Introduction
We had been running together for five months when Sacha announced he was leaving on a business trip to China. The timing could not have been worse; the marathon was just six weeks away, and we had come to rely on each other to stay motivated through the hardest part of our training schedule.
Now, at the height of our work, he was leaving for two weeks.
Since Sacha and I wouldn’t be able to run together, we decided to egg each other on digitally. We agreed to text each other the results from our training run each day as a way to stay motivated. Sacha asked if, instead of texting, we could use a messaging service called WhatsApp.
I was used to texting using the standard service on my iPhone, so I wasn’t in a hurry to learn a new platform. I asked him why we couldn’t just text the normal way.
Sacha replied that the phone company charges a relative fortune to text from China, and WhatsApp, instead of using the mobile networks, runs on the Internet and therefore doesn’t require expensive mobile carrier fees. In fact, the only fee to use WhatsApp is a $1 per year subscription it charges after the first year.
We used WhatsApp to communicate while Sacha was in China, and eventually finished the marathon together, thanks in part to our WhatsApp-supported training regimen. It turns out that, in using WhatsApp, we were not alone. By early 2014, WhatsApp had acquired 450 million users and was adding a million users per day when Facebook announced it had acquired the company for $19 billion—the largest acquisition of an Internet start-up in history.
Most of the other Internet-based messaging services at the time used an advertising model to monetize their users. They offered a free platform but bombarded users with cheesy ads in return. WhatsApp founders Jan Koum and Brian Acton wanted to offer a cleaner, more private messaging experience. Instead of selling advertising, they opted for the subscription business model.
A dollar a year as a subscription fee may not sound like much, but when you have 450 million users and are picking up a million users a day, $1 a year starts to add up. What’s more, because WhatsApp doesn’t try to be anything other than a subscription-based messaging platform, it doesn’t need a lot of employees. In fact, at the time of its acquisition, it had just 55 people taking care of its 450 million subscribers.
WhatsApp won the $19 billion lottery not because its technology was better, or its people were any more caring, or its advertising was funnier. WhatsApp won, in large part, because it made its customers automatic. It chose the right business model for success by asking users to subscribe to its service.
This book will show you how to apply the subscription business model to your own business. When people think of subscriptions, they often think of cloud-based software, gaming, or media companies. While readers from those industries will benefit from this book, you can also apply the subscription business model to your company—no matter what your size or industry. WhatsApp is only one example of how powerful automatic customers can be for the growth of your business.
I Screwed Up
The last time I wrote a book, I screwed up.
Called Built to Sell: Creating a Business That Can Thrive Without You, the book was designed to illustrate how to transform a successful business into a sellable one. In it, I touched briefly on the importance of having customers who repurchase from you on a regular schedule, but in hindsight, I should have dedicated at least half the book to recurring revenue.
In the years since Built to Sell was published, I’ve come to see how important recurring revenue is in building a valuable, sellable company. These days I run a subscription business called The Sellability Score (SellabilityScore.com) that helps owners build valuable companies by examining the eight key drivers of sellability. Owners who achieve a Sellability Score of 80 or more out of a possible 100 garner offers that are 71% higher than the average.
The biggest factor in driving up your Sellability Score is the degree to which your company can run without you, the owner. That’s a head scratcher for a lot of owners who are the best salesperson in their business. The secret is to build recurring revenue that brings in sales without having to resell the customer each month.
To appreciate the impact of recurring revenue on your company’s value, you have to understand what buyers are buying when they acquire a business. Most owners want buyers to value their past achievements, such as last year’s profits or an industry award they’re proud of. In fact, it has been my experience that financial buyers are really buying only one thing when they purchase a company: a future stream of profits.
In the home security business, for example, companies have two forms of revenue. They receive installation revenue when they come to your home or office to install the keypad and wire things up, and they receive monitoring revenue in the form of the monthly payment for keeping an eye on things.
