Subscription Management

What is a Recurring Revenue Model?

A recurring revenue model is how a business makes money by trading access to products or services for regularly scheduled, oftentimes monthly payments.

This definition is an extension of one of the simplest statements we’ve come across for what a revenue business model is. ‘A presentation’ from the Centre of Innovation and Entrepreneurship at Carnegie Mellon states: ‘A revenue model is how a business makes money’, and that’s all it is at the heart of it.

Of course it gets steadily more intricate as you delve into the models themselves, but understanding the basics is a good foundation to begin your pricing journey. It’s going to be a long, but hopefully rewarding one.

The idea is that you get to keep a steady stream of income coming in from your customers rather than only getting paid when they buy something from you. This means that there's less risk for entrepreneurs and business owners because they don't have to worry about their cash flow so much.

There are many products or services that are inherently subscription-based. This includes help desk solutions, team collaboration tools, VoIP numbers for your sales team, and payment gateway solutions, to mention a few

However, for most products and services, there needs to be a coherent strategy to turn your one-time fee structure into a recurring revenue model.

The problem with recurring revenue models is that they can be hard to get started with and take time to build up into something big enough that it makes sense for your company.

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The Five Basic Types of Recurring Revenue Models

1. Usage-based billing

Customers are billed for their usage on a regular schedule. A good example of this kind of recurring revenue model is Zapier.

Pros: Saves the customer money when there’s irregular usage. It’s good value for low to mid-volume users.

Cons: Unpredictable revenue for the business because of customer usage fluctuations, as well as unpredictable and surprising costs for customers. It may not provide good value for the higher volume customers.

Who it works for: Usage based models work best for businesses that can easily track usage whether it’s the number of emails/messages/invoices sent, APIs used, or triggers activated.

2. User-based billing:

Teams or organizations pay for the number of people using the product every month or year. A good example here is Atlassian, that charges $7 a month per user for teams with more than 10 people. Oftentimes with this structure, the same capabilites are provided to all users regardless of usage or volume.

Pros: More predictable revenue and scales well for large/enterprise teams. There’s no need to track usage.

Cons: This system may serve as a barrier for economical teams who will limit number of seats to control costs. Also, it doesn’t always align with product value, in which case you’ll be leaving money on the table. For instance, a customer may end up paying for users who aren’t active. Slack addresses this issue by adding prorated credits for users who have become inactive in a billing cycle, and only charging for active use.

Who it works for: User-based billing works optimally for team collaboration or customer service tools.

3. Tiered billing:

This pricing structure is built in ‘tiers’. Each tier is constructed for a specific buyer persona and is capped off in price. Once a user hits a functionality ceiling on a particular tier, they are upgraded to the next tier offering more functionality and usage. A popular example is Hubspot with its Basic, Pro & Enterprise tiers.

Pros: It allows you to appeal to a wide range of users and their specific needs, so there’s something for everyone. It also helps businesses understand where customers see the most value.

Cons: ‘Something for everyone’ is not always a good bet, because it has the potential to become sprawling and complicated very quickly. There is also the possibility of the tiers not including a certain user-type’s needs.

Who it works for: It’s most commonly used by businesses offering sales or marketing products.

4. Hybrid Billing:

This model takes a mixed approach, choosing aspects of two or more revenue business models. Eg: Both Zapier and Atlassian have hybrid pricing, where hitting specific usage levels or number of users will require you to upgrade to the next tiered plan.

Pros: It’s a flexible way to structure pricing and it allows businesses to overcome the disadvantages of a single model by bringing more nuanced pricing that’s better aligned with value. It also allows for more customizable plans and features.

Cons: It may bring in more complexity, so businesses need to take additional effort to keep their hybrid models simple enough for everyone to grasp. When users can’t understant the process or if it is overly complicated, it discourages use.

Who it works for: SaaS businesses where the value customers get from the product/service doesn’t clearly fit into any one model.

5. Freemium:

Freemium offers a lifetime free plan with a premium upgrade to convert free customers into paying customers. Evernote, Dropbox, Buffer all offer a freemium model.

