 Recurring Revenue: A Key To A Valuable Business
Recurring revenue is the holy grail for business owners looking to have a valuable and sellable company. A customer base with a subset of recurring revenue that is contractual and repeating in nature increases the probability that the business will have stable, predictable revenues and cash flow into the future.
From a buyer's perspective, this reduces future risk and therefore enhances perceived value. The value associated with acquiring the available cash flow is directly related to risk. The lower the risk of losing that cash flow in a transfer of ownership, the higher the price will be to acquire it. Any factor that reduces risk is rewarded with transaction value.
Although all recurring revenue will have a positive impact on business value, some forms are more desirable than others. The following is a list of the types of recurring revenue in an order from good to best.
Consumables
If you sell a consumable product, whether it be diapers, commercial cleaning supplies, or office supplies, start tracking your repurchase rate from existing customers. This will be a number that buyers will use to calculate your projected sales into the future - and to calculate how much they're willing to pay to buy your company today.
Subscriptions
Even better than having loyal customers who repurchase is having revenue that is guaranteed into the future. For example, loyal subscribers to magazines, newspapers, and other publications get a renewal letter each year and pay upfront for the next 12 issues. They make the conscious decision to renew into the future for a certain period of time.
Automatically-renewed subscriptions are even more attractive than periodic renewals because they require a conscious decision to cancel rather than renew. For instance, we use Mozy.com to automatically backup some of our office computers online on a daily basis and are charged a fee each month. This subscription service has no end date unless we tell them to stop providing the service. GoToMyPC.com also operates in this manner. By tracking historic cancellation rates revenues can be predicted well into the future, which is why these types of revenue streams enjoy higher valuations.
Memberships
Memberships are very much like subscriptions. Ever heard of Netflix.com? They're a web-based company in the delivered-by-mail movie rental business. It's an automatically-renewed membership model that almost guarantees a continuous stream of revenue month to month. Your gym membership may also come to mind as one that fits this model.
Contracts
The only thing more valuable than an automatic renewal subscription is a hard contract for a defined term. Wireless cell phone companies come to mind as one of those industries that push hard to get you on a multi-year contract. When a company is acquired, the owner and some employees may leave after the acquisition. But customers with plenty of time remaining on their contracts are security for the acquirer. As you ascend the recurring-revenue hierarchy, the value of the business will go up accordingly.
Recurring Revenue Models for your Business
Here are some examples of recurring revenue models that might spark some ideas for your business:
- maintenance contracts
- monthly support agreements
- annual license agreements
- warranties
- subscriptions
- monthly or annual memberships
- accounting firms that provide annual tax return preparation and audits
- security firms that monitor home and commercial businesses on a monthly basis
- HVAC companies that perform routine maintenance of equipment
- software companies that provide annual user support and software upgrades for a maintenance fee
- landscape maintenance companies
- pool service companies
- janitorial companies
Benefits of Recurring Revenue
The recurring revenue customer base you build for your company will:
- Increase the probability that you will have stable revenues and cash flow
- Decrease future risk in the mind of a potential buyer
- Provide you with an opportunity to sell additional products or services to your existing customer base
- Keep you more attuned to your customer needs while helping you ward off competition
- Provide a corporate buyer with the opportunity to cross-sell its products to your customers
- Provide a higher ROI on your marketing dollars
- Provide a justification for a higher sales price of your business
Ensuring your company has a predictable and stable revenue base will mitigate risk in your business and lead to a much higher valuation.
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Ask the Experts
Question: Why do you require me to sign a contract to purchase before I perform due diligence on the company?
Answer: On main street transactions, the buyer is provided with a profile that gives an overview of the business and a spreadsheet showing historical income statements with the calculation of Discretionary Earnings for each year. The buyer meets with the seller, usually at the business location, and can ask the seller whatever they questions they might have regarding the operation of the company. At this point, the buyer has enough information to make a decision on the price and terms of an offer based on the assumption the seller's financial representations can be proven. An Earnest Money Purchase Contract is negotiated between buyer and seller. Once signed, the due diligence period begins. As negotiated in the Contract, the buyer has a certain period of time to complete due diligence. If the buyer decides not to purchase the business for any reason during the specified due diligence period, then they can terminate the Contract and the earnest money is refunded. The reason that the Contract is signed before performing due diligence is that both buyer and seller must spend time and money in the due diligence process. There is no need for that expenditure if price and terms cannot be agreed on first. The key is that the price and terms agreement is based on the seller proving the representations to the buyer. The seller knows that he/she must be able to prove the numbers or that the process will be a waste of everyone's time, so there is strong incentive to have the numbers and operations correctly presented in the profile. Do not let the process stop you from reaching your goal of business ownership - find the business you want, negotiate the price and terms, prove them up and begin living your dream!
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