Customers do not want a cow; they want milk

Reading is a powerful way to learn. From my book recommendations, 'Subscribed' is written by Tien Tzuo, the co-founder and CEO of Zuora, a company that is a leading player in subscription management software. I read the book to build my knowledge of the subscription economy concept and the radical changes occurring across almost all industries, and I wanted to share some thoughts.

NEW SUBSCRIPTION ECONOMY

The foundational business school concepts of building and selling widgets needs to change. At the core of the product versus services discussion, consider your credit card statement each month. It is a set of services used versus items owned. The services that you use are a combination of services that are recurring and services that are used one-time or intermittently. When it comes to the concept of digital transformation, most business leaders indicate they know the term, but few understand the concept and more importantly what the concept means in terms of change. There are two areas that trap companies in the old way or need to change significantly: margin numbers and customer satisfaction. The typical product company makes a product, gets it in the market, then raises prices as the market saturates while simultaneously looking for operational efficiencies. This is required to meet investor needs but is not focused on the customer at all. Customer satisfaction is typically made up of discussion about customer journeys and net promotor scores by customer service departments. It needs to shift to be focused on creating a relationship with the customer. Think about how Amazon and Salesforce run their businesses.

Customers increasingly do not want a car; they want a ride. They do not want a cow; they want milk. Companies that continue to exist over the long-term follow their customer rather than expecting their customers to follow them. 50% of the Fortune 500 companies in 2000 no longer exist today. To make this shift, there are many examples in the marketplace to use as primers of what to do:

• Amazon: best known for radically changing industries, Amazon started off selling books. One of the challenges in the book was to look back at what your first purchase was on Amazon. His was the book ‘Seven Habits of Highly Effective People’ in 1997 and mine was the ‘Seinfeld Gift Set CD’ in 2004. Both items you’d traditionally find at a bookstore, but a far cry from what is purchased on Amazon.com today.
• Apple: best known for radically changing industries as well (think: music, mobile phone), Apple relies heavily on the traditional widget model, count of iPhones shipped. In a past earnings call, Apple began changing their approach to presenting and shifted from discussions on number of iPhones shipped to discussions on revenue per Apple ID. Discussed more related to Finance changes in this review, this is changing the script from product counts to annual recurring revenue with a focus on the customer.
• Automobiles: examples from the automobile industry continue to pop up, such as Hyundai Electric and Porsche Passport, which are both monthly subscriptions with no haggling aligned to enticing users to the electric car market. More will certainly come here. A pioneer in change, Henry Ford famously stated “If I had asked people what they wanted, they would have said faster horses.” This way of thinking transcends time and is very applicable to the electric car market today.
• Adobe: a fantastic example of the switch from box software to subscription in 2011, Adobe chose relentless communication as the model they would use to make the full and successful transition from perpetual to subscription licensing. They had to convince investors to buy into their vision, which they did by being upfront an open. At the time of the shift, Adobe’s stock was at $25 and in the first year their income fell 35%. In 3 years, they fully converted their creative suite software to SaaS and as of 2018 their stock is at $190 per share with over $5 billion in annual recurring revenue from none in 2011. 70% of the company’s revenue is recurring and this example is now widely used in business schools.

With the examples above and especially the final example, the revenue hit and related curve is obviously a big concern with making the shift. The concept is referred to as “Swallowing the fish.”

In this model, the challenge is companies being in a place to absorb the combined revenue hit and cost increase with the fabled inflection point of recurring revenue outgrowing recurring cost represented at the far right of the diagram as the revenue and cost lines cross for the second time.

Making the turn to a subscription economy means making decisions based on usage data rather than based on the loudest user, which changes your focus from products to outcomes. This product to outcome switch signals the end of ownership being the primary focus. To convince yourself this is really occurring broadly, examples of significant shifts in previous entrenched industries include: Healthcare where CVS bought Aetna, Insurance where data captures from automobiles are being used to customize your insurance rates, Utilities with the option to buy-back power from homes that produce their own energy with solar panels, Real Estate with home rental options such as VRBO and work rental locations such as WeWork, Finance with self-investment options such as Wealthfront and Robinhood, and then if you still don’t believe the shift is occurring, some foreign Governments with options such as one-click taxes and driver’s license renewals from your mobile phone.

SUCCEEDING IN THE NEW SUBSCRIPTION ECONOMY

The “ah ha” moment is described with an example from the video game industry. Users traditionally shell out $60 per year for the new version of a game. Some years they like the new version and some years they do not. Alternatively, the subscription model has users pay $5 per month and the new versions are “included”. They pay the same, but they feel they are getting free upgrades so if they do not like the version for that year, it doesn’t hurt as much as a $60 payment tied to that upgrade. It also translates to a constant flow of updated for the user and revenue for the company. Sounds all good, right? It is important to consider how your company will react to these changes. In this example, Marketing hates it as there is no big launch blitz, Development is upset as the release schedule is blown up, IT is unhappy because the monolithic business systems don’t support this model, and Finance doesn’t like it as quarterly revenue numbers are missed. To succeed, it is critical to sell this change and plan for it internally to be successful.