Pros: Low barrier to entry. It’s relatively easier and quicker to acquire a sizeable customer base. It is a great way to spread brand awareness and get users acquainted with the product.

Cons: If businesses don’t think it through, they could easily run at a loss servicing new customers and find themselves unable to give paying customers the time and attention they need. It could also attract the wrong kind of customers who see the most value in the ‘free’ part of your freemium model and don’t feel the need to upgrade.

Who it works for: It works well for businesses where the cost of servicing new customers on a free plan is low and the potential to convert them into paying customers within a certain period of time is reasonably high. This of course requires a sound business model but can be great way to quickly grow.

Benefits of Recurring Revenue Model

1. Makes budgeting and planning easier

The biggest benefit of having recurring revenue is that it's more steady and predictable than one-time revenue generating models. This makes it easier to plan your business around it.

Additionally, the recurring revenue model reduces the risk of fluctuations in sales and helps businesses focus on providing ongoing value to their customers, rather than constantly acquiring new ones. This makes monthly and quarterly planning easier, accurate, and more effective

2. Improves Customer Retention 

Recurring revenue model helps businesses improve customer retention by creating a long-term commitment for customers and providing ongoing value. 

With a recurring payment, customers are less likely to cancel their subscriptions because they don't want to lose access to their favorite products or services.

The consistent and reliable service provided through the recurring revenue model builds trust, leading to increased customer satisfaction and reduced churn.

3. Helps You Offset High Customer Acquisition Cost

The recurring revenue model can also help offset high customer acquisition costs by reducing the need for constant acquisition and instead focusing on retaining existing customers.

With a predictable stream of revenue, businesses can focus on providing ongoing value to their customers, building stronger relationships, and increasing customer loyalty.

Challenges With Recurring Revenue Model

Difficult To Implement With A Bespoke Product Or Service

The recurring revenue model is difficult to implement with a bespoke product or service. You need to standardize your offering to be able to create a monthly or usage-based pricing structure.

Your customers will become accustomed to paying for the same thing month after month, so you mustn't deviate from that price point.

The most common way to do this is through subscriptions. When creating your subscription model, it's important to make sure that you're getting the most value out of each customer and that there are no hidden costs involved with the recurring revenue model.

For example, if you're selling software as a service (SaaS), make sure that every customer has access to all features and functionality at no additional cost. If you're selling products or services as part of an ongoing contract, make sure that there is an upfront cost associated with each purchase (that doesn't change over time).

Makes It Tricky To Expand To A New Offering

The primary challenge with a recurring revenue model is that once you standardize it, it becomes tricky to expand to a new offering since it may or may not fit into your existing wheelhouse. 

Adding a new product or service to the existing offering could mean adding new pricing tiers, or increasing the price on the existing plans. Both these strategies can tend to impact the overall conversion rate on your offering.

Providing Value Consistently Is A Must

You need to make sure that your customers are happy and continue to use your products or services. To do this, you need to be able to provide them with value at every step of their journey, from the initial contact with your company until they have completed a transaction.

Another challenge is that if you don't keep up with demand, your customers will not renew their subscriptions. This can result in losing a lot of money and also losing the trust of your current customers who may decide to leave for another company if they don't see any improvement in service quality or customer support.

To avoid this situation, you must offer great customer support so that your customers feel comfortable when making purchases from you again in the future.

Building a Recurring Revenue Model Based on Value

The end game of finding the right recurring revenue model is to figure out how to facilitate a fair exchange of value between a business and its customers.

Many businesses unknowingly charge lower than they can and end up hurting profits. The other side of the spectrum is charging too much for something, which will lead to obvious results. Customers will use the product for a few months and when the price and value don’t match, they churn and find other solutions in the competitive SaaS market.

The best path to knowing if a fair exchange is happening, is to identify and align your recurring revenue model with a value metric. It will enable you to price your offerings optimally for you and your customers, resulting in a win-win for both in terms of growth.

Additional Reads

There’s no school that teaches businesses how and what to price their products and why. But as the trend of approaching revenue models more strategically grows, so does the volume of quality information on the subject. Browse through some of these resources and articles to learn more: