The Recurring Revenue Model By Gerry A. Hays / Professor of Practice Indiana University Kelley School of Business

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1 The Recurring Revenue Model By Gerry A. Hays / Professor of Practice Indiana University Kelley School of Business Introduction Not all revenue is created equal. A dollar in sales is a dollar in sales. But the more predictable that dollar is, as in the more likely a business will receive that dollar from its customer every month, the more valuable it becomes. When the start- up begins to multiply that dollar by adding new customers and creating an annuity of cash flow, it begins reaping the benefits of what is known as a recurring revenue stream. What makes recurring revenue so valuable is that a start- up can spend more of its energy growing the business rather than on trying to acquire enough new or repeat business just to hit the same revenue level it did the year before. For example, let s suppose a start- up is generating $1 million in sales, 90 percent of which is recurring. This means it can already bank on receiving $900,000 as it kicks off the new calendar (or fiscal) year and only needs to find an additional $100,000 to match the prior year s results. Anything beyond that is all growth. Compare this to a company with or recurring revenue (i.e. custom software development firm). It may earn $10 million in a single year but every subsequent year it begins again at $0. Investors like recurring revenue because it can better predict what a start- up is going to earn in future years. In fact, the more recurring revenue a company has, the higher the valuation it will receive from prospective investors and buyers. Revenue Stream Types Before developing a Recurring Revenue Model, it s important to understand the ways a business can generate revenue. Revenue streams refer to the specific ways a company brings money into a company. The following are the basic types of revenue streams: Asset Sales Ownership rights are sold of physical product. Amazon sells books. Telsa sells cars. Usage A customer pays a one- time fee for a service. For example, attorneys are paid a fee to provide legal services (i.e purchasing someone s time). FedEx is paid a fee to deliver a package. 1

2 Renting/Leasing A customer pays for the exclusive right to physical asset for a period of time. Fans purchasing a concert ticket are purchasing the exclusive rights to a seat at the venue. Hertz leases a car for a specific period of time. Licensing The business retains ownership of content or software and licenses the same to third parties. Microsoft sells a license to its desktop software. Listing Business charges a fee to list a product or service for sale. Craigslist generates revenue on classified listings and, unlike brokerage below, earns the fee regardless as to whether a transaction is completed from the listing. Brokerage - Revenue is derived from connecting two or more parties together for purposes of consummating a transaction. For example, Real Estate agents receive a brokerage fee if it brings a buyer and seller together and a transaction is completed. E*Trade charges a brokerage fee to its clients whenever they buy or sell a stock. Advertising Revenue is generated by selling marketing access to large community of individuals. Newspapers generate a significant amount of their revenue via advertising. Facebook generates nearly $8B per year by selling advertising space on individuals Facebook pages and timelines. Data Online or mobile businesses that collect and monetize personally identifiable information (PII) and sell the same to third parties. For example, Acxiom claims to have 1500 pieces of information on more than 200 million Americans in which it sells to interest parties. Revenue Stream Considerations When developing the revenue streams, the following questions must be considered: Product/Market Fit The single largest cause of start- ups failing is lack of product/market fit. Thus, it is imperative for the start- up to truly understand the target market s pain point and what type of value that must be delivered to effective take away some or all of the pain. From there, an effective revenue stream(s) can be created. (i.e. deciding between a one- time fee and a rental fee). Is there more than one revenue stream that can be utilized? Customer Acquisition Costs Right behind failure to find product/market fit, the second biggest cause of start- up failures is that the cost to acquire a customer is much higher than the lifetime value of the customer. Most entrepreneurs simply assume that its target customers go out 2

3 of their way to find and purchase the product when this is rarely the case. Additionally, very few products/services lack the viral nature of products such as Instagram, Snapchat, or Tinder. Again, when thinking about customer acquisition costs, a start- up should conduct an exhaustive web search of what other companies are paying to acquire a customer. For example, here is what some companies are paying to acquire a customer in 2014: Online Travel: $7 per Customer (ex. Priceline) Mobile Carrier: $315 per Customer (ex. Sprint) ecommerce: $10 per Customer (ex. Barnsandnoble.com) Web- based Financial Services: $175 per Customer (ex. TD Waterhouse) Optimism has no place when thinking about customer acquisition costs. Entrepreneurs need to fully map out a plan to acquire customers utilizing various techniques such as Search Engine Optimization (SEO), Search Engine Marketing (SEM), Public Relations (PR), Social Marketing, Direct Sales (start- up selling direct to the customer), and Channel Sales (selling to consumers through distributors/retailers). Obviously, a start- up with high customer acquisition costs and non- recurring revenue is very challenging to fund. Pricing Start- ups are going to be price constrained based on what competitors are charging for a similar type product or service that already exists in the marketplace. For example, online advertisers charge marketers on a CPM (Cost Per Thousand Impressions) basis. The average cost of a CPM in today s marketplace is $1 (10 Million impressions will generate approximately $10,000 in advertising revenue). Thus, as a first step to thinking about pricing, a start- up should conduct an exhaustive web search of similar product/service offerings to get a general sense of the overall market. However, start- ups will have pricing advantages if their product is designed to solve a specific problem for a specific niche. In the example above, if a start- up is catering to a specific audience (i.e. females ages 18-22), then it can charge a CPM higher to those companies whose products/services cater to females ages (i.e. $5- $10 per CPM). A separate example would be a gluten- free bread product that targets individuals with celiac disease. Additionally, if the start- up s product or service has certain proprietary advantages against competitors, it may have pricing advantages. As an example, Apple is able to 3

