This week, our guest post is by David Steakley, a past President of the Houston Angel Network, and a reformed management consultant. David is an active angel investor, and manages several angel funds in Texas.
I have a positive fetish for recurring revenue. When I hear a company pitch a business model which I believe has the potential to acquire a customer once, and keep the customer paying for a multi-year period without further marketing expense, my ears perk up. Typical examples are software as a service (SaaS) models, or any kind of content-driven subscription model.
There are so many things to love about a company with this kind of subscription model. Especially for a provider of a virtual good or service, costs of goods sold do not scale with sales, as they do in the real world. In the virtual world, a much higher percentage of incremental revenue falls straight to the bottom line. In most businesses, you can look at the revenues all you want, and you can draw pretty pictures extrapolating the curve of revenue growth, but, usually, the reality is, the company needs to go out and sell the annual revenue all over again every single year.
With the right recurring revenue model, top line growth can really shoot the lights out. Each year, the company can commence with a reasonably predictable big portion of last year’s revenues already in the bag.
[Email readers, continue here…] It requires special capabilities and expertise to really capitalize on a recurring revenue model, and a different way of measuring success for both executives and investors. Subscription businesses typically take longer to get to profitability, because costs of developing the product or service, and customer acquisition costs, are front-loaded, while revenue is back-loaded. By conventional measures of company performance, a recurring revenue company can appear to be struggling at first, but you have to know what measures are predictive for this kind of company.
The key calculation is the cost of customer acquisition, compared to the gross margin contribution of the customer. If an analysis of the gross margin on a new customer acquisition reveals that customer acquisition costs can be recouped in two years, you’re doing well. If you get back customer acquisition costs in one year, you’re doing great. This assumes reasonably low churn of 10% or less.
The crucial turning-point for a recurring revenue model with a potentially massive market is the moment when the acquisition model is sufficiently effective, refined, and repeatable, so you can blow it out and scale it up. If you’ve got a favorable payback period for customer acquisition, and you can repeatedly perform the acquisition model, then that is the moment to forget about profitability and spend like a crazy person by scaling up the sales machine.
When you go to sell the company, you’ll get paid based on the slope of the recurring revenue curve (up and to the right), and even if a company sale is not in your plan, you’ll be glad you sacrificed current profitability for the longer term, if you’ve picked the right moment to go big.
I’ve always thought Steve Case was the early genius of this kind of thinking. In the late 90s, you could have had a hard time picking up your mail without finding an AOL software connection CD in the mailbox. AOL spent about $300 million sending out those CDs, and at one point, half the world’s production of CDs had the AOL logo on them. The lifetime value of an AOL subscriber was about $350. Average customer acquisition cost was about $35. That extreme in postal spamming took AOL from an IPO market value of $70 million to a merger value of $150 billion when AOL was combined with Time Warner. Wow.
Recurring revenue companies have been changing hands in the last few years at four to six times’ annual recurring revenue. Steve Case’s Time-Warner bonanza of perfect timing may not be repeated any time soon, but the appetite for these kinds of companies is more robust than ever.