At SellabilityScore.com, we know from our analysis that when an acquirer buys a security business, it pays 75 cents for “one-shot” installation revenue and $2 for every dollar of monitoring revenue. Said another way, a security company with 100% monitoring revenue (the subscription aspect of such a business) is almost three times more valuable than a security business of the same size that has 100% installation revenue.
The same trend plays out across most industries. Accounting firms are valued based on their recurring fees. Financial planning practices trade based on how likely clients are to stay with the firm after the owner retires. IBM’s stock moves up and down based on its recurring revenue from service contracts.
So recurring revenue makes your business a lot more valuable, and it also makes your company less stressful to run.
The Tyranny of Selling & Doing
In 1997, I started Warrillow & Co., a research company. We started out as a typical “sell/do” services business; our job was to cultivate relationships with people, listen to their problems, and try to come up with a solution. Each project was different, and we spent the majority of our time developing custom proposals, many of which were never accepted.
The company was profitable on paper but debilitatingly stressful to run. I hated the first day of each month because that was when all the dials turned back to zero and we had to scramble to find enough business to cover our overhead.
I remember distinctly the first time our fixed expenses crested $100,000 per month. I thought to myself, “If we don’t sell anything this month, we still have $100,000 in expenses to cover!”
The stress of having to re-create the business from scratch each month led me in search of a better model. I started to study other research companies, like Gartner and Forrester Research, that had successfully “productized” a service and, as a result, began experimenting with automating parts of our business.
Instead of doing “one-shot” research, we decided to offer the identical packages of information to a subscriber base of customers. Instead of doing custom proposals, we created a brochure about our offering and a standard proposal. Instead of getting paid 60 days after the project was complete, we charged up front for an annual subscription to our research.
The business became much less stressful to run. We went into each new month with revenue on the books, and we were no longer beholden to any one customer. In fact, we starting winning the world’s largest companies as subscribers, including American Express, Apple, AT&T, Bank of America, Dell, FedEx, Google, HP, IBM, MasterCard, Microsoft, Sprint, Visa, and Wells Fargo. Charging for our subscription up front also meant that after a while we had more cash than we knew what to do with. To top it off, we were growing at a rate of 25% a year and were quickly replacing the revenue from the one-shot projects we had left behind. Warrillow & Co. was acquired by a public company in 2008.
You may be thinking, That’s nice, but it would never work in my industry or in my company. Maybe—especially if you cling to the standard industry practices of your category. But as you’ll see, virtually every business—from a start-up to a Fortune 500 company, from a home contractor to a manufacturer—can create at least some recurring revenue if it is willing to jettison the old way of doing things to pioneer a new business model.
And companies that don’t just might face competition from those that do. Increasingly, some of the smallest businesses in the world are facing crippling competition from the largest. The subscription economy has pitted small companies against big ones and suppliers against resellers, and has even made partners into enemies. The battle lines are being drawn, and I hope The Automatic Customer will be your secret weapon for winning in the subscription economy.
If you are someone who has a business that you would like to make a little more predictable, a little less stressful, and a whole lot more valuable, this book is for you. Whether you want to transform your entire business model or just pick up an extra 5% of automatic revenue, I hope you’ll see yourself in the following pages.
What You’ll Find Inside
The book is organized into three sections. Part One outlines the surprising truth about who is winning in the subscription economy, why companies like Apple and Amazon are transforming themselves into subscription businesses, and why virtually every venture-backed start-up has a recurring revenue model.
We’ll also look at eight ways your business will be more valuable and less stressful after you adopt the subscription model. You’ll learn how the subscription business model dramatically increases the average value of each of your customers, and how to smooth out demand in your company so that it matches your ability to fulfill it. We’ll discuss why automatic customers buy more than one-shot customers and why subscription revenue is stickier than a one-time purchase.
Part Two is divided into minichapters on the nine subscription business models. As you’ll see, you have a variety of choices when it comes to building a recurring revenue stream for your business. Whether you want to transform your entire business or just pick up a few thousand dollars of passive income, you’ll get a ton of new ideas for applying the subscription model to your company.
