How to Diligence a Subscription Business?

The key is to understand what makes a successful subscription business

Arsalan Pardesi on Canva

When we think about subscription businesses, typically a SaaS or technology or tech-enabled business comes to mind. These days subscriptions are everywhere as the business model is attractive and generates recurring revenue. Not all subscription companies are created equal and in order to diligence a subscription business, you need to understand what constitutes a successful subscription business.

What is diligence?

Before we delve into how to diligence a subscription business, let’s understand what is meant by diligence. If you are a diligence advisor and you consider that “diligence is audit” or “diligence is like audit” or if you still use diligence and audit in the same sentence, then you are living in the past. The diligence of a subscription business is all about the “future”.

Diligence ≠ Audit

So what makes a successful subscription business?

Now that we understand what a diligence is not, let’s look into what makes a successful subscription business. While all subscription businesses will be different, at the core of a subscription model is a product and customer experience that the customer would be willing to pay forever. Generally, most customers do not like to make recurring payments and if a company wants the customer to pay a recurring payment, then it needs to deliver recurring value to the customer.

Imagine if Netflix stopped updating its content at regular cadence and or there is a decline in the quality of content, you will immediately see the subscribers going down. Also, if a competing service comes up that provides similar content for free or at a lower rate, then you will again see the subscribers going down.

Simply having a product is not enough, there needs to be a product-market fit. Think about Quibi. Quibi was designed for an increasingly busy market segment to consume entertainment in short increments on their smartphone. However, the pandemic shifted the market dynamics, making a short-form streaming product not a viable product anymore.

Every subscription business is different but generally, the following traits makes a successful subscription business:

1. The company has a viable product that meets the market demand (product-market fit)
2. The company is highly customer-centric with an aim to develop formal, ongoing relationships with customers
3. The company engages the customers and builds a community of users that drive the product and guide innovation (think about forums and product support for B2B applications, or campaigns that engage the core customer base for B2C companies)
4. The company is as focused on customer retention as on customer acquisition (retention is cheaper than acquisition)
5. The company has an innovation culture (to get the customers to pay forever, the company needs to deliver/meet the needs of the customers forever)
6. The technology stack is built to scale
7. There is clarity and transparency in pricing

Customers hate the hidden fee increases embedded in fine print that a lot of telecom and cable companies still use — a lot of people move to subscription pricing because they want certainty and a cap on spending — not a hidden clause that on the night of the full moon a $5 discount embedded in the pricing will discontinue — whether the price is a fixed subscription or a usage based subscription, it should be clear and transparent.

So how do we diligence a subscription business?

Now that we have described some key features of a subscription business, let’s get into diligence. I am going to take a financial diligence lens as everything eventually gets translated into dollars.

Before, we dive into diligence, it is important to understand that there is no one size fit all approach to diligence. Where you will dive deep into diligence, depends on why you are looking to acquire a company in the first place. A diligence on subscription and particularly tech-driven subscription businesses require you to take a holistic and integrated approach around the following areas:

• Finance
• Product
• Commercial / Customer acquisition / Customer success
• Technology
• Operations
• HR/Culture/Talent
• Legal/IP

Although, I have listed it as separate areas, the approach to diligence should be integrated across these areas. Inputs from commercial, technology and product road map diligence form essential components of diligence feeding into understanding the top-line; while findings from legal, operations and HR diligence inform the level of integration and change management that would be required to make it into a successful transaction.

Since, the majority of these companies have relatively fixed operating costs, the financial due diligence is heavily focused on the top-line/quality of revenue, in addition to the typical analyses that you would do to understand the margins.

The role of the team performing the financial due diligence, is to construct a story of the top-line taking into consideration the findings from all the other diligence work streams. Each transaction will require unique analyses to validate the historical growth of the business and to understand if that is a suitable base for the forecast and is representative of the top-line going forward. The result of these analyses should inform the valuation, the value creation plan and path forward.

A few things to keep in mind, is that revenue recognition, particularly for software companies is complex and often times reported revenue ≠ recurring revenue (ARR) or billings or bookings. Also, there are numerous ways of calculating ARR and retention using the same bookings data and understanding of the sector and contract profile is required to validate which method is the most meaningful. If you want to understand how to calculate and understand trends in ARR, Gross retention and net retention, you can refer to the article here.

As companies with a subscription model demand higher multiples, a lot of companies are marketed as a recurring revenue business even when they are not. Beware of creative descriptions like “Subscription as a Service”. If a business cannot define what is it selling as a service then that should be your first red flag on the product diligence.

Also, keep in mind that re-occuring revenue is not the same as recurring revenue (a lot of wordplay happens in CIMs). If a company has a re-occuring revenue model then it does not have a contractually recurring customer base and is only indicating that it has a bunch of customer that buy certain products or service at a regular cadence. Generally, the customer acquisition cost (CAC) and the customer retention costs profile on re-occuring revenue is very different to a recurring revenue business.

Other key metrics that you would want to look at as part of the financial due diligence are:

• Customer lifetime value to customer acquisition cost (CLTV/CAC) — Building a recurring customer base requires investment and analyzing CLTV/CAC provides an indication towards the “stickiness” of the product and the payback on CAC
• Sales productivity — It is important to analyze sales productivity by sales rep to understand any concentration risk and risk to growth
• Capitalized software costs — Operating expenses could be deceptively low in the historical periods due to capitalized employee costs in connection with software development
• Deferred revenue — Subscription companies sometimes sell multi-period contracts and the cash received may have already been burned/used. You need to understand the performance obligations on these contracts where you will acquire the obligation to serve but may not receive the cash on these contracts till next renewal

When analyzing subscription business, it is critical to understand the retention (gross retention and net retention). For a subscription business, retention is the king of all metrics. I will leave it with an excerpt from my article on retention:

Why is retention (gross retention and net retention) important? For a number of reasons — i) it allows us to analyze the quality of top-line, ii) understand further growth potential, and iii) get an initial idea of the quality of the underlying products/services. Also, acquiring new customers is expensive. There is cost to generate and pursue leads, and depending on a company’s conversion rate, these costs could add up. If a company is not generating enough revenue from its customers over their lifetime that allows it to cover its customer acquisition costs, then it will always remain loss-making. It does not matter, if the overall revenue growth is in double-digits, if all the growth is coming primarily from new customers, as that strategy will not be sustainable over a long-period of time.

Whether you are contemplating building a subscription business organically or through acquisition, or if you are simply in the business of providing diligence services to your clients — remember it is all about the long-term customer centric approach and not just about how much subscription revenue a company currently generates.