Why Business Investors Prefer a Recurring Revenue Model
When I consult with entrepreneurs and owners of small businesses, I begin with this question: Are you building the business for cash flow or equity? In most cases, that question and answer aren’t considered or revealed until it’s time for an owner to exit. The truth is, they should both be considered before the business’s doors open. You see, the answer determines whether the business is seen by the owner as a job or an investment. And in the end, it dictates their business’s value.I’ve met hundreds of business owners whose involvement in their business is significant and mandatory. They have built what they have for cash flow/lifestyle, and save for vacations and occasional days off, their absence means the business likely wouldn't survive longer-term (or certainly wouldn't operate at the same level) without their active participation.
When it comes time to exit, are these owners selling a job or a business? Will the buyer care about how much money the owner has made, or how much equity has been built? The on-going value of the business can't be determined by how much an active owner/operator has made in the past. It can only be determined by projecting what the business will earn going forward, without the owner/operators involvement. Simply put, business valuation is based on a prophecy of future profits.
That's why businesses with a recurring revenue model are so desired by investors. The greater percentage of revenue being generated by longer-term agreements, the less likely businesses performance is dependent upon the continued involvement of an owner/operator. The investor can be far more certain of a return on their investment. They certainly aren't buying a job.
In an environment where future profits are driven by the requirement of yearly sales volume, valuations can be based on nothing more than the businesses performance during that measured period. As a result, an owner can typically expect to receive, at best, one-times the yearly sales volume in valuation. Unfortunately, the greater the previous involvement of an owner/operator, the less the value. I've seen many who have received less that 1X yearly revenue at exit, or have been in a situation where they've had to remain an employee of the company as a condition of the sale. They've sold their company, but can't stop working.
On the other hand, businesses that have contractual agreements with their customers of a year or more have significantly higher valuations in terms of building business equity. The longer the contracts and the lower the loss of customers by attrition, the higher the value. As an example, businesses with 2 to 3 year agreements can expect valuations at 3 to 5 times yearly revenue. And contracts mean that guaranteed revenue and profits aren't at all dependent upon the active involvement of an exiting owner/operator. Investors aren’t buying a job. They are buying known revenue an profits, equity.
So, two messages to entrepreneurs and small business owners. First, start building the process and structure to work ON your business, not IN it. Make EVERY decision based on equity and exit. Second, in every situation possible, seek opportunities to engage your customers in longer-term, contractual agreements. The value of your business shouldn't only be tied to what you sell each month. For an investor, the greater the ability for accurate prophecy of future profits, the higher the business value.