September 8, 2015

I Scream, You Scream, We All Scream for Recurring Revenue (Part 1)

by mike smerklo

In this series, I unveil my secret formula for being discerning when it comes to recurring revenue businesses as an investment opportunity – and how to avoid acting like a two-year-old in the process.


child-eating-cake-and-ice-cream

 


It comes as no surprise that children act with impulsivity, selfishness and an alarming lack of discrimination. Excerpt from a typical Saturday afternoon drama at my house:

Me (as Dad): Do you want to get some ice cream?

My two year old: YES! YES! YES PLEASE!!

Me: What kind of ice cream do you want?

My two year old: I don’t care. I just want ice cream!

Me: Are you sure? You really don’t care? You don’t like one kind better than the other? They’re all the same to you?

My two year old (growing irate, tears welling up): I DON’T CARE. I JUST WANT ICE CREAM. ANY ICE CREAM. PLEASE!!! Can I just please have some ice cream??

And while I’m the first to admit that there’s nothing better than spending time with my kids, sometimes I’m grateful to head to work where communication is nothing if not professional: level headed conversations, meticulously weighed outcomes, and careful decision-making define the business sector I operate in.

So imagine my surprise when I head to a meeting this week with a group of investors as it relates to Software as a Service (SaaS) business and recurring revenue. Here’s an excerpt from that dialog.

Me (as a recurring revenue expert): Do you want to invest in recurring revenue businesses?

Investor: YES! YES! YES PLEASE!!

Me: What kind of Recurring Revenue do you want?

Investor: I don’t care. I just want Recurring Revenue!

Me: Are you sure? You really don’t care? You don’t like one kind better than the other? They’re all the same to you?

Investor (growing irate, tears welling up): I DON’T CARE. I JUST WANT RECURRING REVENUE! ANY RECURRING REVENUE. PLEASE!!! Can I just please have some RECURRING REVENUE??

Berkshire Hathaway Annual Meeting


Dessert Du Jour

For well over a decade I’ve been talking to investors (private and public) about the power of recurring revenue and how the evolution of Cloud computing and SaaS businesses are changing the very nature of the customer-vendor relationship. For the longest time, this message was receiving very little interest, especially from the professional investment crowd.

So on one hand, it is pretty exciting to see how big the shift has been as this business model has gone from a relatively unknown concept to a must-have for the investment community. Every professional investor seems to be giving a ton of value to recurring revenue and basing valuations on this key metric, from VCs investing in startups all the way to public markets valuing high growth companies.

Now it is absolutely standard for every emerging-growth company to talk about their recurring revenue business model – and valuations for growth companies are typically driven exclusively by a multiple of revenue. And these multiples have expanded significantly – in some cases to the double digits – all with the assumption that the revenue will recur in the future and therefore revenue can be seen as a proxy for future earnings.

31 Flavors, Sure, But Only 3 Are Worth the Calories

Recently I was at a technology conference when I overhead a group of investors talking about this concept, but they all were confused as to what exactly to focus on to judge the quality of recurring revenue.

I have also talked to countless entrepreneurs who have enthusiastically described what percentage of their business’s revenue is recurrent – without even having a very good or consistent definition of what “recurring” truly means.

So here is the “secret” that you already know…

Just like ice cream, there are flavors of recurring revenue – and while they are all better than spinach, some are simply better tasting than others. For entrepreneurs, it is critically important to know how to think about managing this part of your financials and how to communicate this effectively to your investor group.

My Just Desserts

The company that I bought and then served as CEO for 12 years is ServiceSource (TICKER SREV), which has become known simply as “the recurring revenue company.” ServiceSource helps all sorts of technology companies manage their recurring revenue streams – so I know more than a little about this topic.

Over my tenure as CEO, I was fortunate to see firsthand just how different a customer relationship can be for various companies – and just how sticky some types of recurring revenue can (or cannot) be. In fact, I have been actively talking about the power of the recurring revenue business model for a long, long time.

Here I am with Alec Baldwin (among others) talking about this topic at Dreamforce in 2014:

Alec-and-Mike

Recurring Revenue, Like Ice Cream, Isn’t a New Invention

It is pretty important to realize that recurring revenue models have been around for a long, long time but mostly outside of the technology industry. But like a lot of things, the technology industry has taken an existing concept and made it a lot better.

Do you remember when your parents would subscribe to a magazine? A bill would come annually and, if paid on time, the magazine would show up in the mailbox every month. Or how about your cable bill? Believe it or not, there used to be these things called record clubs – you signed up and every month a record (music delivery vehicle: Google it) would show up in the mail and you would be billed on your credit card for it.

These were all early “recurring revenue” business models – companies that found a way to get a customer to keep paying again and again for the same thing, but they were called subscriptions. And no, in case you were wondering, a dinosaur didn’t deliver the records to the subscriber’s home….

dinosaur

Nowadays – wow, I am now my grandpa sitting on a front porch – this business model has expanded to just about every type of technology. The most obvious examples come from Software as a Service (“SaaS”) leaders Salesforce, Workday or NetSuite, who sell a subscription to their software, usually on an annual basis. Other examples include web services like Amazon Web Services (AWS), which offers an entire data center infrastructure solution entirely on a subscription model. Or conference call solutions like BlueJeans. Or movies (Netflix), music (Spotify) and even cars (Zipcar). And on and on…

Yellow Snow ≠ Snow Cone

But here’s where the trap comes in and makes me think of the venture capitalist and ice cream. As exciting as some of the new solutions are, entrepreneurs and investors have to be very careful about how they think of these revenue streams – be it for valuing an enterprise or planning what level of churn to expect in your business.

Said differently, you wouldn’t value an annual subscription to Fortune the same way would value a year subscription to Saleforce’s CRM solution, would you? As a CEO, would you want to count on a 95% retention (or 5% churn) for any SaaS offering you build, regardless of the customer you were serving?

In the next post on recurring revenue, Feel the Churn, I’ll unveil my formula for accurately assessing the value of a recurring revenue business. Until then, stick with chocolate…it’s pretty much a sure thing.

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