where you're dealing with less of an AI and more of just a routed choice answer platform. So you can offset it. But then you're looking at things like, well, what's our hosting and infrastructure? If we are in going back to the example of education, if we are putting out a ton of video education, okay, we've got servers, we've got bandwidth, maybe it's AWS servers. If we're doing a ton of zoom and we're doing live, are we having to host those zoom recordings? What does it take to onboard? Are we doing onboarding? Are we doing group onboarding? Are we doing one on one onboarding? Are we doing high value content production? How often, what does that look like from editors? You just have a lot to think of and basing that out on these digital subscription businesses can, you know, it can sound very, very good until you really look at the total cost and start to balance those ratios out.

So.

Is it better not to have.

A content subscription business and then like just have something that doesn't have to be constantly renewed? Like you're better off selling toothpaste because people are going to use toothpaste every day than you know, selling content where you have to create all the time?

If you can come up with an, with a new toothpaste and, and you can get it into a, out of a commoditized market, then yeah, I think it'd be great to sell a new toothpaste that breaks outside of the price point of toothpaste and gets outside of, you know, competing in a commodity. But I do think that you can still have a viable content subscription. You just have to offset it with things that don't have to be updated constantly. I think for example, for us, the mix of content plus community, right? Because community is user, user generated content.

So subscribing for access more than correct.

Right. If there is some core content and then the community is what you're really getting access to, that is, that is the innovation, right? Because the innovation is user generated, doesn't mean that you and your team don't need to be in there. But the models that I've seen are flagship core that are working really well and that are having this core flagship content, not new content that has to be updated or created every month. So that core flagship that's matched with an active community. Because then all of that innovation is based on user generated content. And you're not in the breakage model even in a price point. You're in the access, right. What you're losing is access to the community. So engagement means did I, you know, did I engage with the community? Do I feel part of the community? There's a lot there. So I think community access coupled with education, information, content is a powerful combination to make subscription work.

And is there, are there people that just shouldn't try to come up with subscription or like I liked at our last founders board meeting we talked with one of our members that has this underground storage business and it was like, you know, oh gosh, I could have this monitoring thing that, you know, that can be a subscription that, that shows a picture of what's going on in the tank and stuff like that. Should people be trying to find this or like when do you know that it's a good thing to do and not.

Yeah. So I think that example's great because that was what is a bolt on beneficial service that, that I could add. That makes sense, that adds value to the additional service. It wasn't. How do I take my core model and change it to subscription? Okay, right. I think that when people fall in love with the model and waking up with, you know, all the, you know, I don't have to sell any more customers this month because I've got all the customers that I need and I'll, I know that I'm at this much profit just by subscription revenue, right. And want to go and say, well then we need to stop selling the way that we're selling, stop pricing the way that we're pricing and move over there are businesses that make sense to pay for monthly and services and products and there are those that don't. And I think, I mean it comes to a bit of common sense like if there's something that makes sense to charge for monthly, then yeah, add it. If it doesn't really make sense, then your, your prospect, your customer feels stupid pain for you.

Pain.

Paying monthly for something that they should just pay for once or annually or whatever it is. I think we, you know, we need to define our business by who we serve, not what we sell or the pricing model that we sell it. So what's the most appropriate? Now again, I think that example is a great way of innovative thinking of adding on value based services that makes sense for a subscription model. Right.

And if, if you're. So we like the idea of a bolt on services subscription. If we can figure out what that might be. Definitely worth brainstorming. When you do change the model and you experience the cash flow challenges, is there like do you have lessons learned, takeaways how to do that?

Oh yeah, yeah. So you have to project cash flow, right? We all, we're all looking at the end like when we get here it's going to be great. But I like to think of any, any change like this. Like we're doing a migration, right? Like we were going to do a tech migration. We are doing a cash management migration. This is what we're used to having come in. And if you're moving from, we charge a one time payment of this or maybe we have payment plans. So it's a one time payment or we get, we get that split up into three. You're building ar, but it's a much higher clip than if you go. Well we're just moving over to a subscription model. So you have to forecast out how long of a Runway you need to build up before you're going to be able to do this, right? Because there's going to be a tipping point the month you switch over, you are going even if you make the same number of sales, right. You're going to have dramatically less in the bank. And what would need to be true of the increase in conversion for you to have the same amount in the bank, would it need to 5x10x what's reasonable? So if you believe that you're gonna have a 500% increase in, in the conversion to sale by moving to this model, then that's great, model that out. But also model out what if it's only two and a half percent, right. And then look at the cash implications of that and say, okay, we need to have all the stakeholders understand that it's going to take us three months, six months, nine months until we get back to building based on the assumption of new user acquisition, some assumption of, of initial stick. Because if you don't have a contract and you're dealing merely in month to month subscription model, you're going to have the highest churn from a new user after their first billing. The first time they're billed, they're going to see it. It's not normal. No matter what the price point, you're going to have the highest churn there. The second highest is month two. The, the third highest is month three. By month four, it normalizes. So you have to model that out in a churn waterfall and it gets a little complex. But usually you're talking about a commitment to change your cash, your incoming cash for seven to nine months.

