Recurring Revenue: The Key to Higher Valuation Multiples
High business valuation is critical to raising funds, attracting investors, or negotiating an M&A deal. While strategic planning, reducing costs, marketing, and investing in growth, staff, and equipment are essential to increasing business value, you cannot miss out on developing a consistent and constant recurring revenue stream.
One way to introduce a recurring revenue-based model to your business is by introducing a subscription plan for your products and services. The recurring revenue model is stable, predictable, and shows the company’s long-term value. Investors like that.
Recurring revenue manifests in different forms across various industries and appeals to both investors and customers. It is measured monthly, quarterly, or yearly by the average amount of recurring revenue per client.
Components of Recurring Revenue
New business recurring revenue is revenue earned from new customers onboarded in a subscription model in a particular period.
Expansion recurring revenue is additional revenue earned from existing customers in the form of add-ons or cross-sales.
Contraction recurring revenue is revenue lost from recurring revenue due to dropped features or lost seats (in a software business).
Churn recurring revenue is revenue lost from customers who decide not to renew their subscriptions for a company’s products or services.
Importance of Recurring Revenue
Strengthened customer relationships. A recurring revenue model helps strengthen the company’s relationship with its existing customers. Simply put, it takes less money and time to retain clients than it does to acquire new clients. These savings help increase business valuation.
In-depth insights on growth and forecasts. Investors find businesses with recurring revenue models more appealing than companies reliant upon one-time transactions because they predict growth and accurate forecasts.
Suppose a business with $20 million in annual revenue derives 80 percent of its income from recurring revenue. That means it can easily count on $16 million at the beginning of a particular period due to its revenue generation’s predictable and stable nature. On the contrary, a $20 million business with no recurring revenue starts with zero at the beginning of the same period. It can plan and predict based on past performance, but it has no contract-based revenue stream to base its plans upon.
Insights on business operations. A company offering subscription-based products or services can improve its marketing and cross-selling practices and better retain customers. It is easier to operate recurring revenue models in terms of pricing, as they just have to manage a few pricing tiers. Compare this other retail model with many individually-priced products.
Informed decisions. The high degree of certainty afforded by recurring revenue helps in making informed business decisions. Business owners benefit from knowing how revenue will look months ahead and having enough time to devise growth strategies.
Business segment evaluation. A business segment reflects the success of the company’s sales and marketing team. Recurring revenue lends insight toward evaluating different segments of a business through accurate information on churn, expansion, and contraction revenue for each.
Appeal to investors. High recurring revenue forecasts can boost corporate fundraising. Optimizing recurring revenue makes the business attractive to venture capitalists and investors who feel assured of profiting from their financial contributions.
Why Recurring Revenue Models Appeal to Investors
A company’s valuation can increase 8X by introducing a subscription-based business model. Such businesses demonstrate reliable revenue streams, and investors are more interested in them.
Monthly recurring revenue indicates that the subscription model works well for the company and comes with known risks, making it easier for investors to evaluate the business. It also shows that the business has achieved a sustainable fit between product/service and market for which customers are ready and willing to pay.
Other elements of recurring revenue models that appeal to investors include:
Predictability. A monthly subscription-based model helps the company establish a base to grow upon at the beginning of each period. Financial forecasts are much more accurate with companies having a consistent recurring revenue stream.
Scalability. A subscription model provides deep insights to understand its cash flows and take minimal risks while investing in business growth. These benefits further help the company to scale up easily. The company can standardize its products, services, and subscription values to maximize recurring revenue from satisfied customers and minimize churn.
Expense Management. The predictability of revenue allows the company to manage its expenses more efficiently. Business owners can reduce their expenses by anticipating predictable ebbs in revenue.
Flexibility. Recurring revenue-based models offer flexibility to both the company and its customers. When a customer’s needs change, the company can simply increase or decrease the subscription without rewriting a contract.
Visibility. Recurring revenue models help companies plan and decide on crucial business decisions in advance, giving them sufficient time to adjust when unexpected changes occur. They know where they will start at the beginning of every period and where they need to be by its end.
Durability. In-depth insights and accurate forecasts with recurring revenue-based models help companies reduce risk when making important decisions concerning churn rates or starting a new business segment.
Why Customers Love Subscription Models
Convenience. The subscription model tops customersâ€™ preference lists when looking at businesses offering similar products and services. In short, when a company makes things convenient for its customers, it earns their loyalty.
Subscription models offer desired convenience by:
- Automating billing systems so that the customers do not lose service due to missed payments and do not suffer from anxiety about running out of the product or cessation of service.
- Automating delivery, which saves customers from the hassle of shopping each time they need the product.
- Offering a predictable monthly fee, making budgeting more manageable.
Examples of How Companies Increased Value Through Recurring Revenue Models
Many businesses that moved to recurring revenue models increased their valuation. Let’s take a look at a few examples.
Netflix ensures recurring revenue by offering a subscription model, which also helps in new customer acquisition. Its streaming service had 167 million subscribers in 2019, which proved more profitable than and led to Blockbuster’s downfall.
Rent The Runway, a fashion platform shifted from one-time rentals of dresses and started offering subscription services for clothes. It became a unicorn in 2019 by raising $125 million.
Adobe, offering an annual licensing model, experienced spiked transactional earnings every 18 months and an unpredictable revenue stream in interim periods. For that reason, in 2013, it switched from a boxed-licensed software model to a monthly, cloud-based subscription model, which culminated in the launch of Adobe Creative Cloud.
Fitness startup Mirror offers an ongoing subscription to the smart mirror. Its value proposition is built around personalization based on individual goals and preferences, such as custom workouts. It raised $72 million at a $300 million valuation.
Why Recurring Revenue Is the Key to Higher Valuation Multiples
Subscription models help companies enhance customer retention and better align with customers’ needs via improved customer service and relationship management.
They can know their customers better, acquire insightful data across their customer base, and improve their understanding of consumer behaviors and preferences. Subscriptions, in turn, improve the data related to profiling and targeting the acquisition of new customers.
Because subscriptions are usually priced less than one-time, single-service payments, customers benefit from a lower entry threshold. Being able to cancel a subscription service at any time makes it a lower-risk option for customers, too.
The subscription-based model of predictable revenue helps business leaders and shareholders in strategic and investment planning. The customer and market insights obtained from the model inform companies about innovation opportunities, such as product alterations, new products, marketing decisions, etc.
The predictable recurring revenue stream of subscription-based business models makes them more attractive and, hence, more valuable than one-demand purchases, prone to fluctuation.