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AIA

Accounting systems ‘too backward’ for subscription model

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20th Jun 2012
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When AccountingWEB sister title BusinessCloud9 first met up with Zuora back in 2008, it was in the early months of the company’s existence and the meeting place was a rather overcrowded Starbucks in San Francisco, explains Stuart Lauchlan.

Flash forward four years and we’re in the rather more upmarket bar of the Charlotte Street Hotel and Zuora’s traction in the market has been impressive with customers including Reed Business Information, Pearson and News International.

Zuora was set up as an online service for handing billing, payments and customer orders for firms that have a subscription-based revenue model. Chief executive Tien Tzuo was employee number 11 at Salesforce.com where he first ran into the challenges of traditional billing and invoicing systems when the corporate business model is based around recurring revenues and subscriptions. 

From this challenge Zuora was born. In the intervening time, Tzuo has been at the forefront of opening up debate about the nature of the subscription economy “The message is getting easier to get across,” he says. “In the US, the subscription economy message is really starting to resonate. We noticed something really starting to happen at the start of this year. We used to have to explain the subscription economy, but we’re not really having to do that anymore. BusinessWeek used the term in an article last week – it’s getting into the mainstream.

“Initially our messaging was around billing and the need to do a different type of commerce,” he adds. “It’s evolved. We’re also evangelising the concept of subscription finance. If you look at how financial systems and governance work, you realise that finance is very different in the subscription economy. Subscription finance needs recurring revenue. It introduces the concept of recurring margins and renewal rates. That’s a message that is really well received.”

The shift to services

It’s a message that hinges on the trend of moving from products to services. “We are moving from a manufacturing and product-centric world to a services-based one where people buy what they need, when they need it,” explains Tzuo. “In the old world you thought of yourself as a product company and the goal was to get as much product through your door as possible, to ship as many units as you could at the lowest margin cost.

"In the new world it really doesn’t matter how many units you ship. It’s about how many customers you have and the average revenue per customer. It’s fundamentally a completely different business model.”

This is made manifest in the changed nature of pricing, he adds. “Pricing moves to a plan-based model. You have to be able to bundle into feature sets,” he says. “The commerce is different. It was simple. It was about a shopping cart and you would buy now. You choose how many units, you ship it, you invoice it and so on. 

“With services that are used on an on-going basis, the transactions are more complex. Customers are likely to want more changes during a contract. If you’re the New York Times, you’ll have someone calling you up and saying ‘I’m going on vacation for two week, can you stop my subscription for two weeks’ then restart it. Or if you’re the customers of a wireless cell phone, you need to turn on your international plan for two weeks.”

This all means adjusting to a new way of thinking about revenue and income. “In the old economy $100 says you made $100,” states Tzuo. “In the subscription model, $100 is not a one time thing; it’s an annuity and you hope it will happen again and again. A hundred dollars over eight years has more value clearly.”

General ledgers are backwards

That’s the theory; the problem is that the technology wasn’t in place to support the changing model. “At Salesfore.com we were building spreadsheets that didn’t look like those at Oracle or Siebel or a traditional software firm,” recalls Tzuo. “Ours looked like a telco’s. How many subscribers do you think we’ll have? Will it be $50 a month or $60? What is the churn rate?”

The basic principle of accounting in a subscription economy is actually pretty simple at the highest level, he argues. “You report ARR – Annual Recurring Revenue. You start with a specific ARR, say $100. Throughout the quarter you churn some so that’s down to $90. But then you gain some new customers so that changes. Eventually you end up with an end revenue. You look at your ARR at the start of the year and the ARR at the end of the year.”

But there’s a problem here. “Today’s general ledgers don’t speak this language. They are backwards looking, not forwards looking. How much did it cost me to make $100? What was my gross profit, my operating expense, my net income,” sighs Tzuo.  

“It’s a tired old way of looking at business. It’s an income statement that tells you what happened. In an annuity business with a retention rate you can be forward looking over time. I’d much rather value a company based on what is going to happen rather than what did.” 

At the end of the day Tzuo insists that it can be boiled down to three key metrics: 

  • Retention rate – how much of your ARR you keep each year
  • Recurring  profit margin – your ARR less churn and less non-growth spend
  • Growth efficiency  index – how much it costs you to acquire $1

“Really these are the only three metrics that matter,” he says. “The subscription economy demands a whole new income statement. You still need the traditional one for the accounting authorities but you should start with an ARR level.”

Those metrics are also what Wall Street needs to bear in mind when contemplating how Cloud companies perform, he counsels. While the likes of Salesforce.com may not report profits, that does not mean they are not profitable.  

“You can take as long as you want without making profit as long as you give a recurring profit margin,” he argues. “One time stuff can stop at any time. If you’re Salesforce.com and you believe that you can grow to $10bn a year in revenue then showing a profit is actually a signal to the market that there is no more growth left.”

