What is Quality Revenue?
On the surface, revenue seems like a straightforward concept. It’s generated when a customer pays for and receives a good or a service from a business. But a more nuanced assessment of revenue can offer important insights to business owners and investors who are attempting to understand granular attributes of sales, often referred to as revenue quality.
Definitions of revenue quality vary. Someone who favors predictability may define recurring revenue as high quality, while someone who favors cash generation may define profitable, non-recurring revenue as high quality. Others may analyze assets in relation to revenue, and define revenue generated by a small asset footprint as higher quality than revenue generated from a large asset footprint.
Others still may investigate the problem a business solves on behalf of customers, deeming high quality revenue to be that derived from product-market-fit and competitive advantages. In this case, asset intensity and the recurring nature of the revenue may be a secondary consideration.
“Good” is Subjective
Like many concepts in operating and investing strategy, good is subjective and depends on an individual’s approach to entrepreneurship or investing. Regardless of how one defines quality revenue, assessing the sales of a business can offer a number of important insights into the health and forward looking prospects of a business.
Below we’ll explore recurring revenue and non-recurring revenue to better understand the pros and cons of each type of revenue, and how business owners can think about a pricing strategy that aligns with the value created for the customer and the business.
Defining Recurring and Non-Recurring Revenue
Recurring Revenue
Definition: Contracted revenue that is expected to continue into the future and coincide with the ongoing delivery of a company’s product or service.
This type of revenue is typically associated with subscription services, such as software subscriptions, gym memberships, or streaming media. Other examples include maintenance or support services, such as janitorial services and technology support, or rental and lease agreements for real estate or automobiles.
Recurring revenue contracts can call for payment and service delivery on a monthly, annual, or multi-year basis. Typically, contracts will auto-renew on the same frequency as the original agreement. If a monthly subscription is canceled, the customer has access to the product through the end of the month covered by the subscription payment. If an annual subscription is canceled, the customer has access to the product through the end of the year covered by the subscription payment. Multi-year contracts function in the same manner. If a contract is canceled one year into a three year agreement, and assuming neither party has breached the contract, the customer pays for the remaining two years and the business delivers the product or service for the remaining two years.
The key is that the customer’s consumption of the product or service happens on routine intervals, warranting a recurring fee for ongoing access to the product or service.
Non-Recurring Revenue
Definition: Revenue generated from one-time transactions that do not include a contractual obligation for the customer to repeat the purchase on a predictable interval. Think buying a meal at a restaurant, hiring a contractor for a home improvement project, hosting a live music production, or conducting an appraisal on a home during a real estate transaction.
Non-recurring revenue does not mean non-contracted! For example, if an event production company is hired for a wedding, a contract will govern the terms of the production company’s service delivery. But the contract will not stipulate that the customer must pay for and use the event production company’s services each month for the next 12 months. The event is an example of project based revenue for the production company.
Payment flexibility can also create confusion as to whether revenue is recurring. If the event production company allows the customer to pay the contracted amount over six months, this is not recurring revenue but instead a financing arrangement for project based revenue.
If consumption of a product or service does not happen on a routine interval, then a recurring revenue model is likely not a good fit for a business.
A Note on Repeat (but not Recurring) Revenue
Repeat revenue is often confused with recurring revenue. If a customer is not contracted to pay for a service on a routine interval, but that customer comes back regularly to purchase products or services, then the customer generates repeat revenue and not recurring revenue. Sticky customers who elect to come back to a business are an important sign that customers are satisfied.
An example of repeat revenue would be predictable vehicle servicing at a local mechanic shop. The customer does not contractually have to use the mechanic services every three months, but if the mechanic does a good job then the customer will elect to return to the same mechanic quarterly, thereby generating repeat revenue for the mechanic.
Pros and Cons of Recurring and Non-Recurring Revenue
Budgeting and Forecasting: Perhaps one of the greatest benefits of recurring revenue is that it makes the planning process more seamless and accurate. If a business has customer contracts that auto-renew, then the company’s revenue forecast should be more accurate than in a non-recurring scenario because the contracted base of recurring revenue creates predictable streams of income. The business can measure historical churn (lost customers), expansion with existing customers, and acquisition of new customers to generate a revenue forecast that has a high degree of accuracy.
