Tien Tzuo: Why Wall Street Loves the Subscription Economy

Carbonite was a rare exception to the recent rule that has kept other companies’ IPO plans shelved amid the volatility of the market. While going out then might have seemed incredibly risky, the reality is that Wall Street can’t get enough of subscription-based companies. In fact, of the ten tech IPOs this year, six of them – Zipcar, LinkedIn, Pandora, HomeAway, Zillow and now Carbonite – are from companies that derive much or all of their revenues via ongoing subscriptions.

These recent IPOs are just one proof-point of a seismic shift the world is making from products to services. It is causing billion dollar industries to undergo massive transformation. Subscriptions are now a core part of business models for companies in automotive, communications, cloud computing, media and entertainment, and technology. According to a recent Gartner Group report, by 2015, 35% of Global 2000 companies will generate revenue through subscription-based services and revenue models.

In this new subscription economy, it’s all about owning the customer now, not building and selling products. The goal is to land, maintain and build on repeatable, long-term relationships that change based on customers’ needs and preferences and market innovations. The companies that haven’t made the shift are being threatened by those that have. That’s why we are seeing an increase in deals for services companies as traditional product companies recognize the need to rapidly adopt these models.

Look at the new battle between Amazon and Groupon. Amazon just launched its own Groupon killer, Amazon Local, right in Groupon’s home turf of Chicago. How could Amazon be so bold? Because Amazon understands customer loyalty better than almost anyone. Deals and discounts can be commoditized the same way any widget can from a product-centric company. In the subscription economy, it’s customers, not products that matter most to your profitability. As the Wall Street Journal said, “Amazon has a raft of loyal customers who are used to buying everything from DVDs to sporting goods from the popular online retailer. Meanwhile, Groupon had to spend $262 million last year to attract new subscribers.”

On the flip side, product companies are in a race to remake themselves around services. Dell recognized that selling low-margin hardware was much less lucrative than services. Consequently, Dell has acquired service companies (e.g. Boomi and Secureworks) and refocused the company around, as Michael Dell described, “pricing our products based on value rather than based on cost.” Dell has subsequently reversed its slide, is now posting quarterly profits above 20% including a 63% jump in profits in its latest quarter.

And yet, customer demand is only part of the reason why companies are shifting to subscription models. The other? Predictable revenue streams that create a compounding growth effect. Every dollar a subscription company brings in is considered to be worth six times as much as the dollar brought in by a company that gets most of its money the old way – upfront. Companies are using subscription models to attract and keep customers long-term, constantly adding more and more services that create more revenue opportunities. All of these factors contribute to subscription valuations that are as high as 10 times those of traditional product companies.

A decade from now, economists will look back and say that making products was a 20th century business model. It will be a future in which companies measure success not by counting how many products they sell but, rather, how many high-value, monthly subscribers they have.

Tien Tzuo is CEO of Zuora, a subscription commerce company based in Silicon Valley. Previously, he was the chief strategy officer and chief marketing officer at Salesforce.com. Opinions expressed here are entirely his own.