How Recurring Revenue Boosts Business Valuation
The popularity of subscription services has exploded, growing over 435% during the last decade. Many people have multiple subscriptions for services such as entertainment, gym memberships, and even food.
In today’s competitive marketplace, businesses are constantly looking for ways to increase their value and attract potential buyers or investors. One of the most effective strategies is to establish and grow recurring revenue streams. They provide a steady, predictable income, which not only stabilizes cash flow, but also significantly enhances a company’s value.
In this article, we’ll explore the powerful impact of recurring revenue on business valuation, delving into why it's become such a critical factor and how companies can leverage this business model to enhance their growth rate and market value.
What Is Recurring Revenue?
Recurring revenue is income that a business can reliably anticipate receiving on a regular basis, typically on a monthly or annually. Unlike one-off sales or sporadic income, recurring revenue is predictable, consistent, and often ongoing.
For example, buying a toy is a one-time sale. Subscribing to have a toy delivered every month is recurring revenue.
Here are a few more examples of recurring revenue:
- Subscriptions—Entertainment where you pay monthly to access shows and movies
- Services—Monthly lawn care or weekly house cleaning
- Contracts—Business might have a yearly contract for internet services
- Retainers—Payment in advance for services provided over time, like a lawyer being available whenever needed
- Insurance Premiums—Monthly, semi-annual, or annual payments for coverage
It’s easier to plan and grow a business when you can budget and forecast profits for annual revenue. This makes a business with recurring revenue more attractive and leads to higher valuations.
Importance of Recurring Revenue in Business Valuation
Stable revenue streams from net revenue retention (NRR)—a company's ability to retain and grow revenue from its existing customers over a specific time—can improve a company’s value and scalability. Here are a few reasons why recurring revenue has significant benefits:
- Stable and Predictable Cash Flow—One of the biggest advantages of recurring revenue is that it creates a stable and predictable cash flow. This enhances a company’s ability to count on a certain amount of money during a specific period of time. The income stability not only supports daily operations, but can improve the company’s valuation.
- Easier Forecasting—Recurring revenue is measured through metrics like monthly recurring revenue (MRR) or annual recurring revenue (ARR). These numbers give business owners and potential buyers a clear view of the business's ongoing income and revenue growth. It also allows for assessment of financial health by comparing year-over-year (YOY) revenue changes.
- Appeals to Multiple Valuation Methods—When valuing a business, recurring revenue can have a big impact. Companies with strong recurring income streams typically have a higher valuation due to the reliability of their earnings. A steady revenue stream supports various valuation methods, often leading to a more favorable valuation for the business.
Industries with Recurring Revenue Models
In some industries, recurring revenue is especially important. For example, in the technology industry, recurring revenue from software subscriptions is highly valued because it shows that customers rely on the product and are likely to keep using it.
- Technology: Early-stage companies, startups, and software-as-a-service (SaaS) businesses often use subscription models where customers pay monthly or yearly for access to the software.
- Media and Entertainment: Streaming services like Hulu and media outlets such as the New York Times charge a monthly or annual fees to access their content.
- Fitness: Gyms often have membership fees that customers pay every month.
- Consumer Goods: Retailers like Amazon Prime or Costco offer memberships with recurring fees for exclusive benefits like free shipping or discounts to boost retention.
Impact on Buying and Selling a Business
When a business owner is thinking about selling their business, having recurring revenue can make the business more attractive to buyers. It also influences when and how they might sell the business because a steady stream of income makes the business more appealing.
If you’re selling a business, it’s important to highlight recurring revenue to show potential buyers the company has a steady and reliable source of income. This can help you get a better price for your business.
When buying a business, it’s important to evaluate the sustainability and growth potential of the recurring revenue. Buyers should consider whether the business can keep its customer base and even grow its recurring revenue over time.
Attracting New Customers with Recurring Revenue Models
To boost the value of your business, you can try to increase your recurring revenue. Gaining new customers with a recurring revenue model involves a mix of strategies that focus on building trust, offering value, and making it easy for potential customers to start using your product or service.
For example, offering free trials or a freemium product helps potential customers evaluate your service before committing to a contract. SaaS companies often use this tactic to help buyers understand the enterprise value of the offering. For a small business, this could be as simple as offering a free week of services or a discounted introductory rate.
Retaining Customers with Recurring Revenue Models
A healthy retention rate is a very attractive metric for buyers. Keeping customers happy and making sure they continue to pay for your services is key to maintaining recurring revenue. Businesses often focus on customer satisfaction and customer retention to ensure their recurring revenue stays strong.
Evaluating Recurring Revenue
During due diligence (the process of examining a business before buying it), it’s important to make sure the recurring revenue is reliable and stable. Buyers have valuation metrics that help determine the overall worth of the business. This might involve looking at contracts, customer satisfaction, and other factors that could impact the revenue.
Key Metrics and Indicators: When assessing the quality of recurring revenue, there are a few important metrics and key performance indicators (KPIs) to consider:
- Churn Rate: This measures how many customers stop using the service over a certain period. A low churn rate means customers are sticking around, which is a good sign.
- Customer Lifetime Value (CLTV): This metric estimates how much money a customer will bring in during their entire time as a customer. Higher CLTV means more value from each customer.
- Customer Acquisition Cost (CAC): Understanding CAC is crucial because it helps businesses determine how much they are spending to gain each new customer. This helps buyers evaluate the long-term scalability and profitability of the business.
Maximize Profitability and Valuation with Recurring Revenue
Recurring revenue is a powerful driver of business valuation. It provides income stability, predictability, and strong appeal across various valuation methods. If you’re interested in buying or selling a business, it’s important to understand the impact of recurring revenue.
Want to know more about how recurring revenue affects business value? Check out BizBuySell’s valuation tools.