How to Pay the Right Price for a Subscription-Based Business

From a business buyer’s perspective, what are the attractions of a subscription-based business?

The buyer can count on sales coming in from the get-go. Recurring revenue means guaranteed cash flow, the life blood of any business. Secondly, businesses with recurring revenue tend to be more predictable than other business models. The owners are able to relatively accurately forecast revenue months in advance. Thirdly, the opportunities for growth are often quite straightforward. The business model is one that can make fantastic use of customer data and sales funnel tracking.

Why are consumers gravitating to subscription-based services?

Online behaviour analysts at Hitwise found that visits to subscription box sites increased 3,000 per cent between 2013 and 2016. Since 2014, the number of hits on subscription sites increased by 800 per cent reaching 32 million visitors by April 2017, according to Forbes. And the growth in popularity of this type of consumer experience doesn’t show signs of slowing.

The reason why so many consumers are becoming interested in shopping by subscription are manyfold, but there are trends that stand out. Many believe that with the rise of online shopping, consumers are craving the element of surprise that they once enjoyed when shopping in person. They now search for the exact item they want, they buy it and it arrives. Where’s the fun in that?

The subscription box model helps people to regain that sense of discovery that is missing from online shopping. Although subscription boxes are usually personalised, the recipient is never entirely sure what will arrive in the post and that, combined with convenience, is why people love it.

Buying into this phenomenon by purchasing a subscription-based business is a tempting prospect, but how do you know you’re paying the right price? Valuing subscription-based businesses is difficult but doable. Here, we’ll take a closer look to help you work out what to pay for your slice of subscription perfection.

Buying a subscription business

It may be easy to see why the subscription box model is attracting attention, but for those hoping to acquire a subscription-based business, some caution is also needed. A reasonably high failure rate and a volatile market place is the reality you’re buying into. Some analysts claim that the market for many of the more niche subscription products is small and that private equity investment may have created somewhat of a bubble, especially in the US.

Over here in the UK, though, there is still plenty of opportunity for subscription-based business growth and buying a small business that is already up and running and is ripe for expansion and investment could be a great opportunity. But how do you value a business that makes its money through subscriptions? It might be wise to consider customer-based corporate valuation (CBCV).

Customer-based corporate valuation

The idea behind taking a bottom-up view of valuing a subscription based business is to remain aware of the common problems that can afflict businesses relying on a subscription model. High customer churn is perhaps the most common problem, alongside a reliance on high marketing spend to attract new customers to replace those lost.

CBCV focuses on using data to examine underlying customer behaviour and predict how customers will behave in the future. It looks at average revenue per customer and the retention patterns of existing customers to help form a more realistic view of the value of a business that relies on customer behaviour, as opposed to simply how much they spend.

The CBCV approach to valuation uses the logic that the number of customers who were with the subscription firm that the beginning of a certain period and remained with the firm at the end of that period, plus the number of new customers, is the total number of customers with the firm at the end of that period.

To predict this for each period, analysts will take into account data that can help them work out the number of customers who are new to the business, how many are long-standing loyal customers and how many are something in between. Analysts will also use data, such as transaction history to work out the churn rate for customers within each period.

These calculations will help valuers identify whether sales growth is being achieved through winning new customers or by monetising existing customers. Attracting new customers is expensive and requires major marketing investment, especially in the online subscription-based business model. Therefore, a business that can achieve growth by making more money from existing customers could have a higher value than one that is growing faster but is afflicted with high customer churn.

In order to build a fair view of what a subscription business is worth, we must look deeper than the surface level. A business may show growth in turnover and in customer numbers, but looking more deeply and using CBCV is key.

The Equity Partners, which specialises in this type of analysis, carried out a review of US recipe box business Blue Apron, using CBCV techniques. It found that despite being publicly listed with a high share price, it was way over-valued. Its analysis allowed it to predict a 72 per cent customer churn within a period of six months from signing up to the service. In a business with low customer churn rates, customer acquisition costs (CAC) reduce over time, but if churn is high, CAC costs remain high.

Next, the analysts found that newer customers were spending less through each period than the customers before them. As a result, the costs of attracting and securing new customers is increasing at the same time that the value of these new customers is decreasing. In addition, customers that do remain with the business over a longer period tended to spend less over time, as opposed to more.

Perhaps the most damning finding from the CBCV analysis was that more than 70 per cent of new customers would not generate enough in income for the business to cover the cost of acquiring them in the first place.

The key is finding a business that is in fact as good as it looks

Using CBCV techniques when looking for a subscription based business to buy is key to ensuring you find a business that is as good as it looks at first glance. If you can find a subscription business that can keep CAC low and retain customers over a long period of time, you could be looking at a success story.

It may be that bolting on a subscription business to your existing business might enhance your offering, diversify your business and boost sales. As a buyer, it might also be worth considering a subscription business commanding a higher multiple simply due to the fact that you may be able to cross-sell products to its valuable customer base.

An example is the recent purchase of US-based toy subscription business Surprise Ride by toy manufacturer Fat Brain Toys. Although the terms of the deal have not been revealed, it is likely that Fat Brain Toys, who already offered the Surprise Ride subscription through its website, may have paid a top price for the subscription business.

Surprise Ride’s COO and co-founder, Rosie Khalife, explained: "This acquisition means big things for the toy industry. Every subscription category from food to beauty has a clear leader, except toys. With our products, Fat Brain has the infrastructure to build a global billion-dollar toy subscription."

Buying into the subscription model is an attractive route into ecommerce and an exciting, if challenging, way into a relatively new and growing retail marketplace. However, as with any business acquisition, understand how the seller is valuing the business and using as much raw data as you are able to get, construct your own valuation.

To value an opportunity, consider its customers’ behaviour, where it’s money is actually coming from and how much it costs to attract new customers.

Think of the revenue as two streams. The first is the existing customer base. Look at the last 12 - 24 months and understand the churn rate to estimate what they will contribute to the gross over the next 12 months. Second is the growth stream i.e. New customers. Value these incoming customers and calculate their potential underlying profitability. You may want to use a combination of one or more of the following factors:

Gross margins;
Growth rate;
Churn / Retention;
Upsell / Downsell potential;
Payback period;
Customer ROI;
Market size.

Many buyers are simply looking for a subscription service that will fit in neatly with their existing offering, allowing them to offer a new retail experience to existing customers or, indeed, a new marketplace through which to sell existing products.

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