Amazon, Apple and many of the most promising Silicon Valley start-ups are increasingly focussing on subscription based business models. And so should you.
Subscribers not only provide steady turnover; they make your business more valuable in the eyes of a buyer. In a traditional business, customers buy your product or service once and may or may not buy again. However, in a subscription business, you have "automatic” customers who have agreed to purchase from you over and over again.
There are at least nine subscription models that can be leveraged by businesses ranging from service companies to market research firms to manufacturing concerns.
Recurring turnover—the hallmark of a subscription business—is attractive to buyers and makes your business more valuable when it’s time to sell. How much more valuable? To answer that, let’s first look at how your business would be valued without a subscription offering.
A common way to value a small to midsize business is discounted cash flow. This methodology forecasts your future stream of profits and then discounts it back to what your future profit is worth to an investor in today's dollars, given the time value of money.
This may sound like MBA jargon, but a discounted cash flow valuation is something you have probably applied in your personal life without even knowing it. For example, what would you pay today for an investment you hope will be worth $100 one year from now? You would likely ‘discount’ the $100 by your expected return on investment. If you expect to earn a 7 per cent return on your money each year, you'd pay $93.46 ($100 divided by 1.07) today for an investment you expect to be worth $100 in 12 months.
Using a discounted cash flow methodology, the more profit a buyer expects your business to make in the future—and the more reliable your estimate—the more your business is worth. Therefore, to improve the value of a traditional business, the two most important levers you have are: 1) how much profit you expect to make in the future; and 2) the reliability of that profit estimate.
At the SellabilityScore.com, we can see the effect of this valuation methodology. Since 2012, this methodology has been used to track offers received by business owners who have completed the Sellability Score questionnaire. During that time, the average business with at least $3 million in turnover has been offered 4.6 times its pre-tax profit. Therefore, a traditional business churning out 10 per cent of pre-tax profit on $5 million in turnover can reasonably expect to be worth around $2,300,000 ($5,000,000 x 10 percent x 4.6).
Then compare the value of a traditional business with the value of a subscription business. When a buyer looks at a healthy subscription business, they see an annuity stream of turnover throwing off years of profit into the future. This predictable stream of future profit means they are willing to pay a significant premium over what they would pay for a traditional business.
How much of a premium depends on the industry. Some of the biggest premiums today are going to businesses in the software industry. While software businesses tend to be extreme examples of the benefits of a subscription model, no matter what industry you're in, your business will likely command a premium if it enjoys recurring turnover.
From Alarm Systems to Prescriptions to Mosquitoes
For example, security businesses that monitor alarm systems and charge a recurring monthly monitoring fee to do so are worth about twice as much as security businesses that just do system installations.
Retail pharmacies with a large pool of prescriptions for drugs that people take every day, like Lipitor and Lozol, command a premium over traditional retailers because customers re-order their drugs on a regular basis, creating a recurring turnover stream for the pharmacist.
Even small businesses are worth more if they have subscription turnover. When my colleagues at the Sellability Score analysed small businesses with less than $500,000 in sales, they found that the average offer these businesses attract is 2.6 times pre-tax profit.
Compare that to the average Mosquito Squad franchise. Mosquito Squad is a Richmond, Virginia-based business that offers to keep bugs off your patio by spraying your backyard regularly with a proprietary chemical recipe approved by the US Environmental Protection Agency. Mosquito Squad franchisees target affluent home owners with an average home value north of $500,000 who entertain in their backyard and don't want to be bothered by mosquitoes. Mosquito Squad operates on a subscription basis. You subscribe to a season of spraying, which includes 8 to 12 sprays, depending on how big a bug problem you have where you live.
Mosquito Squad is a franchise business, and the impact of its recurring turnover model on its valuation is remarkable. According to Scott Zide, the president of Mosquito Squad's parent company, Outdoor Living Brands, Mosquito Squad franchises that changed hands over the most recent five-year period had turnover of $463,223 and sold for 3.7 times their pre-tax profit. That's a 42 per cent premium over the traditional value of a business with less than $500,000 in sales, and it’s because Mosquito Squad operates on a recurring subscription model and 73 per cent of its annual spraying contracts renew every year.
Whether you plan to build a subscription-based software application or the simplest personal services business, having recurring turnover will boost the value of your most important asset, your business.