Some types of businesses generate more and more recurring revenues over time, often growing to a size where recurring revenues pay all of the overhead of the company – an enviable position.
The surprising recurring revenue trap
There is a phenomenon I have observed time after time with mature companies receiving
over 75% of their revenues from recurring sources. Management undertakes a simple exercise of calculating the increased profitability of shutting down all R&D, sales and subordinate operations, and universally notes with shock the high net profit that results – from shutting down all operations except customer service to recurring customers (as in software support operations.)
Legacy system recurring revenues
Depending upon the type of business, customers are loyal often because they are creatures of habit, enjoying the existing relationship and service, not wanting to disrupt a working resource. In fact, I am involved with one such company whose customer base extends back to the 1980’s when first purchasing their systems, still paying a regular quarterly maintenance fee to a company that services them well but has no remaining sales staff or R&D functions. The customers are happy and the company profitable. What’s not to like?
The result of “profit only” thinking
[Email readers, continue here…] Well, there are two problems here. The company dooms itself to a slow death over the passage of time as customers desert to newer products. So, the decision to “go into maintenance mode” is known as “milking the cash cow” for a reason. And second, there is no excitement in such a company to retain employees looking for advancement. Employees who leave are replaced with people who are likely not “A” players, often causing future levels of customer service to decline.
The enterprise value of recurring revenue-based companies
And yet, there are many companies where the cost of product renewal and R&D are just too high to keep up with competition. Companies in this predicament often can be sold for their recurring revenue stream, but the multiples they command are not high. In such a case, milking the cash cow may well be the best decision for management rather than selling the company.
An exception: SaaS companies
We started this conversation looking at legacy companies with recurring revenue. Companies that have built their revenue streams upon software, hardware, or other products delivered as a cloud service are a more recent phenomenon – saving capital outlays for their customers and delivering services more inexpensively using cloud-based systems. These companies have the same R&D issues and cash cow tendencies as legacy businesses, but there are two exceptions: new sales fall right to the bottom line in most cases, making these businesses more profitable than most capital expenditure propositions – attracting more customers without the need for financing or large up-front costs. And the enterprise value of these businesses at the M&A or IPO stage is almost always much higher than other types of businesses because of this.
The conclusion:
Recurring revenues are oil for companies growing, reinvesting in R&D and expanded sales efforts. Those same revenues are glue to those choosing the alternative route of milking the cash cow. In those cases, they are attractive slow, sticky streams of glue, slowing a company until it ultimately dies of old age.
measures that help them weed out those candidates that will be too expensive in terms of effort or of too little financial attractiveness.
transfer of institutional knowledge from acquired to acquirer. The best performers from the acquired become candidates to outrank or replace their counterparts, showing that a business combination is not all one–sided.
change. Authors Jeanne Liedtka and Tim Oglivie have created a framework for creation of a new product or service – one worth spending at least a cycle of time for review. From their book, “Designing for Growth,” they iterate a four-question matrix, each with steps for creation through launch. We’ll use this loosely to frame our process.
The Stanford Design School teaches ideation as a five-step process, fitting nicely into the four questions above.
first, let’s examine the three kinds of loyalty you don’t want to engender…
We engage the customer at the time and place most appealing to that person. We under–promise and over–deliver – every time. We react positively to suggestions, reward their loyalty with recognition, and make this important cohort not just seem to be, but actually be the ideal example of our mission personified.
in keeping up with trends. It is natural for executives and entrepreneurs with lots on their plate and little extra time – to just keep up the same activities that have made the company a success.
The industry takes notice when you change up the same old marketing methods and message. A company that uses the best and enhances or replaces the rest will be noticed and rewarded with increased revenues.
team. She holds a weekly meeting of her direct reports and asks them to find three important but actionable items for the group to work on if not complete during the following week. This works for live meetings or those using video team meetings.
had a great lesson for all of us. He had asked his arborist if he could move a mature tree from one part of his property to another – to make room for an addition to his home. “Yes,” replied the professional. “And how much would it cost?” To which the arborist responded, “We’d charge $18,000 for that.”
that asking the right questions may be more important than having the right amount of knowledge. Our friend could have been an architect attempting to protect the look of the homeowner’s property or view from a window. He would have known the positive visual effect of relocating that tree would have created. But he might never have known the consequence of that knowledge if never asking the critical question about the life of the tree.
one of the largest companies in the technology world. Everyone, including those connected with the newly acquired dominant player, wondered what changes would affect their company and their personal lives and fortunes. Well, even though that acquisition is still playing itself out on the field of battle, it appears quite clear that the new parent has directed its new subsidiary to abandon the lower end of the market and focus upon the larger sales, corporate customers, and major brands.
happened in the past? I know. We need financial data for comparison, and to a degree – for planning. But we should be thinking of finding ways to make data available to us much earlier when it would be more meaningful and actionable.
So that should become a departmental or corporate goal for you. Find places where reporting can be made by exception, not routine. Call center getting behind? Production slowed or stopped? Sales slipping unexpectedly? Why wait until the damage is done?
Hardeners of the arteries of progress. Most devolve into a series of reports from each constituency, spewing facts that could have been printed and passed to the board ahead of time. Board meetings should revolve around issues, not progress. Reviewing sales account by account is not an effective use of a board’s collective time. Attacking critical issues after providing background information and perhaps a list of alternatives is a good use of board time.
