One truth in business that most CEOs and entrepreneurs alike tend to overlook: not all revenue is created equal. Sure, a dollar in sales is a dollar in sales. But the more predictable that dollar is, as in the more likely that you will receive that dollar from your customer every month, the more valuable it becomes. When you begin to multiply that dollar by adding new customers and creating an annuity of cash flow, you begin reaping the benefits of what is known as a recurring revenue stream. And people pay for that!
Examples of businesses that have built recurring revenue into their business models range from companies like Salesforce.com and Constant Contact, which charge their customers a monthly fee to use their services, to the online GoDaddy! and dating site e-Harmony, who make their services “sticky” based on the power of their communities of customers. The point is that these companies have found ways to keep their existing customers month after month and year after year rather than having to find a new crop of customers each quarter to keep the business growing.
What makes recurring revenue so valuable is that you can spend more of your energy growing your business rather than on trying to acquire enough new or repeat business just to hit the same revenue level you did the year before.
Easier to Grow
Let’s say you run a business with $10 million in sales, 90 percent of which is recurring. Since you can already bank on receiving $9 million as you kick off your next fiscal year, all you need to find is an additional $1 to grow. Compare this to a business built with no recurring revenue. You might earn $10 million in a single year. But, every subsequent year you begin again at $0–something that makes it difficult to sustain growth.
Which business would you rather run? The answer is obvious.
The beauty of recurring revenue is that because you can predict what you’re going to earn, you can also predict your costs better which results in less risk–something that investors love (one private equity firm even hands out bumper stickers that say: “I heart recurring revenue.”). In fact, the more recurring revenue a company has, the higher the valuation it will receive from prospective investors and buyers. That’s why recurring revenue has become the gold standard of business models and something that every CEO should be working towards building into their own business.
Higher Business Valuation
Consider the example of ADT, which provides security systems. When you sign up for ADT, you sign a three-year monitoring contract. ADT knows that once you clear the three-year mark, you are highly likely to remain a paying customer of theirs–perhaps for another 5-7 years! That kind of predictable revenue stream helps explain why ADT currently has a market capitalization of about $5.87 billion with revenues of $3.3 billion. When you do the math, we see that the market is valuing every dollar of revenue at ADT as $1.78
In contrast, we can look at Ford Motor Co., which has revenues of some $123 billion. And yet, its market cap is just $30.4 billion–meaning the market values every dollar of revenue Ford generates as just $0.25. Why the difference? Because ADT has recurring revenue with lifetime value of customers and Ford is still stuck with a largely transactional business. That’s why, to repeat, not all revenue is valued equally.
Small Steps Matter
Whether you’re the CEO of a company or an entrepreneur hammering out your first business plan, you need to be thinking of how you can drive a higher percentage of these flavors of recurring revenue through your company. Even if you can move from 0 percent to 15 percent recurring revenue, you have done wonders for the value of your company. Ideally, as a culture, we’d never see another business started that didn’t have recurring revenue woven into its core. The point is that if you’re not thinking along these lines, you’re putting the future of your business in jeopardy and making your life harder.
In our next post, we’ll discuss a few strategies for integrating the power of recurring revenue into your existing business.