The third and final section of The Automatic Customer gives you the blueprint for building your subscription business. We’ll discuss a handful of key statistics that will define the viability of your subscription and highlight one ratio you must achieve in order to scale up. We’ll look at the psychology of selling your subscription and how to overcome something I call “subscription fatigue.” Then we’ll turn to financing the growth of your subscription business and explore whether you want to raise venture-capital funding, as WhatsApp and Dollar Shave Club did, or self-fund your growth, like FreshBooks and Mosquito Squad. Part Three ends with a discussion on scaling your subscription business.
Let’s get started.
PART ONE
Subscribers Are Better than Customers
Why are Amazon, Apple, and many of the most promising Silicon Valley start-ups leveraging a subscription business model? In Part One we’ll look at how automatic customers make your company more valuable . . . and a whole lot more enjoyable to run.
CHAPTER 1
Who Wins in the Subscription Economy?
Amazon has come a long way since its days of just hawking cheap books online. Of course, you can still buy books on the site, but today’s Amazon will sell you everything from diapers to laundry detergent. Increasingly, it is digging deeper into our pockets through the subscription service called Amazon Prime.
Amazon Prime subscribers pay Amazon $99 a year in return for goodies like free streaming of thousands of movies and TV shows and free two-day shipping on most Amazon purchases. According to a 2013 report released by Consumer Intelligence Research Partners, there are now approximately 16 million subscribers to Amazon Prime. As I write this, the folks at Morningstar estimate, since Amazon does not release the data publicly, that membership in Amazon Prime could swell to 25 million by 2017.
If you were to carve out Amazon Prime as a stand-alone business, it would already be a billion-dollar subscription company, but that severely underestimates the value of Prime to Amazon. Like many subscription models, Amazon Prime is a Trojan horse that is expanding the list of products consumers are willing to buy from Amazon and giving the eggheads in Seattle a mountain of customer data to sift through.
“It was never about the $79,” said Vijay Ravindran, who worked on the team that launched Prime at its original price of $79 per year. “It was really about changing people’s mentality so they wouldn’t shop anywhere else.”1
According to Morningstar, the average Prime member now spends $1,224 on Amazon purchases each year, compared with $505 for non-Prime customers.2 We cannot say Prime members spend that much more just because they are members, since presumably a lot of Amazon’s best customers would have been attracted to the free shipping offer. However, this data seems to suggest that once someone becomes a Prime subscriber, they become even more loyal to Amazon. Further, Morningstar figures that after factoring in costs incurred for shipping and streaming content, the average Prime member yields Amazon $78 more per year in profits than the typical customer.
Given the positive impact Prime seems to have on customers’ buying behavior, some analysts have argued that Amazon should drop the fee for subscribing to Prime in order to grow the program even faster. But that thinking misses a key element of Amazon’s strategy. When you pay $99 per year to become a member, you want to “get your money’s worth.” Suddenly you start checking Amazon’s pricing on annuity stream adjacent to your main business, you sorts of products, from paper towels to sneakers, with hopes of “making back” what you invested in the membership. Given Amazon’s aggressive pricing and seemingly endless product selection, you can almost always find what you’re looking for at a price that’s lower than what you could find elsewhere. When you factor in free shipping, it becomes an easy decision to buy from Amazon.
Robbie Schwietzer, vice president of Amazon Prime from 2008 to 2013, summarized: “In all my years here, I don’t remember anything that has been as successful at getting customers to shop in new product lines.”3
Through Prime, Amazon is competing head-to-head with the likes of Walmart and Target. Why should you care if three heavyweights are pounding it out for market supremacy? Because as customers buy a broader and broader collection of items from Amazon, Prime is cannibalizing the business of smaller companies too.
The other day I bought a pair of New Balance running shoes from Amazon. I’ve never thought to use Amazon for buying sneakers, but since I am now a Prime member, and therefore get free shipping on shoes, I chose Amazon instead of walking down the street to my local Running Room store.