Rethinking approaches to innovation, marketing, finance, and IT is an important part of the plan. With Finance, changing the focus from unit sales to lifetime customer value and annual recurring revenue is required. Using Netflix as an example, having a plan and explanation as to how you spend $8B on a new show and just “give it away” to your customers is key. The traditional business unit silos need to be removed to move away from being oriented around a product and instead be oriented around the customer. How you look at the services you sell needs to change too. Using Google as an example, Gmail was launched in 2004 as Gmail Beta. The term “beta” was not removed until 2009, and when it was it was because companies interested in using Gmail for their corporate email couldn’t get their procurement markets to sign off on the deal with a beta product. So, what did Google do? They updated the logo to remove beta. That’s it. The software evolves regularly, and users get to take advantage of the advances without having to make a new significant purchase and spend 18 months on a massive upgrade. A fun example from the music industry was when Kanye West launched an album on the streaming service Tidal in 2016. As users bought the stream, he kept tweaking and changing the album, leading to arguably the first SaaS music album that listeners loved.

From a Marketing perspective, the 4 P’s (product, price, promotion, and place) need to be reconsidered with the new model. Stitch Fix has 90 data scientists on payroll that rather than focusing on the new punch line for the marketing blitz they are working to review data to recommend better customer experiences. Most notably, the first P (product) needs to be changed to an S with the focus on service over product. But most importantly, price, most often referred to in business as pricing and packaging, is the single most important item as it represents the most powerful growth lever. Put directly, this must change the most and be done right. With pricing being the dollar amount you assign to the value of your service and packing being the decisions you must make when assigning a specific set of features with a particular pricing plan, the subscription pricing model is much more complex as you are pricing an outcome and not a widget. The two main pricing approaches are consumption-driven growth which represents a subscriber using more of a service (such as freemium to premium conversation) and the capability-driven growth which represents users adding more features. You must carefully define your basic and basic plus tiers as you want a basic tier that attracts users as they buy into the value, but that also converts 70% or more to a higher tier because of continued belief in the value. Promotion focuses on walking the viewer through the rooms of the art gallery. The first room is a 100,000-foot business transformation view, followed by the marketplace story, and finally the product story. These are traditional items but in a more encompassing narrative format: context, value, and product. Notice that the first two really are not about your company at all, but more about the consumer and their benefit. And finally place, which moves the focus more to direct to consumer. And this doesn’t mean killing off your distribution channels, but more changing the flow of information to align with the narrative and create a more aligned approach. Back to the data scientist example, you are no longer waiting for survey results or six months of data, rather everything you need is right in front of you right now.

From a Sales perspective, relationship becomes the new focus. No surprise! The strategy set shifts with some approaches aligned to the traditional methods. Acquiring your initial set of customers is still key. The next, reducing your churn rate, is different as rather than building moats to changes, you are working to keep adding value in the eyes of your current customers so the recurring revenue you assign to them is actually recurring. From there, you can then expand your sales team, that team can increase value to the customer through upsells and cross-sells, then expand, expand, expand. The final item, optimize your pricing and packaging. It was mentioned earlier this is the most important part of the transformation. It is also the most important part of succeeding. Many companies spend less than ten hours a year on this critical item. Ensuring that your sales plan includes a collaborative and complete pricing and packaging strategy that is executed in alignment with the overall business shift is key.

From a Finance perspective, a fundamental view change from the traditional income statement to new subscription economy income statement will ensure the appropriate focus to successfully swallow the fish. This moves the view from the traditional backward-looking view to a view focused on how you make the right R&D financial decisions when your revenue is decoupled from the release of new updates. Although the traditional income statement where debits and credits always equal will continue to exist as an outward view for the SEC and investors, an internal view that updates the statement to look at annual recurring revenue, removal of churn, and additional of annual contract value through new growth and up growth, will enable financial decisions to be made in alignment with the new sales model. This includes updates to contracting processes that support renewals rather than just straight buys.

Subscriptions are the only business model that is entirely based on the happiness of your customers. While it is a simple concept to understand, it is a difficult concept to realize due to the cultural changes required across companies inclusive of the investment community to be successful.

LESSON LEARNED

The short of it is that businesses must make this change. It cannot be a change that is tried and then continue with business as usual if it doesn’t work. The change requests a commitment to succeed with over communication on why. Businesses should not try to figure this out themselves, there are playbooks and examples everywhere. Although there are critical cultural changes that must occur across the companies and in strategies from Marketing to Sales to Finance to IT, the pricing and packaging of what is sold is one of the most important aspects. This will help drive the changes need to IT systems to then support the new business workflows. Communication is also critically important. Communicate. Communicate. Communicate. From business unit strategies to investors, the buy-in to the strategy will get everyone on board and enable everyone to change the mindset that can achieve the progress Adobe saw from $0 in annual recurring revenue to $5B in annual recurring revenue in 7 years along with a 700% plus return on investment for shareholders. Win, win!

References:

• Tzuo, T. (2018). Subscribed: Why the Subscription Model Will Be Your Company’s Future – and What to Do About It. Portfolio/Penguin.
• Swallowing the fish: the risks of transforming your service into a subscription at https://www.cerillion.com/Blog/December-2020/Swallowing-the-fish-the-risks-of-transforming-your