When valuing technology companies, the importance of recurring revenue – recurring revenue in business jargon – very large. But one recurring revenue is not the other. No Monkey Business helps you on your way as an entrepreneur.

Important for everyone

The focus on recurring sales is not something of today or yesterday. Recurring revenues provide stability in business operations and have therefore always been interesting for entrepreneurs. That's how it works: a company whose turnover (or a certain part of it) returns annually, knows (approximately) for the coming periods how much money it has available for investments, for personnel, and so on. That offers room for growth plans. A predictable flow of money is also possible for financiers, suppliers and investors (cash flow) of interest. Recurring sales let them know they can count on you.

For this article – make your business more valuable! – is especially important how investors view recurring revenue. An example. A company that generates revenue from newspaper subscriptions (the traditional publisher) is likely to have a more stable cash flow than a company that trades in auto parts. That makes the publisher's future revenue (in theory) more valuable than the merchant's.

Less risk, more value

Why that is so has everything to do with risk. Investors, of course, want to make money on their investment. And making money starts for every investor with at least not losing his investment. When sales fall, companies become worth less. So: the less risk investors run that a company's revenues fall or disappear altogether, the more they will be willing to pay for that revenue (in the case of an acquisition) or to realize growth (in the case of growth capital). .

With recurring revenues, the risk for an investor is low, which has a positive influence on the value of the company. Recurring revenue has by far the most value if that revenue actually grows. The aforementioned example of the newspaper publisher is then interesting. The turnover from subscriptions is indeed predictable and highly stable, but since the rise of the internet, turnover for many daily newspapers has fallen by one to a few percent each year. A declining cash flow is not very attractive to most investors – there are exceptions.

Two valuation methods

All this leads to the concept of the so-called discounted cash flows. An entire scientific discipline has emerged over the past decades around the valuation of (future) (recurring) turnover – with a number of schools of thought. Broadly speaking, there are two basic methods.

The first is to look at a company's past performance (for example: net or gross profit) and solve for a multiplier. It may be common for a company in one sector to pay 10 times its profit for the past year, in another case five times.

The second method – and also in the high-tech sector that is certainly common – is to estimate the future turnover of a company. For every bit of risk that the turnover will be lower or that it will take longer before a certain turnover will be realized, a discount – ie discount – is applied in the valuation of the company.

In concrete terms (and simplified), suppose that a company expects to achieve a turnover of 1,000,000 million euros next year. Then that turnover for an acquiring party might be 700,000 next yeare worth euros. Why the discount? There are three reasons why future sales are worth less than today's sales. We already mentioned one: the risk of loss of turnover. In addition, the level of inflation (money depreciation) plays a role, and thirdly also the psychological 'fact' that people simply want to give more for something they get now than if they only get it in the future.

Tip: click on this infographic and print it out.

SaaS in the lead

Now let's apply some of this to the high-tech enterprise—especially the software enterprise. In the early days of the software company (roughly the eighties) all software was customised. In the 1990s and 2000s, software entrepreneurs mainly sold sortware packages. Now they sell as many subscriptions as possible, or also: software as a service (SaaS).

Software as a subscription has a number of advantages for the provider (also for the customer, by the way, but we will not consider that here). Instead of developing different products, the provider can continue to develop and roll out one service. This obviously benefits scalability. Provided that this is done properly, the product development process also creates a closer relationship with the customer: a subscription leads to more contact points than a single sale.

Above all, a stable turnover is created. Because many software companies are growing rapidly in this age of digitization, these companies are all about rapidly increasing stable turnover – and that is what makes investors very happy.

Sticky, stickier, stickiest

Long story short: entrepreneurs who want to sell company, would do well to aim to increase recurring revenue. If that's possible, of course. For a hardware developer, a subscription is a lot more complex than for a software maker.

What types of recurring revenue are there? The distinguishing factor is stickiness (stickiness, but metaphorical) The more your product is used in the customer's central business processes, the more difficult it is for that customer to say goodbye to you. The more valuable is the recurring revenue.

Suppose your company makes software that enables banks to simplify and accelerate the process of mortgage applications through data management and artificial intelligence. You offer this service as a SaaS supplier. Once a bank has taken out a subscription with you, you are deeply involved in the primary business process with that bank and it will be very difficult for the bank to distance yourself from you. That's stickiness.

Just a little less interesting

After a while, some companies that are active in primary processes also face considerable competition. Consider, for example, suppliers of accounting software. As an entrepreneur, you prefer not to change your accounting package at all, but it is certainly possible. There are plenty of providers. If a provider stands out in terms of quality, you as a customer do well to switch to it, despite the effort it takes.

Even less interesting from an M&A perspective is a situation when sales are recurring, but stickiness is low. Suppose you are a provider of photo editing software, and your service is used by the marketing department of many companies. Or you are the provider of food boxes or a flower subscription.

Customers can also take out a subscription with this type of company, sometimes it is even mandatory. But switching to another provider with (alleged) better quality is easily arranged. As an entrepreneur, you will have to do your best year after year to guarantee the recurring turnover. And business valuers usually know how to estimate that.

Number two: The SLA and SA

There are also plenty of opportunities for companies that did not start out as SaaS providers. Suppose your company sells computer systems. Those computer systems need maintenance – and who understands the systems better than you? The Service Level Agreement (somewhat crookedly translated to Service Level Agreement) and Service Agreement offer possibilities for recurring revenues.

An SLA or SA is seen as less sticky than recurring revenues of software companies in primary business processes, but it does represent recurring revenue for a business valuation – especially if you as an entrepreneur can present a long history.

But what if your technology company is a consultancy company that thrives on providing tailor-made advice in a particular area? Ultimately, it is also advisable for companies that do not yet have a recurring turnover to get started. Very rough; a hearing party pays once the revenue for a company that charges hourly rates, and three times the revenue for a company with recurring revenue.

Number three: services packaged as a product

What can you do as a traditional consultant? Undoubtedly interesting to look at are the so-called productized services. This is also a model with which No Monkey Business has a lot of experience.

Productized services are services packaged as a (scalable) product. As a rule, an advisor in a certain area has strong in-house knowledge. More often than not, that knowledge can be turned into a template, template or even portal. Especially with the advance of artificial intelligence, all kinds of smart tools are increasingly becoming a possibility for customers. 

These productized services offer all kinds of advantages. They offer – you guessed it – recurring revenues if use of the product is then offered again in a subscription form. But often a service is also created that is interesting for smaller customers. Customers who shy away from expensive consultants may find your portal very interesting. And as the saying goes, many small ones make one big one. That is interesting for every entrepreneur, especially if those little ones also potentially turn into big customers.

How do you get started?

Building recurring revenue can seem like a huge task, especially if your company is based on completely different foundations. Our advice is: start small. Start with a separate, somewhat smaller product that makes you as scalable as possible, including customer service via online channels or even via a chatbot. Put this new business side by side with your existing business – so you can protect the existing one while you try the new one.

For a dream exit it is not necessary that the entire revenue is recurring revenue. But a beautiful, fast growing chunk recurring revenue does wonders!