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By sclack
21st Jun 2012 11:25

Non-growth spend and growth efficiency

I love these measures, which are far more relevant to one particular client I have and I have been thinking about what measures they should be reporting instead to improve their planning,so this article couldn't have come at a better time!  However, I have two questions:

How do you define non-growth spend in this model?  For this client, I would say non-growth spend is very small, despite growth spend not being large enough IMO.

When measuring Growth Efficiency, are you only measuring growth spend? What constitutes good news: as low as possible?

Many thanks, especially if you answer fairly fast!!

Thanks (0)
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By mackthefork
21st Jun 2012 22:47

What was the name of that compnay that liked this way of.......

“It’s a tired old way of looking at business. It’s an income statement that tells you what happened. In an annuity business with a retention rate you can be forward looking over time. I’d much rather value a company based on what is going to happen rather than what did.”  

 

....doing things, thats it Enron.

N/M

MtF

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Gary Turner
By garyturner
22nd Jun 2012 11:08

For a more comprehensive view...

This article is pretty close to perfect, if a little long and written from a software subscription basis.

Gary Turner
Managing Director, Xero
@garyturner

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By Zulf1kar
24th Jun 2012 06:22

Crystal Ball Accounting

Doesn't the world ever learn? "tired old way" is actually tried and tested assured way.

I agree with mtf its these Enron type of transactions (derivatives included) that have landed us in the financial mess .

Zulfi. 

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Replying to thestudyman:
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By sclack
24th Jun 2012 10:36

Enron type of transactions?

Whilst Zuora may imply that you should dump the old-style reports, these are required by statute and no sensible FD would stop using all the old measures.  However, it is reasonable, given the rise of subscription-based operations, to look at what manages those best and I can see ways in which the measures proposed are superior.  For example, the distinction between renewals and churn is especially relevant to my client.  I can see nothing Enron-esque in this.

Thanks (1)
Replying to AndrewV12:
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By mackthefork
04th Jul 2012 23:34

Sorry slightly flippant but....

sclack wrote:

Whilst Zuora may imply that you should dump the old-style reports, these are required by statute and no sensible FD would stop using all the old measures.  However, it is reasonable, given the rise of subscription-based operations, to look at what manages those best and I can see ways in which the measures proposed are superior.  For example, the distinction between renewals and churn is especially relevant to my client.  I can see nothing Enron-esque in this.

When you think that there is a better way of reporting financial statements than historic cost accounting, you can only be wrong, almost everyone who has tried this has ended up broke or in jail.  The O/P implied (not directly said) that some guesses about what can happen in the future will be more relevant to this type of business than actual reports of what has happened, I could not disagree more strongly.  Information on renewals and churn has its place in the flannel sections (directors reports, chairmans report, etc) and can be very useful, so long as it is based on historical information, any mention of guesses about the future in anything other than internal information should be taken with a large pinch of salt.

Regards

MtF

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ghm
By TaxTeddy
04th Jul 2012 17:38

Enron Accounting?

 

You have two cows.

 

You sell three of them to your publicly listed company, using letters of credit opened by your brother-in-law at the bank, then execute a debt/equity swap with an associated general offer so that you get all four cows back, with a tax exemption for five cows.

 

The milk rights of the six cows are transferred via an intermediary to a Cayman Island Company secretly owned by the majority shareholder who sells the rights to all seven cows back to your listed company.

The annual report says the company owns eight cows, with an option on one more.

 

You sell one cow to buy a new president of the United States, leaving you with nine cows.

 

No balance sheet provided with the release.

 

The public then buys your bull.

 

With thanks to http://mindnumbingtrivia.wordpress.com/category/enron-jokes/

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Gary Turner
By garyturner
05th Jul 2012 18:08

I think the point was lost,

in that I read it to mean traditional management reporting is flawed, not statutory or annual reporting.

Whether it's flawed or not is debatable, however what I think is a valid viewpoint is that fast growing subscription based businesses such as the one run by Tien Tzuo require extra management reports alongside a regular P&L and balance sheet, not instead of them.

But I think the point is that he's referring to management reporting, not statutory. And to that extent, I happen to agree with him.

Gary Turner
Managing Director, Xero
@garyturner

 

Thanks (1)
Replying to Ruddles:
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By sclack
05th Jul 2012 21:59

Extra management reports

Thank goodness you've arrived!  I was starting to think I was operating in a parallel universe or something!  I never advocated dumping the stats, but they aren't necessarily the best tool for management decisions, even if they are a good context for something that is, so that you can sense-check it.  In particular, when presenting financials to people who have no knowledge whatsoever of statutory accounts, etc - they just want to know what they need to know and several of these measures look very helpful to me.

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