The Running Room is a small company compared to Amazon, with 100 or so locations scattered around North America. Most people would not consider Amazon a direct competitor. Yet the Running Room is now losing my shoe-buying business because of a little $99-per-year Prime subscription I bought.
Everything by Subscription
Amazon, having learned a lot about the subscription business through Prime, is now applying the subscription model to other areas of its business. AmazonFresh is a grocery delivery business Amazon has been experimenting with in its hometown of Seattle since 2007. Amazon Fresh didn’t start out as a subscription business; instead, it was open to anyone willing to pay the delivery fee of $8 to $10 to have milk, veggies, and meat brought to their door in a one- to three-hour delivery window.
AmazonFresh stayed stuck in beta in one city for six years as the company tried to work out a profitable business model. The business proved challenging, which Amazon founder Jeff Bezos seemed to acknowledge in response to a question about AmazonFresh at Amazon’s 2013 annual shareholders meeting: “They have made progress on the economics over the last year,” said Bezos.4 “They’ve been doing a lot of experiments and trying to get the right mixture of customer experience and economics. I’m optimistic that the team is making good progress.”5
In spring 2013, AmazonFresh added Los Angeles as the second city for the program. But in L.A., the Amazon Fresh offer had one stark difference: L.A.-based customers were asked to subscribe to Prime Fresh for $299 a year, which gave them free grocery delivery on orders over $35.
As with Amazon Prime, the act of subscribing spurs Prime Fresh members to buy more frequently and from a broader array of grocery categories. If I’m ordering milk anyway, a customer might reason, why not top up the order north of $35 with a case of Coke and a refill on the laundry detergent I’m about to run out of? As with Prime, the very act of sinking money into a subscription triggers the desire for the consumer to want to “get his money’s worth,” which in turn creates the kind of customer behavior Amazon wants to see. And Amazon isn’t stopping at groceries: Subscribe & Save is yet another subscription service from Amazon; you subscribe to receive regular shipments of things you frequently run out of, like dish soap and paper towels. If you sign up for five or more subscriptions that share the same delivery date, you receive 15% off the entire order.
As more consumers consolidate their buying on Amazon’s subscriptions, the competition is reacting. In the fall of 2013, Minneapolis-based Target launched Target Subscriptions, a program similar to Subscribe & Save. Not surprisingly, its first focus was on baby products like diapers and wipes—a category Amazon placed a big bet on when it paid $545 million to acquire Quidsi, the creators of Diapers.com, which itself offers a subscription for diapers that enjoyed 30% month-over-month growth in 2013.6
Amazon is known for its wins in selling to consumers—but subscriptions can work for B2B as well as B2C. One of Amazon’s latest ventures is a subscription that offers to help other companies grow their subscription businesses. Amazon Web Services (AWS) offers companies access to servers, software, and technology support on a subscription basis. Many of the world’s largest subscription companies, including Adobe, Citrix, Netflix, and Sage, use AWS, along with many of the highest-profile start-ups, like Airbnb, Pinterest, Dropbox, and Spotify.
Amazon is pioneering the subscription model in virtually every area of its business, but the subscription model is nothing new. In fact, it’s been around for quite a while.
A (Very) Short History of the Subscription Model
The history of the subscription business model dates back to the 1500s, when European map publishers would invite their customers to subscribe to future editions of their maps, which were evolving as new lands were discovered, conquered, and claimed. The geopolitical landscape was evolving, and map publishers would obtain commitments from members of the noble and academic classes to subscribe to future volumes of their maps, giving the publishers the capital they needed to plot the world’s discoveries on paper.
This model was then applied to early newspapers and magazines, dating back to the periodicals of 17th-century Europe.7 Eventually the subscription model became the standard business approach for information publishing. Readers were asked to subscribe to general interest publications, and their subscription fees, combined with advertising revenue, provided the money needed to fund the editorial product and the cost of mailing the publication to each reader. This trend continued well into the 20th century, as it was also a reliable way to get rich. Publishers like William Randolph Hearst and, more recently, Rupert Murdoch have made their initial fortunes from publishing subscription-based newspapers.