On the other hand, non-recurring revenue can be more challenging to forecast due to uncertainty of timing related to a customer’s use of a product or service. Seasonal factors, economic factors, competitive forces, and other external dynamics can further complicate non-recurring revenue forecasts. While these forces also affect recurring revenue businesses, the volatility tends to be higher for non-recurring revenue businesses because they lack a base of long-term contracted revenue. You’ll often hear references to pipelines when a non-recurring revenue business attempts to forecast sales. Ongoing discussions with prospective, or repeat, customers, known as pipeline, are often the basis for quarterly revenue forecasts for non-recurring revenue businesses.
Cash Flow and Growth: A lot of fanfare is generated for the steadiness of recurring revenue, and rightfully so. But balancing cash generation and growth can be challenging for a recurring revenue business. Businesses often bear sizable upfront costs to build a product or service, with the goal of acquiring customers to drive utilization of the product or service. At scale, recurring revenue businesses may have superior economics relative to non-recurring revenue businesses, but scale isn’t a given.
Take for example a subscription business that charges customers $100 per month. The operating expenses required to support, maintain, and enhance the product amount to $250,000 per month, suggesting the business needs 2,500 customers to cover operating expenses (assuming a 100% gross margin). This begs the question of how long it will take to acquire 2,500 customers? Furthermore, will operating expenses increase as the customer count grows? Building a sufficient base of subscription customers to cover $250,000 of monthly expense is hard, and so too is figuring out how to fund operations prior to acquiring 2,500 customers.
Conversely, the non-recurring revenue business may be able to recoup a greater portion of operating expenses in a single customer sale. A tree removal business, for instance, might charge $3,000 to remove a tree. After paying for equipment, a crew, and fuel, this one job could contribute $1,700 of gross profit to cover operating costs (assuming $1,300 of job costs). And unlike the subscription customer who expects monthly enhancements to the product (new content, new software, new gym equipment), the tree trimming business leaves behind a happy customer who has no ongoing expectations related to the service.
At scale, recurring revenue businesses offer tremendous opportunities for operating leverage (more revenue covering a fixed base of expenses). But how much will it cost to reach that scale? And how much risk is an entrepreneur or investor willing to take? For some, a 25% cash margin on a tree trimming business is far more palatable than a breakeven software business growing at 50% per year. Neither is wrong, or bad, but this highlights the subjectivity associated with assessing the risk and reward dynamic inherent in running a business.
Valuation: Generally, recurring revenue businesses will receive more favorable valuations than non-recurring revenue businesses, all else equal, due to the predictability of revenue. Among recurring revenue businesses, software tends to be the most highly valued type of business due to the attractive gross margins and low incremental cost of an instance of software. Software is built once and can be sold thousands of times.
While recurring revenue businesses are more highly valued at exit, it’s important to note the trade-off between cash at exit versus operating cash flow generated over the life of the business. If a recurring revenue business requires investment of $5 million to break even over five years, then sells for $15 million, the business has generated a net $10 million of cash ($15 million at sale minus $5 million invested). Now consider a non-recurring revenue business that is profitable from year one, generates $5 million of cash over five years, then sells for $5 million, generating a net $10 million of cash (discounting and present value considerations aside). Both businesses generated a net $10 million in cash, but it’s likely that to raise $5 million of cash the recurring revenue company had to sell a portion of the business, resulting in outside equity ownership and a distribution of the $15 million at sale to parties other than the founder.
Again, this isn’t a bad or good dynamic, but instead highlights the subjective nature of defining quality revenue. Recurring revenue receives a premium valuation at exit, but can be more expensive to generate. Non-recurring revenue is less highly valued at exit, but can generate more operating cash on the path to exit.
Concluding on Recurring Versus Non-Recurring Revenue
Although on the surface revenue may seem like a simple concept, analyzing the quality of revenue opens up a number of opportunities for unique understanding of a business’s risk, growth prospects, and ability to generate cash. Recurring and non-recurring revenue are both important sources of sales for a business and each has a unique impact on a business's financial health, strategic planning, and risk profile.
As entrepreneurs and investors consider whether to pursue recurring or non-recurring revenue, it’s important to reflect on the frequency of product consumption, the price point for the product, the cost of delivering the product, and whether the business can meet its funding needs for the foreseeable future.
