What is the revenue trough? For recurring revenue and subscription companies it is an economic reality that needs to be dealt with. Given the fractionalized nature of a lot of SaaS and subscription pricing it means that at the point of initial sale, the cost to acquire that new customer is greater than the price they will initially be paying you. So what does that mean for scaling subscription startups? Any how does venture capital, debt financing, and other forms of capital come into play?
To start, this entire conversation is from a cash flow perspective. Balance sheets can report deferred revenue as a liability, but the goal of this post is to examine the cash implications of customer acquisition on what typically are illiquid startups. If you look at the image above, you can see the impact of customer acquisition on cash flow, the numbers are in the millions which is a more mature startup, but the same principle hold up at sub $1M in annual revenue.
Let’s look at a fictional SaaS startup, DistribuHR, a HR and payroll service for distributed teams. At $100/month for their service, they generate $1,200 in revenue each year from each customer. Sounds great right? Well from a cash flow perspective there is a different story going on here. With sales and marketing expenses (salaries, software, advertising, equipment, etc.), it costs DistribuHR $1,600 to acquire each new customer. This means that at month one, DistribuHR is $1,500 in the red to start their relationship with this new customer. They are then counting on that customer sticking around at least 16 months to pay those acquisition expenses back and then generate profit for the company moving forward.
Now, as we can see from those numbers and the image above, this trough becomes a deeper and deeper hole that needs to be filled as a startup begins to scale and add their growth % begins to increase. Below shows you just how big that trough can get as you start acquiring more and more customers:
10 new customers in a month:
- $1,000 in new monthly recurring revenue
- $16,000 revenue trough (10 customers x $1,600 acquisition expense)
100 new customers in a month:
- $10,000 in new monthly revenue
- $160,000 revenue trough (100 customers x $1,600 acquisition expense)
1,000 new customers in a month:
- $100,000 in new monthly revenue
- $1,600,000 revenue trough (1,000 customers x $1,600 acquisition expense)
I think we made our point, but you can see that the size of the expense hole, or revenue trough, keeps getting bigger and bigger as growth accelerates. The monthly revenue is great over time, but these startups have existing expenses (salaries, rent, overhead, etc.) which you need cash to pay for while your businesses scales to a size where you have enough revenue that your monthly income can fill that gap.
This is where venture capital, debt financing, and other forms of lending to startups comes into play. As startups begin to grow and scale, investors are essentially coming in and footing the bill for that gap on behalf of the business in return for equity, royalties or some form of debt repayment. This of course is an oversimplification of the entire process but overall it is how these relationships work.
The revenue trough is a reality that many startups have to face. Competition and rapid iteration means that more often pricing is a race to the bottom forcing pricing down while acquisition cost remain the same. For most founders and their teams, the hope is that with some outside financing, they can subsidize this revenue trough long enough that the business builds enough monthly revenue and streamlines customer acquisition to lower costs to the point where the company is profitable and can cover the cost of its own customer acquisition. There are a host of other factors that play into this such as revenue retention and margins which can impact the economic viability of a startup but for the purposes of this article we wanted to keep it clean.
If you and your company are interested in discussing more how to fully analyze the economics of your recurring revenue/subscription business, reach out to us about our consulting services and setup a time for your free initial consultation.