Startups

The 4 Numbers You Need to Know Before Investing in a Subscription or SaaS Business

Recurring revenue is a wonderful thing, but not all subscription businesses are created equal

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If you’re considering startups as part your investment crowdfunding portfolio, chances are you’ve encountered more than a few selling their product or service via subscription. From Netflix and Spotify to Blue Apron to Birchbox (and even Barkbox, woof!), whether it’s digital content or dog treats, new companies are popping up everywhere to let you subscribe to get it — and a lot of them are raising capital via equity crowdfunding.

That means the ability to evaluate the potential of a subscription business is an important tool in your due diligence toolkit, and this post covers the basics around 4 numbers critical to understanding the health and long-term viability of any subscription business.

Subscriptions can be a great business model for a lot of reasons, not least of which is that they deliver a predictable stream of revenue instead of “lumpy” one-time sales, which may be linked to promotions or seasonal demand. But they also present unique challenges compared with more transactional sales, and there are 4 key numbers you should know about any subscription business before you invest in it:

  1. The average price (and whether it’s monthly or annual)
  2. The current number of customers
  3. The churn rate
  4. The customer acquisition cost (CAC)

Let’s look at each of those in more detail, as well as how to use them to better understand a subscription business.

1. Average price (and whether it’s monthly or annual)

This one is the easiest to get, since in many cases it’s available right from the company’s website. Where it gets a bit tricky is if there are multiple options available (like a Basic vs. a Pro package). If possible try and find out what the average price is across all variations. (Also, make note of whether that average price is based on a monthly charge or an annual one.)

The price alone can actually tell you quite a bit about a subscription business. For example, very low monthly subscription prices are usually found in products aimed at a general consumer audience (think Netflix), whereas higher prices (especially if they’re only offered annually) are more often found in businesses selling to other businesses (aka “B2B” — think Hubspot).

2. Current number of customers

Like the average price, this one should be fairly easy to get from the company looking to raise money. Really high growth percentages (“we grew subscribers by 500% last quarter!”) can sound impressive, but there’s a big difference in going from 10 to 60 vs. 10,000 to 60,000, even though the percentage increase is the same.

But the current number of customers is mostly useful as part of some of the other calculations we’ll talk about: for example, simply multiplying Average price X Current number of customers should yield a rough estimate of current revenue (again, be sure you understand whether the price reflects monthly or annual purchases).

3. Churn Rate

One characteristic common to every subscription business is that during any given period, some of the subscribers will choose to cancel their subscription. Maybe they don’t want or need the product anymore, maybe they are cutting costs, maybe they’ve moved out of the service area for the product. Or maybe their credit card expired and you’re not able to bill them anymore.

When a customer’s subscription stops, that’s often referred to as “churning out”, and it’s usually expressed as a percentage of the subscriber base. For example, if a company has 1000 subscribers this year, and next year only 750 of them renew their subscription, the churn rate is 25%.

Thanks in part to the law of large numbers, most subscription businesses have a surprisingly stable churn rate. It’s very difficult to predict whether any particular customer will churn, but when looked at in aggregate, if it’s 25% this year, then unless something significant changes, it will very likely be about 25% next year too.

A super-important implication here is that the number of customers lost is a function of the number of customers overall, so that the absolute number of customers lost grows as the customer base grows.

Put another way, if the total number of subscribers grows over time, the total number of cancelling customers will grow along with it. In the example above, when there were 1000 customers, the business lost 250 of them; if a year later they have 10,000 customers, odds are they’re going to lose 2,500 of those when it’s time to renew.

Why is that important? Because continually growing the customer base in a subscription business is not just about finding new customers, it’s about finding enough new customers to grow and to replace those that churned out. In our example, if the company has 10,000 customers and wants to grow that by 50% to 15,000 customers next year, they don’t just need 5,000 more customers, they need 7,500 — 2,500 to make up for the ones that churned out, along with the 5,000 needed for absolute growth (and the following year they’ll have to find a way to replace the 3,750 who will churn out of the 15,000!).

Also, just as you can estimate revenue by multiplying customers by average price, you can estimate a company’s customer lifetime value (LTV) by dividing the price by the churn rate. For example, if the product above costs $100 per year, and the churn rate is 25%, the average lifetime value is approximately 100/.25, or $400.

Understanding churn rate will also help you understand how realistic a company’s growth prospects are, especially when combining it with LTV and with our next metric ….

2. Customer Acquisition Cost (CAC)

If you know the churn rate and the number of customers you can work out how many new customers are needed to reach any given growth target (just like I did above with the 10,000 to 15,000 example). But it’s also important to know more about how much it’s going to cost to actually get all of those new customers.

In its simplest form, customer acquisition cost (CAC) is just dividing how much was spent acquiring new customers (sales, marketing, advertising, commissions, etc.) by the number of new customers. With the CAC, you’ll then know how much the business will have to spend to get those customers.

In particular, you want to work out whether the CAC is sustainable relative to the lifetime value (LTV). If it costs a business $100 to acquire a customer but they’ll only earn $50 over time from that customer, then whatever growth is happening is unsustainable (some companies, especially in the startup stage, choose to spend more to acquire customers than they’ll earn because they’re focused on something besides profitability — like growing the number of users).

As a very rough rule of thumb, a CAC that is about 1/3 or less of the LTV is healthy and sustainable.

Putting it all together

With these metrics in hand, let’s look at some conclusions we can draw about subscription businesses.

  • Competition drives down prices while driving up CAC. This is especially true of companies that rely heavily on paid online advertising to acquire new customers. The more companies bidding for the same ad inventory, the higher those ad prices will go. Ironically this exact dynamic is at work within the crowdfunding ecosystem, especially among real estate platforms, many of which are competing for the same pool of accredited investors (see RealtyShares).
  • Overall CAC spending will grow inexorably without a low-cost acquisition channel. All else equal, getting to 10X the subscribers will require 10X the customer acquisition costs. That can work for a time, but eventually the capital requirements to fund that kind of growth will be challenging to keep up with, and growth will stall. The exception is if a company can find a free or low-cost customer acquisition channel. For example, if the product has a viral component, and each new customer results in 2 or 3 more. Another example is if a company has a high level of organic search traffic, which while expensive to build, essentially delivers a perpetual stream of free prospects to try and acquire as customers.

There’s of course more to evaluating a subscription business than just these numbers, but knowing them can help guide your further research and due diligence before making your next equity crowdfunding startup investment.