Move to subscription-based licensing a risk worth taking, CFO says
When William Edmondson joined 1E, he had come to a company whose software was popular among large enterpises to help their IT support staff do a better job responding to service requests. But the way the company charged for its software needed revamping. It used a perpetual licensing model, which led to revenue visibility problems and, too often, tricky end-of-year adjustments. Edmondson's solution was risky but potentially game-changing: switch to a subscription-based licensing model.
"Its really hard to operate as a CFO [under a perpetual licensing model] because you might get that $5 million deal on the 28th of December, just before your financial year end, or [payment] might slip four days, to the second of January, and suddenly your whole financial year looks totally different," Edmondson said in a CFO Thought Leader podcast.
Even more than the tricky management issues it raised is the difficulty of attracting investment into your company.
"That sort of volatility in revenues and new business is just so hard to sell to an investor," he said. "It was really clear to me we needed to do something [different], but what was that going to be?"
Moving to a subscription model helps companies create a recurring revenue stream by having customers renew their license to use the software annually. But until the transition to the new system is complete, the company is faced with the potential for declining revenue since it generates only a fraction of the income it otherwise would when it brings on a new customer.
"When you make this transition there's always a working capital crunch, so once I decided we needed to do this, I spent a lot of time just modeling it out, looking at all of the scenarios, sensitivities, what would be the result if x happened, or if y happened, all the normal things you'd expect a CFO to do," he said. "And I finally got reasonably comfortable with the fact that we were ready to do it."
But the timing wasn't right so Edmondson pulled back at the last minute.
"There was actually a bit of a downturn in the business and we were just about to go live with this subscription model," he said. "I got the board together and talked about it and ultimately they agreed with me we did have to just pause this massive transformation. So, we went through another six to nine months."
Edmondson used the delay to secure a stand-by credit facility to give the company access to money in the event the switch led to a cash crunch.
"I went to our bank, a Silicon Valley bank — great technology bank, great partner for us — just in case things didn't pan out the way that I expected them to," he said. "We would have that as insurance."
Once he pressed the button on the change, two years ago, the company made the transition quickly.
"Most organizations take three to four years to do it; we did it within two years, and now we're a 100% subscription-based business," he said. "It’s been just great for us. One of the most important moments of my career, I think, both in terms of the potential risk but also the potential reward. And it wasn't just a financial exercise. In order to make this transition, you’ve got to get your product right, your marketing, your sales, you've got to understand how to position subscriptions to customers, and then, crucially, the post-sales, the customer success team. We invested pretty heavily in the success team to make sure customers would renew a year after buying their initial subscription."
Accounting training key
Edmondson, a U.K. chartered accountant (the equivalent of a CPA in the United States), credits his solid background in accounting with enabling him to approach his work with confidence.
"Without a high quality accountancy qualification, there will always be gaps in a CFO's ability to deliver the very core of a CFO’s responsibility, which is basically safeguarding shareholders' interests," he said. "While I do come across other CFOs who might just have an MBA, for me personally, that qualification was really a bedrock for everything that then followed."
His first move at 1E was to split his finance and accounting staff into two teams: one to manage traditional accounting operations and the other to focus on commercial finance. The move was necessary, he said, to reach his company's goal of growing annual revenue from $30-$40 million to $100 million.
"What I found is, if you do all finance together, in one pot, with one team, the transactional stuff — the taxes, the months end, the years end, the audit — will always shout louder than the commercial finance piece," he said. "Then, guess what? The commercial finance piece never actually gets done."
Edmondson said he was lucky to have a finance executive already on board who could step in as head of the new commercial division.
"I identified he was a very talented individual quickly," he said. "I put him into heading up that role, and then, within about six months or a year, we hired a couple of more people into that team and also expanded the responsibility to also include sales operations."
The new team oversees the financial planning and analysis (FP&A) function, which covers reporting, budgeting, and forecasting, and also works on the business side of things: contract negotiations, pricing, and ROIs.
"Even today my commercial finance function is out there talking to customers, negotiating with customers on contracts and on pricing structures and models, so it’s really quite a broader role than the way you'd traditionally be an FP&A," he said.
Edmondson said the numbers he looks at in the morning have changed over the last five years, mainly because of the company's shift to the subscription model, which puts heightened importance on annual recurring revenue (ARR) and renewal rates.
"There’s little point in selling a new subscription if you lose it the following year," he said. "If you imagine a bucket, you've got the new subscription business coming in at the top but you've also got some leaking out the bottom when they don't renew. What I focus very much on is how to reduce that leakage."
Another metric he looks at is new subscription contracts. "Clearly, that over time is going to add to our annual recurring revenue," he said.
The subscription model also puts a premium on customer satisfaction, a qualitative measure which, if tracked carefully, can open the door to individual customer metrics that can be used in encouraging subscription renewals.
"We can actually point to a particular customer and say, 'We have done this for you,' and that’s very rewarding for us and what we’re about as an organization," he said. "And of course it's very good for us in marketing messaging and things like that, so as an example, we saved the Department of Veterans Affairs [the company’s largest client] $57 million in software licensing costs over the past couple of years just by them implementing our technology and us holding their hand and helping them use that technology. For me, that's an astonishing statistic. What they actually paid for that software was a fraction of that. So, we try to look more at what real tangible impacts we have had on our customers."
With its new revenue model and ability to sift through its data to let customers know its software is helping them, Edmondson believes his company is well positioned in a market space that's set to keep growing.