4 command high prices for its computers because its hardware and software cannot be purchased anywhere but Apple. Certainly, the costs to produce a product or service are a part of the pricing equation. However, if the cost to produce a product or service forces the start- up to charge a price that s way out of line with other competitive offerings, then is it really a viable business to begin with? Number of Customers Required Each business will require the acquisition of a certain number of customers in order to reach profitability. Consider the following; For an advertising- based revenue model, at $1 per CPM, a start- up is going to have to build a community of several million to reach a $100MM in annual revenue (making the odds of success very low); and For a brokerage- based revenue model seeking a small fee per transaction, a start- up will need to process millions of transactions to reach $100MM in annual revenue. Generally speaking, most successful start- ups eventually find on a non- commoditized area of a market in which margins are not razor thin and there is an opportunity to acquire a large number of customers at reasonable margins. Strategies to drive Recurring Revenue There are multiple strategies to drive more predictable revenue. Having the lowest prices IS NOT a strategy to drive recurring revenue. This strategy ends up driving short- term purchases and reduces margins in the long- term. I call it a race to the bottom strategy. Rather, as an entrepreneur, it s your job to create a unique revenue strategy that drives recurring revenue without having to sacrifice reasonable margins. Affinity Affinity is a strategy in which a business offers a loyalty or rewards program to customers in order to increase the frequency and amount of purchases. Some examples include Dicks Sporting Goods Scorecard program. The Delta Sky miles program is designed to increase purchase loyalty. Affinity is a strategy that s often deployed by businesses that sell commodity- type products and services. Membership Companies may choose to offer their products and services at a bigger discount than normal if the consumer or business purchases an annual membership. An example would be Costco. The Company keep prices on everyday items, clothing, tools, etc. low by buying in huge quantity and never marking up any product more than 15 percent, less than the typical 25 percent at a 4

5 supermarket or 50 percent at a department store. Costco makes up for those low margins by charging a $55 annual membership fee of its 64 million members. Subscription Subscription is the strategy of a consumer paying a monthly fee to gain access to an online product or service or to receive a certain type of product on a monthly basis. Basecamp, a web and mobile- based software company, charges $19.00 per month for businesses to launch and host a business collaboration space. Several businesses have been launched around consumable subscription models. Birchbox, for example, offers consumers of monthly kit of grooming and beauty products. Of course, the subscription model has been around long before the Internet. Think magazines. Marketplace Successful start- ups that have utilized brokerage as a revenue stream have successfully created a large marketplace of buyers and sellers. This results in a certain level of predictability in terms being able to sell a product/service or acquire a product/service in as efficient means possible. For example, Craigslist has managed to aggregate millions of users around its classified ads by allowing free listings. It then charges a fee for specific listings (i.e. $75 to list an apartment in San Francisco). Creating a large marketplace of buyers and sellers can be a very expensive proposition. However, the appeal is that the more buyers and sellers aggregated, the less likely the buyers and sellers will move to a competing offering. Community As a corollary to marketplace, companies that create successful advertising revenue- based businesses have aggregated a large number of loyal individuals. For example, Facebook has not aggregated more than 1 Billion users with hundreds of millions that come back to the site every month. Advertisers pay billions to gain access to Facebook s community of users. Other successful start- ups have built smaller, more refined communities that have become valuable properties. For example, Cheezburger has create large communities around Pokememes, LOLcats, etc. Each of these communities attracts a certain demographic that is valuable to certain advertisers. Additionally, outside monetizing a community via advertising, building a commmunity can help a company drive sales for physical products. Companies such as Red Bull are trying to create a community of extreme sports enthusiasts. Experience Building a loyal following around brand or product or way of doing business can help drive recurring revenue. For example, Trader Joes caters to a specific loyal following of consumers seeking a great in- store experience and access to quality food products. Zappos offers a customer- centric, e- commerce- based approach to selling shoes and other items to drive repeat business. Nordstroms is known for its policy never to say no to a customer. Because many of these models require the right people to make them work, they are very challenging models to execute. As a result, investors remain skeptical of these models until there is ample proof that they can scale. 5

6 Upgrade The idea behind this strategy is to create recurring income of one- time purchased products by encouraging customers to consistently upgrade to a new product or service. For example, Microsoft will release a new version of Office every few years (2003, 2007, 2010) and sell upgrades to both individuals and businesses. To ensure the upgrades, Microsoft may announce that it will no longer support previous versions of Windows. Oracle has a revenue model of continuously selling new features to its clients. For example, it may sell an Enterprise Resource Planning (ERP) system and then entice the customer to add Customer Relations Management (CRM) at a later date. Loss Leader This strategy involves a start- up offering a product or service at a price that is not profitable for the sake of offering another product/service at a greater profit or to attract new customers. A classic example is that of razor blades. Companies like Gillette essentially give their razor units away for free, know that the customers will have to purchase their replacement blades, which is where the company makes al of its profit. AT&T sold the original Apple iphones at a steep loss in exchange for a minimum 2- year usage contract. Freemium The word Freemium is a combination of the words free and premium. It describes a business model in which a start- up gives a core product away for free to a large group of users and sells a premium version of the product to a smaller group of users. This is perhaps the most used model for internet & mobile based software companies. For example, Dropbox offers a free solution for less than 10 GB of storage and charges $10 per month for 100 GB of storage. Summary The key takeaway is that, as an entrepreneur, you need to be thinking of how you can drive recurring revenue through your company. One of the biggest factors in determining the future value of a start- up is the extent to which an acquirer can rely on future sales. Businesses that live from project to project or start at zero revenues each year will have a lower valuation while those that can demonstrate a reliable source of future revenue will achieve much higher valuations (and more exit opportunities). 6