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Running a business with recurring revenue is the most common way large companies are built today. Amazon, Netflix, and Apple are just a few of many examples. By this type of business model, your company does not need to depend on having the market for its products or services dry up before it can survive.
By offering memberships or subscriptions to their products, these businesses have transitioned from being sellers of goods to become service providers. This shift has allowed them to stay in business by generating steady income over time!
Recurring revenue doesn’t happen overnight though, which is why it takes more than just knowing how to value a startup properly to succeed as an investor in such a business model.
In this article I will go into some details about what types of information is important to know when investing in a recurring revenue business and some things to consider while doing so.
The second way to determine the value of a business is by calculating the cost to produce and sell each piece it offers. By having separate products, you increase the valuation of the company because you have an additional source of income.
This also means that instead of getting a single income stream for the whole business, you get several dependent upon how much money they make!
By breaking down the business into individual pieces, you can more easily find the total market value of the company.
There are many ways to do this depending on what type of business structure the company has. For example, if the company operates as a LLC, then you could calculate the value per item directly from the owners’ shares.
If the company does not have shareholders, then you can use the liquidation preference to determine the value. This is when the owner receives a certain amount of money in return for giving up their ownership stake in the company.
Typically, this number increases due to the departure of the current shareholder(s). Therefore, using our recurring revenue business example again, this liquidated preference would be calculated for each product independently.
The multiplication of these two numbers gives you your gross profit, or how much money the business makes before it is invested in the company and the employees.
By adding an additional layer of complexity to the equation, you have to consider what kind of business you are looking at. Is this a one time sale? Or will there be repeated purchases? If so, then we can add another element to the equation – average transaction value.
This is very important as it changes the multiplier slightly. For instance, if the average purchase was $1,000, then 1,000 times 30 would give you a gross profit of $30,000!
But what if the average transaction was only $100? Then the gross profit would drop down to just under $3,000. Important note here: even though the averages may seem low, they can still make a lot of money for the business owner!
That is why it is crucial to understand how to value a recurring income business.
The multiplying factor you use to calculate value is called the multiplication method. This method compares how much the business could make relative to what it makes now, not just how well it does its current job.
By this math framework, the multiplier should be increased every time the company brings in more money than they did before. So instead of using Sales as your multiplier, you can use EBIT (Earnings Before Interest and Taxes) or even Net Income!
The reason why we recommend using either EBITDA or net income as our multiplier is because these numbers are calculated with less bias than sales. When calculating value using the multiplication method, there’s no need to also include the cost of goods sold in the equation.
The most important factor in determining the value of a business is how many people use it every day. If there are not very many users, this signals that you might want to look at other options.
The recurring revenue model means that the business does not need to rely on its up-front sales for income. Instead, it generates new money from existing customers over time – making it more stable than businesses that depend heavily on one big sale per month.
By adding these extended years of steady income, the business has greater potential earnings compared to companies with only short term income.
With this knowledge, you can now calculate the exact price tag of any business by looking at the average size of their customer base and what they make off each person.
The best way to value a business with recurring revenue is to look at how many products or services it sells. More product sales means more income, which implies a higher valuation.
Businesses that sell a large amount of merchandise can be given a market capitalization (stock price multiplied by the size of the shareholding). For example, if Amazon was sold for $1 trillion dollars then its stock price would be $10 per share ($1 trillion divided by the total shares outstanding of 50 billion), which makes sense because investors are paying around 10 times the annual gross profit of the company!
But this isn’t practical for most people who run a small business. So what is?
The easiest way to value a business with recurring revenue is using the sum of the years' profits as the basis for calculation. This method assumes that the longer the period over which profitability is calculated, the better.
A common variant of this method uses an average cost base instead of just year-by-year figures. By averaging out the costs across different time periods, you get a lower overall cost figure, which boosts the value.
Another option is to use the net asset value – also referred to as book value. Net asset value calculates the current value of a firm’s assets less any liabilities. In other words, it gives us a clear picture of what the company is actually worth today.
Many business owners make the mistake when they try to value their business of thinking that calculating the price of a restaurant is just multiplying its cost by two! They assume that if you know how much a business costs, then you have determined its market value.
This isn’t always the case though. The reason being is that most people don’t take into account the going rate for similar businesses in the area as well as the average number of customers a like-business has.
The average amount of money a person will spend at a restaurant is called the Average Reqular Visit (ARV) metric. This ARV metric is typically reported by research companies such as KJ Camp’s and HubSpot’s. Both of these report not only the average meal price, but also the average drink price and additional fees or purchases while there.
By adding up all these expenses, we are able to get an idea of what the average person would pay for a meal at this specific restaurant. By comparing this number to the total amount spent on food and drinks at the restaurant, we can determine how many meals were consumed.
Dividing the number of meals by the number of days the business was open gives us our second metric: The Average Revenue Per Customer (ARPC). By using either of these metrics as a basis for determining the value of a business, we ensure that we are factoring in important pieces of information.
The best way to value any business is by calculating its average revenue per product or service. This method looks at how much money the business makes on each product it sells, and then divides that amount by the number of products it has sold to get an overall value for the business.
For example, if a business made $1,000 off one product, then its ARP would be 1. If it made $5,000 off five products, then its ARP would be 5.
The reason this calculation is so powerful is because it removes most of the variables that can affect whether a business does well or not.
If a business doesn’t do as many sales as other businesses in its category, then why should investors give it a higher price? In fact, it could even be undervalued by investors who don’t take this factor into account.
The next step in calculating the value of a business is multiplying the company’s current market value by its predicted annual recurring income (ARI). An ARI is how much money a business expects to earn every year, typically focused on repeat purchases or services.
A common way to determine the ARI for any product or service is to look at what other similar products or services are earning. By looking at what others charge for a product or service and how much they make per customer, you can calculate an average cost per user (ACPU) for that product or service.
By dividing the ACPU by the number of users, you get the ARI. To be clear, this isn't necessarily how much the business will make, but it is a good estimate.
With respect to software companies, there are many free tools people use to evaluate whether or not a given piece of software is priced fair. You can find comparisons here: http://www.maketechelling.com/software-cost-value/.
In fact, one such site even produces a score called the Software Value Index, which uses both price and quality as factors in determining if a program is overpriced. Here's their definition of a high scoring software package:
"High scoring software is usually understood to be affordable, effective, practical, reliable, straightforward, intuitive, and easy to use.