Right?

Seven to nine months before you're going to get back through kind of the snowball effect of the building of the subscription revenue. Even with an increase in front end conversion rates before you get back to the normal cash position that you're used to taking in. If you're switching a model now, the better thing to do is to ask what our client asked. How can I bolt something on? So if you're already selling something that is working really well on the front end, then how do I add value after that sale that they're continuing to pay for? Because that shouldn't affect front end conversion rates, it shouldn't affect your cash flow on the front end. You only get the building benefit of that cash flow on the back end. And you still get to build a subscription, but you build it on the back, not on the front.

Right. That makes sense. So overall, have you been happy more, have you been happier with a business model conversion to subscription or a bolt on?

Bolt on.

Okay. And so for most people you would say unless the business is, unless you own a cell phone company, a streaming service, something like software. A software company, then, then you're probably better off. Stick with the model that you've got. But think about how do you add value through subscription? Right? Right. Yeah. And is there for, for helping people brainstorm that? Is there any kind of process or thinking that other than hit the, the chatbots that, that you would recommend?

Big fan of the chat bots. I'm also a big fan of just talking to your, your customers and the ones that are already buying what you have and figuring out where are they stuck? What do they need. And it really doesn't matter if you're in a B2B services, if you're in a home services company.

Right.

I mean, home services, there's a ton of companies that are doing, you know, like a garage door company may come out and install a garage door and they're going to charge me for a garage door and never come back. Well, I'll tell you, I've replaced garage doors. That's a terrible experience. If there were anything that that company said, hey, for $75 a quarter, 25 bucks a month, or 50 bucks a month, we come out, we do this, we replace the springs. I'm sure there are things that go out. There's chains and stuff. They likely need oil. I don't really know how those work.

Right.

But. Because I don't want to. But I also don't want to go pay whatever, $15,000 a garage door again to have another one put on.

Right.

I would gladly pay for a service to come out and maintain my garage door and chain and opener and spring and whatever else goes into a garage door. Yeah, right.

So what's, what's the biggest thing for people to look out for when they do create this service? Like, what's the biggest pitfall that you might be able to help them avoid by saying look out for this or monitor this or something like that?

So I think if it is a conversion, it's cash flow. That's the number one thing that's the most obvious. If it's a bolt on, then I think you have to think of it as a cohort based in isolation. And you have to live in MVP long enough, like serve a small amount of people. Make sure that what you're looking for is the, you know, you're, you're looking for those cost of service ratio, even if it's not your core business model. I mean, best in class cost of service ratio for a service or a subscription company is 15 to 25%, meaning you're keeping 75 to 85% of revenue as gross margin. Right. If you are anywhere, anywhere close to 50% or above, you're losing money. So you have to figure out, one, when you model it out, does it make sense on paper? Two, when you deliver it, does it match the model? Three, will they buy it? Four, does it actually negatively impact the front end conversion? Because if it's a bolt on, I don't think it should. But if I get less referrals because I'm installing garage doors and I'm pissing people off, Because I'm asking them to join my subscription program after a garage door. And I used to get two referrals from every garage door that I installed and now I get none. But I've got someone paying me 20 bucks a month. That math doesn't work. So you really have to look at the total business impact, both of cost of fulfillment, initial conversion impact, retention impact from not only that program, but from promoters and referral. Is it going to negatively impact that, you know, the client's willingness to refer your business? Like, what is the total impact of it?

Okay, that's awesome. I appreciate it. Well, thanks for coming on. Any last, any final words, any last thought that you went to leave people with before we send them off into checking into this themselves?

Yeah, here we keep saying referral or. I'm sorry, we keep saying subscription. And I love AR as much as I love subscription.

Okay.

Right. So if you can sell something and it doesn't have to be forever, and you can break it up into payment plans and you can effectively capture those payment plans on a shorter basis, you could think of it as a, as a micro continuity if you want to, or just a much higher version. But if you know that for every one sale you make, you're going to get paid for the next three to six months, you're going to have less of an impact, usually on your front end conversion. And it's still predictable revenue. And as long as you're making a consistent number of sales every month, it still builds in the same way that continuity or subscription revenue does. So don't think that subscription revenue is the only path to having predictable recurring income. Don't forget about accounts receivable and payment plans and things like this, and also floor planning. Right. There are companies out there that, that will create, will create financing options for your clients that will help pay you almost the full amount and give those payment terms to the, to the customer. So there are ways that we can go and capture what we're looking for without fundamentally making a change to our sales motion, our cash, our cash position, or, or, you know, statement of cash flows or, or the, the, you know, the way we do business. So I like it.

Awesome.

That's what I'd say.

Well, hopefully you guys enjoyed this. Definitely something to consider. There are some pitfalls. It's not all roses and unicorns, but there are a lot of good things about these types of systems. And so I think they're worth thinking about putting them into your business. If you enjoyed this episode, please share it with a friend. Let Us know, hit us up on Social. Richard and I are both on all the socials, pretty much under our names. And we'll see you next time on Business Lunch.

All right, thanks guys.

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