Subscription Business Models Explained: Why Investors Love Them and Customers Hate Them

Here’s a list of companies. Think about how you feel about them:

Netflix. Spotify. Dollar Shave Club.

Here’s another list of companies. Think about how you feel about them:

Comcast. Spectrum (formerly Time Warner Cable). Verizon. AT&T. Sprint.

My guess is you love the first set of companies; you hate the second. What links them? They’re both subscription services.

Subscriptions are hot right now. Hot! The Ringer has their article on subscriptions taking over the world. Here’s an Economist article on subscriptions (they also had a Money Talks episode on thist). Here’s a Forbes interview with the author of Subscribed!. Here’s another book on subscriptions. And since this is a website on entertainment, here’s Variety opining that subscriptions are here to stay.

Subscriptions!!!

My quick splashing of cold water on this hot take is this: um, subscriptions have been around in entertainment since the 1980s. At least. If you count “media”, well magazines pioneered subscriptions decades ago, if not centuries, depending on your definitions. (Yep, I just checked and a German magazine was selling subscriptions in 1663.) What was old is new again.

So subscriptions aren’t new, but they may becoming more prominent. I’ve seen two explanations for this: 1. Investors/Wall Street/shareholders loves subscriptions and 2. Customers prefer subscriptions. Are either or both those claims true?

Let’s dig to find out.

Why Investors Love Subscriptions: Customer Lifetime Value

There is a simple economic formula that explains why investors and shareholders love subscription services:

Screen Shot 2018-08-28 at 12.10.27 PM

That’s the formula for “customer lifetime value”, which is the economic way to model the value of a customer in a subscription business. In short, if you know the revenue of a future customer, and the margin you collect of that customer, and the number of people who stay with the program in a given time period, you can calculate the full value of a customer. And yes, I pulled that definition from Wikipedia. Here’s another way to look at it, also ripped from Wikipedia:

Customer lifetime value: The present value of the future cash flows attributed to the customer during his/her entire relationship with the company.

To put it in layman’s terms, if someone signs up for a subscription service, at the time they sign up this formula puts a dollar amount on that sign up. And it makes intuitive sense. If someone signs up for Netflix, say, they aren’t just worth $10 that month. They’ll pay that ten dollars next month and the month after and usually so on. Since Netflix and other subscription companies know the rate that people churn—or cancel their subscription—they can make some strong estimates about the CLV for customers and hence total value.

This is why companies can offer high sign up rewards. If you calculate a high retention rate with high margins in the future, you can justify higher “acquisitions costs”,. In other words, if acquiring a customer is worth $500 for your company, then spending $100 dollars in marketing to acquire that customer is worth it since you’ll still make $400 over the lifetime of the customer.

If you don’t believe me, here’s a quote that just about sums it up perfectly from a Wired article on Lyft contemplating a subscription plan:

“Subscription business models are very popular among investors…“Wall Street loves them,” says Daniel Ives, the head of technology research for GBH Insights. He calls this approach a “golden business model” because it locks in repeat customers over time.”

Why Customers Hate Some Subscriptions: Paying for something they don’t want

That’s it in a nutshell.

If I told you I was locking you in your room, you’d think I was an evil step-mother in a Disney movie in the final act. So when companies “lock customers in”, well that’s not really a good thing. So let’s review the specifics of why customers (can) hate subscriptions.

Reason 1: They can’t cancel.

If you’re selling goods “transactionally”–one of the three main business models in entertainment–the number financial analysts dwell on is total sales (total units by price per unit).

In subscriptions, the key number is different: it is both new signups (that’s new revenue) and “churn rate”, (or 1 minus churn rate, which gets you the retention rate). Those numbers really tell you what your customer lifetime value is because the lower it stays, the higher the value for each new customer you subscribe.

So let’s put on our “Chicago School of Economics” blinders and pretend businesses want to do right by customers in a crowded market place (in reality, most entertainment distribution isn’t crowded). If decay rate is the key variable, then it is is incumbent upon companies to offer the greatest products possible to keep customers subscribed. This is what pushes Netflix to expand their content library and cell phone companies to offer add-ons like free HBO. In a crowded market, companies need to compete for your business.

Could I put on a set of skeptical goggles to look at business behavior? Sure. (And mostly I do.) If many US markets are consolidated to two or three major players, then you could argue that the easier way isn’t to increase the value of a product for customers but simply to increase barriers to churn. If you want to know why you can subscribe to a cable bill without waiting, but the cable company spends hours keeping you on the phone line trying to cancel, that’s why.

