I am very interested in start-ups that have a subscription based revenue model and will be quick to pounce on any investment opportunity in the space. I covered at length why I find this model attractive in my two-part blog titled My Fascination for Subscription Based Start-ups. The first post covered the reasons why this space fascinates me while the second covered the pitfalls that subscription based start-up should keep an eye on.

Recently, we decided not to invest in a subscription-based start-up. While there were many reasons for and against the investment, what truly broke the camel’s back was the founder’s argument that their growth till date was due to a low marketing spend and organic traction. This claim was extravagant and displayed a complete lack of entrepreneurial maturity because a significant share of the venture’s expenses were dedicated to providing free samples to new customers, the conversion rates from free trials to subscriptions  were abysmal.

This venture procured its products (let’s call them widgets) from different suppliers and branded them as their own with a mark-up. The venture provided an extensive network for the delivery of those products and assured its’ customers authenticity and several benefits of consumption through various online and offline channels. Therefore, there was a direct cost to acquire customers from online/offline sources but in addition, there were glaring in-direct costs in terms of lost revenues (on the free samples), the costs of staffing sales, customer service and a delivery team to deliver all the free widgets.

Is it fair to say that these aren’t marketing costs?

If these costs are not accounted for as marketing costs, then the sales team can have a field day with the easiest sales pitch in the world – take something for free! The customers have nothing to lose by trying something new and giving awesome feedback because they are valuing something they got for free. The founders claim that they have cracked the model, things are looking better than anticipated and they will raise money based on these skewed numbers.

Suddenly, the sales will stagnate as the initial market gets burnt out and customers continue to take free samples but not pay for a subscription. The margins will shrink dramatically because the costs of free samples are not being recorded anywhere, and the widening gap between widgets procured and widgets sold is only increasing. Meanwhile, the company is strongly opposed to stopping the free sample program because the sales team will not have to do real sales i.e. sell for cash, not air.

In the board room the confused investors will question the panicking founders who will blame the suppliers for raising prices as the costs have been wrongly divided by the number of widgets sold instead of the number of widgets procured. The founders want to change their suppliers in order to reduce costs, but this would risk tinkering with the preferences of loyal customers. They contemplate raising the prices, but this would alienate the same customer class.

Finally, the founders decide to raise more capital to reinvigorate the company and to fund an expense that has gone out of control, but their investors want a mark-up even though the complete botch-up is clearly visible to the outsider’s eye. This tussle will lead to the drying up of funding options and adreaded email from our end.

The accounting of free giveaways is markedly different in SaaS platforms because their cost of servicing the nth customer is almost nil. Surely, there are costs associated toward acquiring those customers and the team towards servicing them, so the costs of an acquired customer are derived after taking these costs aka CAC (Customer Acquisition Costs). However, this is very different for companies that are providing physical products that cost money as in the case of our target venture.

8/2019