Recurring Revenue: Models, Metrics and More on Subscription-Based Revenue
Sep 12 2020
Recurring revenue is the lifeblood of subscription companies, and for good reason. First, it lowers the activation energy required for companies to try the product. Companies can try the product before committing to a multi-year license. It also ensures customers receive perpetual value from the product. If the product doesn’t hold up its end of the bargain, a customer can churn. Finally, recurring revenue gives the company a sense of predictable revenue and compounding growth.
Implementing a recurring revenue model requires enabling a data-driven process and understanding the axes through which SaaS metrics impact your business. Throughout this article, I’ll unpack what recurring revenue is, some examples of different models, and revenue metrics you need to track.
Recurring revenue is revenue continuously brought in by customers who are on a subscription. Recurring revenue is not only more predictable than regular revenue, but also more stable (if you have a happy customer base).
What is the recurring revenue business model?
The recurring revenue business model is a model in which a business’s primary revenue stream is from recurring subscriptions, rather than one-off purchases. Recurring revenue businesses rely on metrics like ARR (annual recurring revenue) and MRR (monthly recurring revenue) to measure growth.
Many companies don’t take the time to comprehend what’s driving their recurring revenue, and miss a great opportunity to learn and grow through understanding cash flow and metrics.
Having a strong foundation in your recurring revenue metrics can help you recognize where growth is or isn’t coming from. Every subscription company should be tracking metrics, including revenue, upgrades, downgrades, churn, customer reactivation, and total monthly recurring revenue (MRR), to understand the truth behind their monthly subscription growth and where to invest their resources.
Why the recurring revenue model is becoming so popular
For the first time in the history of business, we have a revenue model where the relationship with the customer is baked directly into how you make money.
The recurring revenue model allows you to:
Control retention and identify upsell opportunities
A recurring revenue model allows you to master customer retention, then use it to up and cross-sell. Data shows that retention produces far more effective growth than through acquisition. Thus, you must continually foster the customer relationship to control retention.
Identify customers on the verge of churn
Recurring revenue comes with the risk of churn, but you can take steps to reduce it. Recurring revenue gives you consistent data to examine, so you can track customer patterns and predict when someone is on the verge of churning.
Build customer loyalty
Recurring revenue means recurring customers, thus, you have to build long-term relationships. Communicate consistently with customers and provide them with stellar customer experiences to nurture their loyalty.
Popular recurring revenue models
Recurring revenue goes beyond subscription models. In fact, you’ve likely encountered various recurring revenue models without even realizing.
Customers will sign a contract covering a certain time period with monthly payments. Take AT&T for example. You can choose your pricing plan, but you’re obligated to a contract. You can bundle phone and internet for $72/mo, but you’re locked in for a year.
Auto-renewal subscriptions are exactly how they sound; companies collect revenue automatically until a customer cancels the subscription. Auto-renewal subscriptions are known as evergreen in the world of recurring revenue because they can go on forever
Subscriptions are finite with the option to continue or not. Almost every streaming service is subscription-based—Netflix, Hulu, HBO, Disney+, etc.
Tiered-billing is recurring revenue with a pricing structure equipped with built-in tiers. Each tier is constructed for a certain buyer persona and capped off in price. Tiered billing offers more functionality or usage with higher tiers.
Usage subscriptions are when customers are billed for their usage on a regular schedule. Your utility bill comes in monthly, but it’s a different charge each month depending on how much electricity and water you used.
Does length of contracts matter?
You can decide the length of customer contracts in a recurring revenue model.You can choose long contracts that are annual, or even bi-annual; or, you can choose short contracts, which are monthly.
In general, ProfitWell believes longer contract lengths are better. Long contracts can be more difficult to acquire since they require a great deal of trust between both parties, but it secures more revenue. Long contracts lead to fewer purchasing decisions each year and fewer credit card failures. Therefore, leaving less room for churn.
However, if the contract length is too long, you can’t increase prices as easily. As you increase the term beyond one year, the reduction in churn is minimal so there’s not much to be gained in terms of retention for two-year (or more) contracts.
Short contracts are better for initial clients who need to be shown that your product can work. The revenue is minimal, but sometimes short contracts result in better margins per month. For example, a prepaid phone plan may cost $25 per month, but only $150 per year.
Short contracts mean customers have to make more purchasing decisions. So if the contract is month-to-month, that’s 12 purchasing decisions a year.
Importance of tracking and understanding your recurring revenue
Once you acquire a recurring revenue model, you must remain current on specific metrics in order to be aware of your company’s health.
Tracking basic recurring revenue metrics can help you:
When taking a look at your metrics, you can see things, such as popular months for new customers and when to push advertising to capitalize on those time periods. Double down on acquiring segments that have high retention.
Identify high-value customers
Identify the customers who spend the most on your product, and reach out to ask what they like the most. Push those values and upsell opportunities.
Identify close-to-churn customers
Identify customers who have shown lower usage times over the past few months, and keep them from churning. Offer them discounts, get feedback etc.
See where money is being lost
Your recurring revenue may be gaining over time, but a quick look at your metrics could show you where some customers are dropping off and costing you money. Doing some cohort analysis can help in identifying which segments of customers are cancelling over time.
4 recurring revenue metrics to start tracking
There are tons of metrics you could track, but I’ll unpack the four I think are most important to look at on a regular basis.
Monthly recurring revenue, or MRR, measures the total amount of predictable revenue that a company receives on a monthly basis. Companies track MRR for financial forecasting and planning, as well as for measuring growth and momentum. Businesses with less than $10 million ARR tend to focus more on calculating MRR.
Annual recurring revenue, or ARR, is your MRR multiplied by 12. It accounts for all recurring revenue within a year. Not calculating ARR and MRR correctly means you’re not only lying to investors and your team, but you’re miscalculating the health of your business. Tracking MRR and ARR will help you plan for the short and long term.
Average revenue per user, or ARPU, is the average amount of monthly revenue each user brings in. This metric allows you to identify trends and implement changes that can shift the trajectory of your business toward a larger pool of SaaS profits.
Lifetime value, or LTV, is the total dollar amount you’re likely to receive from an individual customer throughout the life of their account with your company. LTV shows a more complete picture than other metrics. A growing LTV means your company is doing well. A declining one indicates your company is acquiring less money from each customer and you need to act accordingly. Tracking LTV can inform decisions, such as how much you can pay to acquire a user, the effects of losing users, and how changes to a product impact the sum-total revenue you can expect to bring in from a user.
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By Patrick Campbell
Founder & CEO of ProfitWell, the software for helping subscription companies with their monetization and retention strategies, as well as providing free turnkey subscription financial metrics for over 20,000 companies. Prior to ProfitWell Patrick led Strategic Initiatives for Boston-based Gemvara and was an Economist at Google and the US Intelligence community.