The Ringer show “Damage Control” made a great point about MoviePass a few weeks back. Justin Charity described how he judged subscriptions on how hard it was to cancel. He noted how it was really hard to find out how to cancel the service when it came to MoviePass. Indeed, every time he went to that window in the app, the app would crash. Now, we can’t prove MoviePass put up that barrier deliberately, but it is impressive how many websites work really hard to obscure how to cancel a service, but have none of those barriers to sign.

Economically it makes sense; these methods all decrease the rate of churn, but don’t really do anything to improve the customer experience. If anything, they make it actively worse.

Reason 2: They hate long term contracts.

In all the love for subscription services, I think through a combination of cultural amnesia and youth, people forget the biggest scam of the 1990s: subscription CD services.

Here’s how it worked. You get a mailing from Columbia House that offered you “8 CDs for a penny”. What a deal! (Oh, for those not alive in the 1990s, we used to have to pay $15 for an album of music. That’s why revenue was so high for music companies and has never recovered.)

So you get your eight CDs and you’re stoked. Then, the next month, you get two more CDs. But Columbia House charges you $20 or more for each. Then if you don’t cancel, they send you two more. The crazy part is sometimes you were locked in for a year or more of these deals, and if you don’t cancel they keep coming. Researching this article, I came across this quote by Jack Hamilton in Slate that just captures how these companies worked:

“But the most devious part of this hustle—the reason Columbia House and BMG deigned to call themselves “clubs”—is that each month they’d send you a CD you hadn’t asked for, unless you mailed them back a card within 10 days saying you didn’t want the CD, which, let’s face it, requires some foresight and organization that is well outside the wheelhouse of an average middle schooler. It all had a sort of brutal elegance, superficially simple yet deceptively complex. (Making things worse, the clubs were notorious for changing fine-print rules without informing customers they’d done so.)”

Besides the really shady parts of the fine print in the contracts above—something Senator Elizabeth Warren has tried to fix for years, including with the Consumer Financial Protection Bureau—the notable part of the above business model is the long-term length of the contract. The goal is to get people paying monthly, but locked into year long deals.

Reason 3: The marginal benefit decreases over time.

A year is a long time, and few services are as valuable in month twelve as they were in month one.

In the CD example above, the first 12 CDs are the most valuable CDs. They’re the 12 you really want. Each CD after that gets less and less valuable, especially if you have to take whatever Columbia House sends you.

My favorite example of this exploitation may be wine clubs. (Is drinking media and entertainment? Close enough.) A wine company gets you drunk at their tasting room, then convinces you that you need to buy 12 bottles every month at some great price. You don’t need 12 bottles, and you get really bored of the same wine after month three.

Essentially, the goal of a subscription program is to make payment automatic or nearly automatic so that when you the customer no longer wants to pay for something, you’re “locked in”. That’s what the Wall Street analyst said up above! But I want to put this in terms of “value creation” because that’s really the theme of this week. (It’s almost like I had this planned.)

So let’s go with the other subscription hotness: box-of-the-month clubs.

Imagine a box for geeks or fanboys. I’ll call it “nerd cube”. You sign up and each month, for only $16 a month you receive a box of trinkets.

It’s the first month. You get your box and love it. You’re stoked, and would value the first box at $24. So your consumer surplus is $8.

But a month later another box comes, and you don’t have room for another coffee mug and one of the things in the box is from a show you don’t watch. You’d value this box at $20. So still a surplus of $4. But the next month you really don’t have room from the stuff and you’d never buy these things on your own. You’re at $10 for WTP, so you lost $6. Now, at month three you’re still up $6 in consumer surplus.

slide4.jpg

You can see which way this is headed. You signed up for 6 months so you have three months to go. You remember to cancel month four. But you forget for months five and six. And soon, instead of having created value for you, the box company is simply capturing your dollars.

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Again, I made up these numbers, so they aren’t “scientific” but they provide a great case study for how subscriptions can kill customer value while generating great profits. As the table shows, if you use my assumptions, then customers end up “breaking even” whereas the box company does just fine. It will depend a lot on the company and how often you use their service, but I bet this captures more value relationships between subscription companies and their customers.

Subscriptions have a lot of downsides for customers, but some subscriptions are hot for a reason. And I’ll address that tomorrow.

  1. […] this more when I write an article on “Transaction Business Models Explained!” (the sequel to my two articles on subscriptions) but for movies you basically can only charge the same price per movie ticket, regardless of movie. […]

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