Business

Top 6 challenges with a subscription model

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Craig Vodnik is the co-founder and vice president of operations at Cleverbridge.

Gone are the days of simple one-time transactions with customers as the subscription business model goes mainstream with companies like Dropbox, Netflix, Adobe and Zipcar because it offers a predictable, recurring revenue stream.

The management of these subscription models, however, can be quite complex.

Subscription models used by companies like Salesforce offer customers different levels of functionality for a variety of prices per seat, per month. That, in and of itself, might not be too complicated to calculate and bill. But what happens when a customer upgrades or downgrades in the middle of the billing period and prorated billing must occur? Or the credit card “on file” expires and renewal billings fail? How do you bill customers for actual usage? What’s the tax rate on your product? Can you track each product’s churn rate?

The truth is success with subscriptions entails much more than merely switching from one-time to recurring billing. Whether your company is starting or switching to a subscription-based model, let’s examine six top challenges that you must master.

1. Revenue recognition

The subscription business model is mature enough that Generally Accepted Accounting Principles (GAAP) address it. However:

  • Subscriptions are at the intersection between software and services, requiring expert judgment as to the “right” revenue recognition approach.
  • It can be unclear how specific GAAP apply to many revenue recognition situations.
  • Subscription pricing model changes (e.g. from a fixed price to actual usage) may be easy to make, but may have revenue recognition implications.

2. Taxation

Worldwide, technology is changing faster than regulations can keep up, resulting in more subscription taxation confusion and turbulence. Let’s discuss just the U.S. first:

  • What is the taxation method? Sales tax can apply to subscription products, at rates as high as 10 or more percent. In a typical year, thousands of state sales tax rules, jurisdictional and rate changes occur. Can you keep up? It gets worse.
  • Are subscriptions software, services, or other? Most states treat a 100 percent cloud-delivered subscription product as software (often taxable), not a service (usually not taxable). But because jurisdictions apply many different definitions of “software”, knowing this distinction is not enough to accurately assess your taxation situation. For example, if a subscription purchase includes a component defined by states as “services” (e.g. phone support), then additional taxes may apply.
  • Is it taxable? If a company located in one state sells subscription products in other states, then various states may determine if they are taxable using delivery-related factors such as where a company server is located or whether a download is part of the subscription.

Selling internationally amplifies tax calculation, accounting and remittance overhead. In other developed economies, Value-Added Tax (VAT) is imposed, which introduces additional complexity. One example: the selling company can capture taxes already remitted by someone earlier in the value chain.

3. Credit card expiration/payment method changes

One-time transactions using online payment methods like credit cards are simple: either the payment goes through and the customer gets the product, or it doesn’t and they don’t. For subscriptions, you must be able to bill customers repeatedly, and to respond appropriately if payment is not forthcoming.

Because renewals are often billed using payment details provided for the initial purchase, subscription billing is more vulnerable to payment detail changes such as credit card expiration. Renewal billing using prepaid cards (growing in popularity) fails after the card is “spent” unless the customer provides completely new payment details, requiring more effort (and reducing renewals) compared to updating a credit card expiration date.

4. Compliance

If your company is retaining online payment details for subscription renewal billing, then you are subject to PCI regulations. If you are selling only in the U.S. using an enterprise payment gateway (e.g. Chase Paymentech or Braintree), you can outsource PCI compliance challenges. Selling internationally? It is vastly more difficult and costly to negotiate, integrate, and manage multiple payment processor relationships to remain compliant globally.

Compliance challenges unique to subscriptions:

  • Obtaining customer consent for renewal billing at time of initial purchase: As the rash of lawsuits against software giants Symantec and McAfee attest, many jurisdictions require customer notification during checkout that the subscription entails recurring billing. To settle just one lawsuit for non-compliance in April 2013, Symantec offered $10 refunds or free subscription extensions to 3,900,000 customers
  • Changing a subscription’s renewal billing amount and/or frequency: While EU law is very precise on this topic, many jurisdictions are vague on what constitutes reasonable or effective notification or consent. As courts interpret the law, the definition of “reasonable” can (and likely will) change.

The cost, complexity and risks associated with this challenge escalate with every additional legal jurisdiction in which your company does business.

5. Analytics

Subscription companies can experiment with price, feature, and other product changes more easily than perpetual license software companies. This advantage largely disappears if the profitability, efficiency, and growth impact of such changes cannot be determined. This means that tracking and managing activity in subscription-centric ways — above and beyond traditional, transaction-based reporting — is mission-critical. Without it, a subscription company will be sorely challenged to monetize and optimize their products, predict cash flow or achieve profitability.

6. Lifecycle management

Unless your company’s subscription products cannot be changed during the payment term, customers will want to modify their subscription (upgrade, downgrade, change the number of users, etc.) at some point. Usage-based subscriptions require billing unique amounts with each renewal. Manually-renewed subscriptions require advance customer notifications in order to reduce churn and keep cash flowing.

Your company must decide how the above changes should be made available to customers so that they are able to manage their subscriptions directly, versus which should be executed via an internal customer support team. Regardless, you will need the tools to enable subscription lifecycle management functionality.

Craig Vodnik is the co-founder and vice president of operations at Cleverbridge — a global e-commerce provider for more than 300 international software and SaaS corporations. He is also the chief blogger of “Building Keystones,” a digital e-commerce industry focused blog. You can connect with him on Twitter, LinkedIn and Google+.


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