Note: This article was originally published on CFO.com.
Companies that rely on recurring revenue business models are rapidly growing market share and Wall Street is rewarding their performance with higher multiples. More and more successful enterprises such as Amazon, Adobe, Salesforce, Netflix, Audi, and Uber are employing recurring revenue models across a wide range of target customers and verticals.
Increasingly, consumers prefer incremental payment arrangements. In the U.S., nine out of ten adults, more than 226 million people, take advantage of online subscription models. On average, they spend more than $850 in monthly subscription fees, including utilities, auto insurance, mobile phone plans, and health-care premiums. No wonder nearly half of U.S. businesses have adopted recurring revenue models, or are planning to.
As a CFO, adding recurring revenue to a business may seem like a slam-dunk. But, be warned. The CFO has to constantly measure to determine if the model the company is using works, or if it should recalibrate to master changing market conditions.
I polled a group of respected VCs, billing experts, and thought leaders to come up with a short list of “go-to” metrics I think every CFO of a recurring revenue business should track.
Here are my top 5. Use them to measure performance and determine where to fine-tune a model to maximize outcomes.
1. Customer Lifetime Value (CLV)
Formula: ((MT x AOA) AGM) ACR
MT = Number of Monthly Transactions
AOA = Average Order Amount
AGM = Average Gross Margin
ACR = Average Customer Retention (in Months)
Bob Feghali, a billing industry adviser, puts CLV at the top of his list. It reflects the total revenue derived from a customer over the course of the relationship. In addition to showing the potential dollar value of a customer over time, it also tells the CFO how much that customer should cost.
“Average CLV allows a business to know how much to spend on customer acquisition and be profitable,” says Feghali.
Using Feghali’s formula, let’s see what the CLV would be for a customer of a hypothetical recurring revenue business, say, a high-end subscription wine club. The customer makes one transaction of $100 per month. We’ll say that the gross margin is 25% and the average customer retention is 36 months. The formula would be: ((1×100) x .25) x 36 = $900
In theory, this wine business should spend below $900 acquiring this customer and be profitable. But as we’ll see a bit later, there’s a metric that can tell the business just how much recurring revenue to shoot for per customer.
2. Average Revenue Per User (ARPU)
Formula: Total Revenue/Total Subscribers
Ted Brookbank, senior partner at Advanced Technology Group, favors this metric. ARPU measures how much revenue a company generates per user (or unit) over a given period of time. Industries that rely on ARPU include communications and networking companies and many SaaS businesses that provide subscription- or usage-based services.
Says Brookbank, “ARPU has always been a key benchmark in communications and other services industries, because it provides insight into which product lines are profitable and driving growth.”
And while ARPU is primarily a recurring revenue metric, it encompasses all revenues per subscriber, including those from value-added services and one-time purchases, such as an extra bottle of wine offered at a special discount in the subscription wine service example. Increasing ARPU is one of the most cost efficient ways to improve profitability because it enables a company to expand revenues from existing customers, an inherently easier route than growing the customer base.
3. Churn and Retention Rates
Formula: Retention Rate: % of Customers Retained from Period to Period
Churn Rate: % of Customers Lost from Period to Period
For Bob Harden, Principal at The Harden Group, among the most crucial metrics for recurring revenue businesses are retention and churn rates.
“Customer retention/churn rates are prime indicators of a business’s health. Minimizing churn is not just a revenue protection strategy, it’s a revenue growth strategy,” says Harden. That’s because the higher a business’s retention rates, the more opportunities it has to build customer loyalty and enhance APRU.
At the same time, underestimating the impact of churn on a business can cost a company dearly. Consider the subscription wine business. If its churn rate increases by just 2% a month, CLV would fall precipitously from $900 to $525, or 42% (by lowering the retention figure to 21 months in our CLV equation in metric number 1).
4. Customer Lifetime Value to Customer Acquisition Cost Ratio (CLV-to-CAC Ratio)
CLV = See metric number 1
CAC = Total Sales and Marketing Costs/Total New Subscribers Added
For Salil Deshpande, Managing Director, Bain Capital Ventures, one of the most revealing recurring revenue metrics is the CLV-to-CAC ratio. It’s a way of determining the return on investment of customer engagement efforts.
“CLV-to-CAC ratio is better than CAC or CAC ratio because what you pay for something should be a function of what it’s worth,” says Deshpande.
So ideally, what should ROI be per customer? “The general rule of thumb is that CLV-to-CAC should be 3.0 or higher,” Deshpande says. Applying that 3:1 ratio to the $900 CLV figure for the wine business, the total cost of acquiring a customer should be no more than $300 over the course of the relationship. The closer CAC gets to CLV, the less worthwhile the customer becomes.
Keep in mind that there’s an upper limit to the CLV-CAC ratio. For example, if the wine company is making $6 for every dollar it pays for sales and marketing, then it’s likely not spending enough going after new customers and its long-term growth may suffer as a result.
5. Annual Recurring Billings (ARB)
Formula: The Sum of all Customers’ Annual Subscriptions and/or Usage
My personal favorite among recurring revenue metrics is a summation of the expected total yearly billing of customers’ annual subscriptions and usage fees. ARB is what I call the “true north” because it represents the actual cash flow irrespective of GAAP revenue recognition and because all roads lead to it, including annual contract value, renewed bookings, upsells, cross-sells, and retention. It’s essential in understanding a business’s success in building customer relationships.
ARB shows the big picture over time of how recurring revenue efforts are performing. But a CFO can also use it more granularly. For example, management can track recurring revenue generated from new sales versus renewals, or from upsell and cross-sell. Conversely, it can also apply ARB to monitor revenue losses from downgrades, churn, and so forth.
In summation, going back to the wine business example, if the company were to improve the performance of variables such as CLV, APRU, churn, and customer ROI, it would ultimately drive its ARB to new heights.
Recurring revenue metrics are invaluable to a business and highly influential with investors and analysts. There are dozens of valuable metrics that can help CFOs boost recurring revenue results. These are just a starting point. Choose ones that fit the business model, pay attention to what they tell the company, and adjust accordingly, then repeat. Quarter and after quarter. Year after year.