The recurring
revenue of your company is one of the most important factors in the valuation
of your company. It allows your potential buyer to have confidence that the
revenues you have today will be there every year. This is extremely important
to the buyer because a target with strong diversified recurring revenue is far
less likely to have a significant decrease in revenues over the typical
lifetime of the private equity investment period of three to five years.
Instead, it can build on its recurring revenue stream to add more recurring
revenue and deepen relationships with clients to add more value-added revenue. If I had to select three key success factors
that are crucial to improving your current lifestyle, the ability to live a
life of absolute freedom, and the ability to leave a dynastic legacy for your
family, recurring revenue would be on that list. This article will explore the
different types of recurring revenue models that the target corporation could
use to build or create a recurring revenue base. The more recurring revenue we
can create the higher the value of the company. The types of recurring revenue
platforms are discussed in their hierarchy of value below.
The first type of
recurring revenue and the most attractive to buyers is long term contracts for
a fixed term. The long-term nature of the contract essentially guarantees a
recurring stream of revenue that you can protect into the future with a high
level of certainty if the customer is strong financially and operationally. A
perfect example of how long-term contracts can create value is the cellular
phone industry where customers sign long -term contracts to pay for their phone
incrementally over time and to pay for their service plan. The typical three-year
life of the contract essentially guarantees the revenue for the duration of the
contract. The value of the long-term contract can further be enhanced by the
cell phone providers’ ability to retain customers at the conclusion of the
contracts.
The second type
of recurring revenue is automatic renewal subscriptions. Automatic renewal
contracts are renewed on a periodic basis unless the customer takes the
affirmative step of cancelling the contract according to its terms. Think of
this in terms of your gym membership. You sign a one year contract with an
automatic renewal provision that renews automatically unless you give thirty
days’ notice that you are terminating the contract. If you have a low rate of
terminations historically, this further strengthens the power of your automatic
renewal model for developing recurring revenue.
The third type of
recurring revenue is the sunk-money renewable subscription. A sunk-money
renewal contract generally involves a significant investment in a product and a
subscription for using the information. A good example is the Bloomberg model.
Traders must expend significant capital to purchase or lease the terminal.
However, the terminal has potentially no value unless you are going to
subscribe to the data package which automatically renews each year.
The fourth type of
recurring revenue is the renewable subscription. The initial subscription
period is designed to create significant interest in the product or service so
that the customer will be more likely to renew at the expiration of the initial
contract. A good example of renewable subscriptions is the magazine industry.
In the magazine industry, the customer prepays for a one or multi-year
subscription. Prior to the conclusion of the initial term of the subscription,
the magazine company will send numerous letters and emails to encourage the
customer to renew their subscription for a one or multi-year subscription. If
the magazine has high retention rates, this can be a very strong revenue model
for the magazine companies.
The fifth type of
recurring revenue is sunk-money consumables. Sunk-money consumables typically
involve the purchase of a platform product that has essential elements that
must be replaced on a frequent basis. The best example of this is the razor
industry. Interactions with the razor company generally involve the purchase of
a razor platform and some initial razors. The customer is then motivated to
continue purchasing razors that conform to the razor platform because of their
initial investment.
The sixth type of
recurring revenue is consumables. Consumables are disposable items that
customers routinely purchase on a regular basis such as toothpaste or shampoo.
There is generally no compelling difference between competitor offerings and
the company’s offerings, and brand loyalty is the make-or-break factor in purchasing
decisions. Consequently, consumer companies spend large amounts on advertising
to build brand loyalty so that they generate recurring revenue from their
customer base.
The value of your
company is the one metric that business leadership teams should focus on every
day because that will have the most impact on your current lifestyle
pre-retirement, your lifestyle post-retirement, and your dynastic legacy for
your family. A proper analysis of that
metric must include the quality of your recurring revenue streams. A strong
analysis, plan, and implementation of your recurring revenue strategies will
increase the value of your company exponentially.
