Four Secret Ingredients to Analyze User-Based Business Models

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Photo by Danny Howe on Unsplash

You all know them, you all subscribed to them.

I’m talking about firms like Facebook, LinkedIn or Twitter. Social media platforms as well as Netflix, Spotify, Canva, Uber or Grammarly. In short, subscription-based business models.

But what’s the challenge with these business models?

It’s quite difficult to understand how these companies can be analyzed and valued. And ultimately, how a sustainable picture can be drawn. Because in the end, it depends on each of us. Each user, each subscriber has a different value attached.

Our job during a financial analysis is to understand what the drivers are, how the business is operating, if the business is sustainable, and how it will look in the future.

So today, I am going to show you the basic formula.

Simplified.

This is the one formula, you need to know to understand user-based business models. I will show you the different drivers and components to analyze these firms.

Overview and the basic formula

Let’s have a look at the formula first

copyright: author, for the sake of simplicity revenue instead of gross profit, is taken and the time value of money is not considered

CLV_f stands for the customer lifetime value (here on a firm level, i.e. for all customers), that’s why we need to consider the number of customers. Either revenue or gross profit can be used as a starting point. That depends on the interpretation and the business case. For the sake of simplicity, we will use revenue here.

CAC reflects the customer acquisition costs and CRC is the customer retention cost.

The latter stands for the recurring expenses to keep the customer. In a B2B business, for example, this could relate to regular visits or regular meetings with clients to renew contracts. Customer acquisition cost is the cost to acquire the customer. This could e.g. be a free trial month or a discount in the first year of your subscription.

Note that the time value of money is not taken into account for illustrative purposes, i.e. future revenues are not discounted.

The user — a mystery

So, as you can see, it’s all about the user. What seems quite simple at first — the USER — turns out to be a fun exercise.

Here’s why:

  • the mystery “user” and user-based businesses are relatively new,
  • there is only little data on user trends. Firms don’t publish details on the users. So, it’s not easy to understand what drives the customer lifetime value.

Many assumptions or simplifications are necessary to estimate the customer lifetime value. In the following section, we will discuss the individual components.

Revenue

Each user-based business generates revenue, with or via its subscribers.

There are three basic models:

First, the traditional subscription model, e.g. Netflix, Canva, or Spotify. Second, the monetization via ads applied e.g. in Twitter or TikTok. Third, the transaction-based business model, whereby users pay as they use. Uber is a well-known example of this category. Apart from that, there are hybrid models, with a free version and a premium version, e.g. LinkedIn.

Inherent to all these models is that users are required. Either to generate enough traffic to attract ad sponsors or to generate subscriptions.

Hence, these questions result for the revenue analysis:

  1. What’s the average duration of a customer or: what’s the average churn rate?
  2. How much revenue per customer is generated?
  3. Do customers switch to a premium or lower-cost version?

Depending on the business models, the answers can be provided with more accuracy. For example, for Netflix or Spotify, the fees are well-known and don’t differ significantly across different countries. But, for transaction-based user businesses, the behavior might differ significantly. For example, across countries or age classes. The behavior is also affected by outside forces, such as the current pandemic.

Acquiring new customers

How does the company get new customers and at what cost? This is the crucial question to understand the customer acquisition costs. Some companies offer a free month, others offer a $10 voucher for your registration. To analyze these costs, you’ll need to understand the dynamics of the company. Also, you need to understand how these acquisition costs differ by region or user group.

Retaining new customers

Whether there are significant customer retention costs depends on each company. Significant retention costs apply rather in the B2B (business-to-business) sector, e.g. when discounts are offered for renewing the contract or when the sales manager regularly visits you to keep you as a customer.

Number of customers

Challenging one. It’s not only about “how many”. It’s also about “when”. So it’s rather “how many and when”. This point is particularly important when analyzing and valuing a user-based business that is up for sale. If the business relies heavily on future users, it is a riskier asset compared to a firm that already has acquired these users.

Forecasting user development is complex. Significant disruptions or shifts in the different business models can occur. Factoring these developments into the forecast is almost possible. Here, a scenario analysis would be the most suitable way to analyze different options. So, if a business model works well today, it doesn’t mean that it attracts a high amount of people tomorrow.

But overall, size matters. Unless it’s an exclusive network with high installments per user. The larger a user-based business, the better it can make use of network effects. Large networks attract more users, whereas small networks need to “fight” to attract users. This also implies that the acquisition costs can potentially change with size. Especially in the social media environment, the largest networks will typically survive.

Key aspects

  1. Understanding how long users stay and what revenue is generated with each user matters
  2. Acquiring new customers comes at a price — but at which price?
  3. Retaining customers is crucial — but how is it done and at what price?
  4. Scaling matters — network effects become more prominent with size

Final thoughts

User-based businesses have been on the rise for the last few years. Being relatively new, it makes it challenging to analyze these firms for a transaction. In the end, it’s a firm — just as any other firm — and it’s eager to generate a positive cash flow. Yet, given that its cash flows are generated with users, the focus is shifted from cash flows to users. To determine what the value of each user is is the first step to determine the value of all users and the firm.