Most every business can take advantage of continuing, recurring revenues from its customer base. Sometimes, products are designed to make all of their profit upon the recurring revenues from supplies or support. We immediately recall the razor and blade analogy to illustrate the point when planning product development and release.
Xerox in its formative years, even though barely having enough cash to market its then revolutionary copier, elected to lease rather than sell the units. Even though that reduced short term earnings, lease revenues over time far outweighed any combination of sale and maintenance revenues, and Xerox grew into a major company based upon its innovation and its recurring revenues.
In examining mature software companies in vertical markets, one of my first questions is to ask for the percentage of total revenues coming from recurring sources – leased software, maintenance agreements, or monthly retainers. Usually that amount exceeds 50% of total revenues, and is often much more. Mature businesses bring less in an M&A transaction than fast-growing companies, but the stability of recurring revenues always gives comfort to the buyer and allows the seller to slow the sales process, find multiple candidate buyers, and create increased demand for the company.
[Email readers, continue here…] Think of the portion of fixed overhead covered by recurring revenues. If the gross profit margin averages fifty percent in a service company, and if fifty percent of all revenues come from recurring sources, then it is probable that the company is stable and operating at or above breakeven.
And in a sale of the company, it is usually better for the seller who will command a bonus valuation based upon some multiple of recurring revenues due to the comfort value to the buyer and the increased lifetime value of each customer to the enterprise.
Finally, in a downturn, and there will be downturns that match the economy when a company begins to mature, recurring revenues can and often will save the company itself and smooth the revenues through the downturn.
If you have not spent considerable time refining a strategy to include recurring revenues, do so now. And remember, that once annual contracts are in place, they must include escalation clauses based upon some cost index to prevent their profitability from declining involuntarily over the years as inflation eats into the value of each non-indexed contract.