Benchmarking Your Recurring Revenue Model

Benchmarking Your Recurring Revenue Model

I just finished reading The Automatic Customer by John Warrillow. His other book, Built To Sell, is on my top 10 list of business books worth reading, so I was excited to check out some of his other work.

While I think the content in Built To Sell is hard to top, this book offered a lot of great ideas for those of us looking to build recurring revenue businesses, no matter what industry we’re in. What I found particularly helpful was the way Warrillow identified several analyses and benchmarks that can help us measure how healthy our membership and subscription businesses are.

Here are three benchmarks he highlighted that I’d encourage you to take a look at. They’re a great way to measure the effectiveness of your recurring revenue streams.

It’s as Easy as LTV > 3 * CAC

Huh? Let’s take a step back and start with some definitions.

Lifetime Value (LTV) is defined as the profits you receive from a subscription customer over their anticipated tenure as a customer. So let’s say you charge $100 per month, your profit margins are 90 percent, and a customer stays enrolled for 36 months on average. Their lifetime value would therefore be $100 * .9 * 36 = $3,240.

CAC stands for Customer Acquisition Cost. This is the total cost of acquiring a new member: the sum of ad spend and sales force time per new customer. So, if you spent $10,000 on marketing and $20,000 on your sales team to generate 30 new subscribers, your CAC would be ($10,000 + $20,000) / 30 = $1,000.

Here’s where the magic comes in. Research has shown that recurring revenue models are sustainable when LTV is greater than three times CAC. In this example above, LTV is 3.2 times as great as CAC, so we’ve found a sustainable business model.

But what if instead of spending $30,000 to find 30 new members, you had to spend $50,000?  That would mean the CAC would be about $1,667, meaning your LTV would be only 1.9 times CAC. This signals an unhealthy recurring revenue model.

I bet now you’re eager to go crunch your business’s numbers! What should you do if you find your LTV to CAC ratio is below three? Take a look at the levers. You either need to increase the amount of money you make per customer or decrease the amount you spend to acquire one.

You could find ways to increase monthly fees by adding more value to your product and services. You could work to reduce churn and increase the number of months a customer remains subscribed (more on that below). You could take measures to improve the margins of your product. Or you could look at more efficient ways to sell.

For one of our clients in the education space, we found that their CAC was around two, yet our pricing analysis determined there was an opportunity to increase pricing without reducing overall sales. We did this by increasing the average price. We also saw a way to better leverage their website to drive more self-service conversions, reducing the need for salespeople to get involved in closing a deal. By increasing the LTV and reducing the CAC, we were able to get this company to an LTV almost five times as great as CAC, making the model far more economical.

Think About Net Churn, Not Gross Churn

Look, churn is natural, and you’ll never get it to zero. Unfortunately customers move, pass away, run into life problems, and will cancel no matter how awesome you are. So now you’re left with managing avoidable churn. A lot has been written about how to reduce churn…a topic for another day.

This is where another amazing lever enters the scene: Counterbalance your churn by upgrading existing customers.

Net Churn = Gross Churn – Upgrade Revenue

Let’s say your monthly recurring revenue is $100,000, you charge $100 per month, and you lose 20 subscribers per month due to churn. That means your Gross Churn Rate = ($100 * 20) / $100,000 = 2%

But you also have an upgrade program, where you try to move your existing subscribers from the basic $100 plan to a $150 per month premium plan. Let’s then say you are successful at upgrading 30 members per month. Your Net Churn becomes ($100 * 20 – $50 * 30) / $100,000 = 0.5%

You can only move subscribers to more premium products if you have them to offer! That’s where a product pyramid comes in. Creating a one-size-fits-all model inhibits your ability to take advantage of the enthusiasm of your biggest fans (who we like to call your whales). People who already love your basic offerings are often eager to move up to bigger and better options, but they’ll only be able to do so if you have a model that includes premium products.

Why Raise Money When You Can CUF:CAC?

One dilemma with the subscription model is that typically you need to wait some time until monthly revenues “pay you back” for your upfront sales and marketing efforts.

In the example above, with monthly profit per customer of $90 and a CAC of $1,000, it would take over 11 months to earn back your initial investment. That’s actually not so bad, but you need cash to finance that gap.

Instead of raising money from investors, redeploying profits from other operations, or taking a loan from the bank, you can simply charge more up front. This is known as increasing your Cash Up Front (CUF)—the amount of money you get from a customer when they decide to buy. This has two different flavors. You can either charge for the full year up front, or you can charge some sort of implementation fee. 

In this illustrative example, let’s say you charge a $1,000 set-up fee. That means your CUF:CAC ratio increases from 0.09 to 1.09 (i.e., from $90:$1,000 to $1,090:$1,000). Whenever your CUF:CAC is greater than one, that means you don’t need to fund growth—you have a self-financing growth engine! If CUF:CAC is less than one, that means you have to find other sources to fund expansion.

Here’s a real-life example. HubSpot reduces their cash needs by requiring new customers pay $2,000 for training. The customers are happy to do so because they feel like they are getting value from the course. But the secret is, the course itself costs far less than $2,000 to execute; it’s just a way to quickly earn back some of the CAC.

What Else Does John Say?

The book also talks a lot about the benefits of recurring revenue, which, as a subscriber to this newsletter, you’re already familiar with. He also covers different recurring revenue models, but if you’re tight on time, I’d skip this section; it’s quite basic. Finally, he discusses how to reduce your churn rate with ideas on effective onboarding strategies, maintaining multiple tiers to allow subscribers to upgrade/downgrade rather than cancel, and requiring customers to pay up front to increase commitment.

So how are you performing on the benchmarks? Is your lifetime value greater than three times your customer acquisition cost? Are you using upgrade revenues to offset your churn? What can you do to increase your ratio between cash up front and customer acquisition cost? 

Want ideas on how to improve where you’re falling short, or how to take great performance and make it outstanding? Drop us a line with your questions.

About The Sterling Woods Group, LLC

The Sterling Woods Group’s mission is to help clients make sense of their data to predictably grow sales. We apply data science to help you optimize your sales funnel, improve your marketing ROI, launch new products successfully, and enter new markets profitably.

We use a hypothesis-driven, data-supported methodology to discover insights that no one else is paying attention to. Then, we help you assemble the right sales strategies, marketing plans, technologies, and resources to seize this opportunity.

About the Author

Rob Ristagno, founder and CEO of the Sterling Woods Group, previously served as a senior executive at several digital media and e-commerce businesses, including as COO of America’s Test Kitchen. Starting his career at McKinsey, his focus has always been on embracing digital technology and data science to spur strategic growth.

Rob is the author of A Member is Worth a Thousand Visitors and is a regular keynote speaker at conferences around the world. He has been featured on ABC, NBC, CBS, Fox, and Digiday.

He holds degrees from the Harvard Business School and Dartmouth College and has taught at both Harvard and Boston College.

Rob lives outside Boston, MA with his wife, Kate; daughter, Leni; and black lab, Royce.

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