Our firm does a lot of “B2B” and “B2B2C” investing. We are comfortable backing start-ups attacking the SaaS/software/tech spaces, whether they end up selling directly to other businesses or helping other businesses sell something unique to consumers. An example of the former is VoltDB, and an example of the latter is OwnerIQ.
So, it is with that lens that I quote my super-smart partner, Eric Hjerpe: we, meaning entrepreneurs and VCs, have killed one of the best revenue models out there. That is because we have shifted from the traditional licensing model and moved to subscription revenues.
The traditional licensing model was very cash-rich. Say you wanted to buy some software from IBM, and let’s say that it costs $100,000. The pricing model would mean that you would pay $100,000 up front and then $20,000 a year per year for maintenance/support. That was a great way for start-ups to get non-dilutive cash into their companies: license revenue.
Now, assume apples to apples. The subscription model says this: the customer agrees to pay $100,000 over, say, three years. That $100,000 order is called a “booking.” So, each payment is $33,333, which the start-up reports as “revenue” each year for three years.
In the first year, $66,666 of the booking then moves into what accountants call “back log.” The positives of this model is that the start-up now knows that it can get $33,333 each year for the subsequent two years. That creates phenomenal visibility into future revenues and helps forecast top line growth to the ever-vigilant VCs on the Board.
But, there are two downsides. The obvious one is the start-up gets less cash into its coffers short term. Since cash is king, less cash means less margin of error allowed for the entrepreneur.
In fact, if you model it out, the faster a company grows revenues, the more cash it will need to raise, since it isn’t collecting all the cash up front from customers. In other words, you can show good growth in revenue, but you’re less well-off regarding that which pays the bills: cash.
The less-obvious downside is that customers can usually opt out of a contract without penalty. And, if a contract does have a cancellation penalty, many customers ignore it, knowing that it is very unlikely that a vendor will sue its own customers.
So, if customers churn (and, they often do), a pretty clever new revenue model involving subscription revenues has gone from sounding pretty effective to this: a pure transfer of value from the start-up to the customer. Thus, it can be a situation whereby the entrepreneur is quite literally subsidizing his/her customers.
This mathematical fact has huge implications for entrepreneurs and how they manage costs and how those costs fit into the go-to-market strategy. But, I’ll save that for a future post.