Subscription revenue can be defined most simply as a model which generates income from customers through recurring fees that are paid at regular intervals. These can be weekly, monthly, or annual payments. Before we get into the more complicated stuff, let’s consider the difference between earning revenue and collecting revenue.
According to many tax authorities, SaaS companies must use the accrual accounting system, which stipulates that you record revenue when it is earned. In the case of a subscription revenue stream, this means when you have fulfilled your part of the service agreement.
Consider the following two (very unrealistic) subscription revenue examples to make this point clear.
1. Your company has only really great clients who all pay for their annual subscription on January 1st. These invoices total $600,000. As much as we’d all love to take 364 days off and call that a job well done, you haven’t actually done anything yet!
U.S. GAAP (Generally Accepted Accounting Principles) standards stipulate that instead you should move $50,000 at the end of each month into your revenue account and keep the unearned subscription revenue in a deferred revenue account as you have not yet earned the money.
2. Your company has a mix of good and not so good clients that either pay their invoices monthly or don’t seem to pay them on time for various reasons. In this case, you might be earning $50,000 at the end of each month, but you may not be receiving all of it until some days, weeks, or months late—or, unfortunately, sometimes not at all.
In the first case, you have more cash on hand than your company has actually earned. In the second case, you have less cash on hand than you have earned, and you might not even receive all the money you have earned. Both situations can give you an unrealistic view of your company.
It’s important to know who has given you money, and from what type of plan you have received this money. Using Baremetrics, you can measure exactly where your MRR has come from, and plan your accounting accordingly.
Connect Baremetrics to your revenue sources, and start seeing all of your revenue in a crystal-clear dashboard. You can even see your customer segmentation, deeper insights about who your customers are, forecast into the future, and use automated tools to recover failed payments.
Subscription Pricing Models
There are several pricing models that can be used for your subscription revenue service.
- The flat-rate pricing model is the simplest recurring fee model. You charge everyone the same flat fee for your product and bill them weekly, monthly, or annually.
- The tiered pricing model is a better model for services which scale in usage with revenue, employee count, or number of customers. You can charge different clients different amounts based on their size or the features they want to utilize. Most companies have between two and five tiers.
- The usage-based pricing model charges based on how much the client uses the service. There may or may not also be a base fee. Usage can be measured by total revenue, API calls, transactions, number of employees, etc.
How to Get Subscription Pricing Right
Once you have settled on a pricing model, it is time to price your model. Aside from the very technical aspects of calculating what it costs to offer your service, including the constant upgrading of what you provide, the cost of acquiring new clients, and the value add you give to your clients, there are some broad concerns to consider.
- Avoid Hidden Charges: About half of all customers will abandon their purchase if they see an unexpected fee on their transaction while processing. This shouldn’t surprise anyone as we’ve all decided against a purchase because the company added an unexpected shipping charge right before checkout. Consider skipping unnecessary onboarding or processing fees where possible and aim for full transparency when they are necessary.
- Offer a Free Trial or Add a Freemium Option: You know that your SaaS service provides immense value to your clients, but how can they know that? Offering a free trial is a good way for prospective clients to see just how much value your product provides them. Similarly, if your finances support it, consider a freemium option that can allow you to potentially onboard clients with valuable add-on services over time.
Get Subscription Pricing Right!
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The Advantages of a Subscription Revenue Model
Although almost any product or service can be turned into a subscription revenue model, when your SaaS company seamlessly meshes with a subscription model, the advantages are substantial.
1. Subscription Revenue Provides a Recurring Payment Cycle
Unlike a traditional business model, where you sell to a customer and move on, a subscription revenue model gives you recurring payments from the same customer. This can allow you to offer a lower upfront price to clients, while setting up your business to receive a stable and consistent cash stream.
2. Subscription Revenue is Easier to Scale
Every time you onboard a customer, you need to create an invoice, get their payment information, and provide some immediate customer service. For a traditional business, this happens for each payment, whereas a subscription revenue model only deals with this once per customer. That frees up your effort to work on expanding your services suite or finding new clients.
Similarly, for a traditional company to double their sales monthly, they’d need to find 1, then 2, then 8 (or more!) customers each month. Since a subscription revenue model maintains long, mutually beneficial relationships with customers, to dramatically improve revenue a sales team only needs to find marginally more new customers each month.
3. Better Customer Relationships
Since your SaaS company can maintain long relationships with clients, you can see what products they are using, and listen to what they are looking for. This gives you the opportunity to tailor your offering to the benefit of the client. This makes it easier to retain clients, better position yourself in the market for new clients, and even upsell your existing clients with new add-on features.
Baremetrics monitors subscription revenue for businesses that bring in revenue through subscription-based services. Baremetrics can integrate directly with your payment gateway, such as Stripe, and pull information about your customers and their behaviour into a crystal-clear dashboard.
How to Calculate Subscription Revenue
There are many, many ways to calculate your subscription revenue—and each of those ways has many, many alternative calculations that could be better for you. Let’s look at a couple of the main ones.
1. Annual Recurring Revenue (ARR): This is the most common way to calculate subscription revenue. This metric is ideal for customers with long standing contracts that either pay up front for a contract lasting over 12 months or pay monthly with a contract in place that will last at least one year.
Let’s consider these subscription revenue model examples:
- If you have one customer and they have a two-year contract valued at $12,000, then their ARR is $12,000/2 = $6000.
- If you have 20 customers each paying $1000/month, then you need to first multiply the 20 by $1000/month to get your total monthly income of $20,000. Then, you multiply your monthly income by 12 to calculate your total ARR: $20,000 × 12 = $240,000.
Although ARR can be a useful metric, if your customers pay by usage, often purchase new add-ons, or otherwise have flexibility to increase or decrease their payments each month, then calculating the ARR is difficult.
2. Monthly Recurring Revenue (MRR): This metric is similar to ARR but calculates how much your customers are paying in revenue each month. The formula is essentially the same as ARR, only the time period is one month instead of one year.
Let’s look at the same two subscription revenue examples from above.
1. Instead of dividing by two for the length of the contract in years, you divide by 24 for the length of the contract in months: $12,000/24 = $500.
2. In this case, just stop after the first step: 20 × $1000 = $20,000.
The benefit of calculating MRR versus ARR is that you can adapt it as your customers cycle through different plan tiers or add/drop some add-on features.
When deciding which metrics to track, consider going through the different versions of each metric. For example, MRR also comes in a net MRR version which might be better suited to your needs.
3. Lifetime Value (LTV): Getting customers to sign up for your service is difficult—and expensive too! LTV is an absolutely crucial metric to follow so that you know how much you can spend on customer acquisition. LTV is simply how much your customers will spend on your service during the lifetime of their contract.
In addition to the above information, to calculate LTV, you need to know how long your customers use your service before severing their service agreement.
Let’s look at the above examples and consider an average lifetime of 10 years.
- Your customer pays $12,000 for each two-year contract, so their LTV is $12,000 × (10/2) = $60,000.
- Each customer pays $1000/month, so the LTV of each customer is $1000 × (12 ×10) = $120,000.
Since LTV requires some estimation about churn, it can be misleading.
Take a look at our article dedicated to LTV to gain more insight into how best to use this crucial metric.
Keeping track of all the available metrics to maximize your recurring revenue through customer retention, upselling, and new customer onboarding is important but difficult. Thankfully, Baremetrics is a business metrics tool that provides 26 metrics about your business, such as MRR, ARR, LTV, total customers, and more.
Check out the Baremetrics free trial and start getting great metrics on your subscription revenue! Data drives understanding, so don’t hesitate to get great data on your subscription revenue.