Most everyone understands that, all other things being equal, a business growing faster than another should be worth more. Similarly, all things being equal, a business that has more predictable revenue streams should be worth more than one that is less so. These are precisely the reasons why, in the tech world, so many businesses with highly recurring revenue models are valued at a premium to others that have similar top line growth rates (especially firms that rely primarily on one-time sales of software or services).
In fact, in recent times in our m&a world, it’s become about more than premium valuation; it’s become the case that fewer and fewer investors or buyers of whole companies want to look at anything but companies with high degrees of recurring revenue, high renewal rates, and strong growth.
That’s why most tech firms that still rely on non-recurring revenue are working so hard to change. If you need any evidence, just look at Salesforce vs IBM and Accenture, for example:
For sure the growth rates of these firms are different and so is the predictability of revenue. It all derives from the recurring revenue model. The result is clear: the market is valuing each dollar of Salesforce revenue almost 3x those of IBM (56% recurring revenue) and Accenture (<50% recurring revenue), who are also market leaders in their space.
Working with investors and buyers of technology companies, we hear the same mantra repeated over and over again: they want recurring revenue businesses and will pay up for them – especially when combined with strong top line growth.
It should be obvious that when you start the year with 90% of your revenue “secure” you are in a much stronger position to grow than those who must start all over again. That also means much less risk.
Look at three hypothetical companies as an example:
- Company 1 is has 100% recurring revenue
- Company 2 is has 75% recurring revenue with the remainder professional services
- Company 3 is a traditional license / maintenance business with 50% of revenue coming from maintenance agreements
We can look at three scenarios that illustrate how these three companies are likely to perform differently given a similar level of new sales productivity. Assume that each company begins year 1 with $50mm in sales in “Year n”, sales happen evenly throughout the year and that non-recurring revenue is recognized over a one-year period with strong (90%) renewal rates.
Scenario 1: Moderate sales ($5mm in new bookings per year):
This difference is very clearly illustrated in our first scenario, in which each company signs $10mm of new bookings each year. Company 1 maintains its base each year and grows revenue from $50mm in the initial period to $69mm in year 5 – a 7% CAGR, compared with CAGRs of 2% and -5% for Companies 2 and 3, respectively.
Scenario 2: Strong sales ($20mm in new bookings per year):
In scenario 2, each company is able to successfully grow revenue, but Company 1’s revenue growth significantly outpaces that of its peers. Still, Company 2 is able to maintain a solid pace, increasing revenue at an 11% CAGR. Company 3, in contrast, grows at only a 5% CAGR.
Scenario 3: Weak sales ($5mm in new bookings per year):
None of these businesses fare extremely well in Scenario 3, with $5mm in new bookings each year; it is only Company 1, with 100% recurring revenue, that is able to sustain its revenue base, while Companies 2 and 3 suffer significant deterioration.
In a slow sales environment, a large recurring revenue base delivers the predictability that buyers and investors value highly.
Businesses with large amounts of non-recurring software and services revenue should think really hard about how to adjust. There will be some difficult decisions in the short term, but ultimately, they put themselves in a much stronger position to grow, to increase predictability, and to create significant long term value.