What Is Recurring Revenue?
Recurring revenue consists of stable, predictable, and reliable revenue that is expected to continue with a high degree of certainty for the foreseeable future. This contrasts with ‘one-off sales’ which is a revenue stream from unpredictable one-time events with less degree of reliability to recur in the future. There are degrees to which the certainty of the future revenue from a business is truly predictable and recurring. More certain sources of recurring revenue are customers with monthly or annual subscriptions or pay invoices with auto-pay. Less certain sources of recurring revenue are regular and repeat customers but with relatively low ‘switching costs’ when changing their preference in favor of a competitor.
Recurring Revenue Enhances Business Valuations
A business with strong recurring revenue create a high degree of certainty that the income stream will remain indefinitely intact. Buyers of businesses pay a premium for a secure income stream (sometimes 2-3 x higher multiples) with recurring revenue compared to businesses with one-time sales. Moreover, having a high degree of recurring revenue typically makes it easier for a business to grow over time. This is the case so long as the amount of churn – or lost customers – is minimal and the company can expand its customer base. Since a business with strong recurring revenue already has an established customer base, it does not need to constantly seek out new customers. This can substantially reduce marketing and overhead costs while increasing a company’s net margins. Strong growth, high margins, and a stable customer base all translate into higher business valuations.
Transferability of Recurring Revenue
The degree to which a business valuation with recurring revenue is enhanced depends upon the transferability of the recurring revenue base to the buyer. In many cases, recurring revenue is based on a contract with customers or suppliers. It is therefore of critical importance that the contracts be transferable to a buyer of the business. Often there are transferability clauses in customer contracts which gives the business owner the right to transfer the contract to another corporate entity. Supplier contracts usually require a qualification process of some kind for the transferee. No matter the language of the contract, business owners should ensure a smooth transition after the sale by jointly reassuring key customers and suppliers that there will be no change in the level of service.
Transferability of Goodwill
For businesses that derive their recurring revenue from repeat or regular customers (without contracts), the loyal customer base represents the goodwill of he business. Goodwill is an intangible asset and includes a company’s brand name, reputation, proprietary technology, supplier and employee relationships, and customer service. In a business sale, the seller (in consultation with their business broker) should have a clear exit strategy in place to transfer this goodwill to the buyer. The strategy depends on how the customer base is attracted and retained. If the seller is personally active in the operations of the business, then plans should be made to de-emphasize and minimize their own role prior to a sale. This will make the transfer of the goodwill more likely after the seller leaves.
Stock Purchase Deal for Contract-Dependent Businesses
Businesses with a high degree of recurring revenue are often reliant upon contracts with customers, suppliers, insurance companies, or the government. The need to safely and more easily transfer such contracts to the buyer often leads the parties to effectuate the sale by a stock purchase transaction. A stock purchase deal means the buyer of the business personally purchases the seller’s corporate entity (as opposed to the more typical asset purchase deal where the buyer of the business forms their own corporate entity which buys the assets of the seller’s corporate entity). In a stock purchase deal, the buyer of the business does not generally need to worry about the transferability of contracts since the same corporate entity remains intact and operational after the closing.
Example of Selling Business with Recurring Revenue
- Cain and Abel are twin brothers who each own a plumbing company they wish to sell.
- Cain’s plumbing company mostly does large renovation and remodeling jobs.
- These jobs mainly come via General Contractors (GCs) who are personally friendly with Cain.
- In contrast, Abel’s plumbing company focuses on residential service and repair.
- Abel has a large amount of customers who have recurring service contracts.
- Let us suppose that Cain and Abel each have $500K of adjusted owner benefit, or true economic profit derived by the owner.
- All else being equal, Abel will receive a significantly higher valuation (or multiple of owner benefit) for his business compared to Cain.
- While Cain would be unlikely to receive more than 2 x his adjusted owner benefit (assuming a buyer can be reassured that the GCs will continue referring business after Cain leaves), Abel is likely to receive at least 3-4 x his adjusted owner benefit in the event of a sale.
- Abel’s revenue stream is predictable, safe, regular, and not dependent on a few referral sources.
- Cain’s revenue stream is unpredictable and considered ‘one-off’ sales.
- So long as Abel’s customer service contracts are transferable, Abel will receive a premium valuation for his business.
Businesses with a high degree of certainty of their future income stream receive a higher business valuation than businesses without the same level of predictability and certainty of their future income stream. Buyers of businesses ultimately want to receive a sufficient level of future income from their investment to make the purchasing decision worthwhile. The higher degree of certainty that the future income will actually be realized, then the higher the business valuation.
Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.