Revenue Type and the Impact on Acquisition Appeal
Understanding the nuances of revenue types is crucial for business owners who are navigating the sale of a company. Among various revenue models, recurring revenue and contracted revenue stand out for their significant impact on a company’s valuation and attractiveness to potential buyers. While both terms are often used interchangeably, they hold distinct differences that can affect financial planning, reporting, valuation, and ultimately, the ability to succeed during a sale process.
This blog explores these differences and explains why investors typically favor true recurring revenue over contracted revenue, and which types of contracted revenue are of appeal to prospective investors.
What is Recurring Revenue?
Recurring revenue refers to income that is expected to continue in the future on a repeatable schedule. It is predictable, stable, and contractual. Examples include subscription services, membership fees, and any other revenue streams requiring customers to commit to regular, ongoing payments in exchange for ongoing access to a product or service.
The predictability of recurring revenue is highly attractive for business owners and investors alike because it increases the odds of steady revenue.
What is Contracted Revenue?
Contracted revenue, on the other hand, is income that arises from agreements or contracts with customers, but the agreement may not guarantee utilization of a good or service, and subsequently may not guarantee predictable revenue. While recurring revenue is always contracted (i.e. customers agree to be billed monthly, annually, etc), not all contracted revenue is recurring.
Contracted revenue includes various forms of agreements such as master service agreements (MSAs) that outline terms, pricing, and service levels. However, these agreements do not guarantee regular revenue unless they include specific clauses for utilization or minimum payments.
The Role of Master Service Agreements
Master Service Agreements are contracts that define the relationship between a service or technology provider and a client. The agreements cover aspects such as pricing, service quality, delivery timelines, conflict resolution, and the in-force term of the agreement. However, MSAs do not inherently guarantee revenue as they often lack requirements for utilization.
This means that while an MSA dictates how business will be conducted, it does not ensure that the client will consistently use the services or make regular payments. This uncertainty makes it more challenging for a business to budget and plan compared to recurring revenue models.
Pin the Tail on The Budgeting and Planning Exercise
For businesses relying on contracted revenue through MSAs without guaranteed utilization, budgeting and planning become more complex. The absence of predictable client use of services can lead to poor visibility into planning for team member assignments or asset availability. Professional services firms, such as law firms and consulting firms, face this exact challenge. Just because a client agrees to pay $500 per hour for services does not mean the client will consume a predictable number of hours week-to-week.
Companies may face difficulties in forecasting revenue, managing operating costs, and making investments in growth. The ongoing challenge for MSA governed service companies is striking a balance between providing enough capacity to meet client needs, but not so much capacity that half of the team sits idly waiting on work. This unpredictability is a significant drawback when compared to the steady and reliable nature of recurring revenue.
Recurring Revenue Offers Reporting Benefits and Unique Analytical Opportunities
Beyond budgeting and resource availability benefits, recurring revenue offers opportunities for granular measures of financial performance. Since recurring revenue streams are predictable and stable, companies can generate more accurate financial forecasts and performance reports. This predictability simplifies the formulation of key metrics such as customer acquisition cost (CAC), customer lifetime value (LTV), customer churn (i.e. lost customers), and expansion with existing customers.
For businesses with contracted but non-recurring revenue, these metrics are harder to calculate and are notoriously more volatile, complicating the assessment of financial health and growth potential. For instance, without recurring revenue, it’s difficult to assess whether a customer has been lost, or whether that customer is simply not in need of a service but plans to return once need arises. In the latter scenario, how should a company project the timing of the customer’s return?
Acquirers and Investors Tend to Prefer Recurring Revenue, But…
Investors place a premium on businesses with true recurring revenue for several reasons. The stability and predictability of recurring revenue reduce investment risk and provide a clearer path to scale and quantifiable value of marketing and sales efforts. This makes businesses with strong recurring revenue more attractive as acquisition targets.
On the contrary, companies that show contracted revenue, but not recurring revenue, can bolster the quality of revenue by demonstrating strong repeat customer activity and consistent utilization of services or technology by customers. If a customer does not have to contractually pay each month, or quarter, but the customer's need for a good or service warrants coming back to a business on a regular basis, this is a positive.
Valuations Vary Depending on Revenue Type and Quality
Recurring revenue is often a key factor in assessing the valuation of a company. Businesses with high levels of recurring revenue typically receive higher valuations due to their predictable cash flows and lower risk profiles.
For companies relying on contracted revenue without guaranteed utilization, the valuation process becomes more complex. Investors will analyze the business’s historical performance, customer retention rates, and utilization patterns to gauge the reliability of future revenue. A business with a defensible service offering (hard for competitors to replicate) and a reputation for quality service to customers can be an attractive investment, even if revenue isn’t contractually recurring. But the detailed diligence conducted on historical service provision will be an important part of due diligence.
Concluding on The Importance of Recurring Versus Contracted Revenue
Understanding the difference between recurring revenue and contracted revenue is essential for any business owner considering a sale. While both revenue types can be contractual, only recurring revenue offers the predictability of ongoing revenue that is guaranteed for the contracted period (monthly, quarterly, annually, etc). Master Service Agreements and other forms of contracted revenue can provide a foundation for strong business relationships, but they do not guarantee consistent revenue without clauses for retainers, minimums, or utilization. The ability to demonstrate reliable, repeat customer activity becomes critical in these cases.
