Free Trial. Subscribe. Repeat.
The biggest technology & business trends have converged to bring one of the most lucrative business models and everyone’s in on it. Software as a Service (SaaS) delivered via a subscription model has inevitably been the forefront of all the rising stars and a pivot for the biggest companies.
As a kid, I remember when I used to be excited to rush to the mall to discover new games for my Xbox. Malls were jam-packed because that was the outlet of consumption. But now, many of the things I consume are almost just a click away. Gaming, music, entertainment, shopping, productivity, communication are few of the many things I can count off the top of my head that I subscribe too. It isn’t just one thing, but a domino effect that has transformed every industry. There has been massive growth in a few core areas; Service, software & subscriptions. Put together they somehow seem to magically fall in place but in reality, each of them grew independently and converged.
What’s interesting to me here is what’s often not noticed — the business model disruption. When you think of a traditional business, it has direct costs (COGS) that are easily attributable. When I buy a T-Shirt, there are direct costs such as the cost of cotton, printing & distribution, whose unit costs typically, for businesses at scale, would remain the same for every new piece made. And then you have the labor and capital costs. When you think of the software industry the cost of making one T-Shirt isn’t the same as the second. It’s more upfront and decreases for every new consumer — you only have marginal costs. When you think of the service industry the raw material (i.e. the T-Shirt) disappears, but you typically see higher labor costs for delivering the service. Lastly, when you think of subscriptions, you typically see a recurring revenue with inconsistent utility. A large number of people subscribe to using the same set of T-Shirt’s but only a handful use it.
Leverage the benefits of all three and you have recurring revenue, on a product which only realizes marginal costs of production, on-demand delivery, and unequal consumption.
Netflix, Spotify, Amazon, and Adobe are adopters that have created a growing subscription revenue for their services. Companies have directed their focus on the number of subscriptions and started reporting Annual Recurring Revenue (ARR). For an investor, this is transformative, because it is a much more reliable indicator to predict future revenue. Customers are spending the same amount of money on a regular basis for the constant consumption of the same product. Imagine a retailer who has a customer coming every month to pay for the same product again and again without actually giving a new product. Research suggests that, for an average subscriber, the total aggregate revenue acquired via subscriptions has been greater than the cost of buying it off-the-shelf. This brings up a second point — it is much easier for a consumer to pay $9.99 every month over 3 years than ~$360 upfront. The psychological gain has lowered the barrier to subscribing (at the expense of making it difficult to unsubscribe!).
Although it doesn’t necessitate success for every business to adopt this model it does cater to the consumer-business relationship in an effective way. And the example above about the “same product” isn’t entirely accurate. The expectation to innovate on the software and service provided is much higher. We expect new content on Netflix & Spotify, expect the capabilities on the Adobe productivity suite to increase and are constantly given a compelling reason to renew our Amazon subscription. But even then, these are often the marginal costs to maintain and improve the software, as opposed to deriving from them.
Either we like it or not, all businesses are steered in this direction. My Xbox now has a Gamepass which allows me to play any games without having to go to the store. Unfortunately, I never really had more than a handful of games but I still end up paying more than that to use the pass. The next time I sign up for a trial, I may think twice but is that really going to stop me? Do I have an alternative when my need to constantly consume the latest technology, in response to my ever-changing needs, is higher than my need to pay a one-time fee for a quickly outdated software product?
At least, next time when I am on Robinhood I will put my bet on SaaS businesses with the potential for a growing subscription model!
