Running a business that relies heavily on recurring revenue is very different from businesses that rely mostly on sales or service-based income, like most small businesses do.
That's not to say there's anything wrong with the latter types of businesses! But for companies that sell products or provide services on an ongoing basis, it can be tricky to value them.
Recurrent revenues are typically priced at either the cost of the product/service or what the market will bear, making it hard to compare their worth directly.
There are ways to account for this, however. By understanding how large corporations handle such businesses, you'll have some helpful tips for your own!
This article will go into detail about why investing in a recurring revenue model is a great way to run a business, as well as some strategies for pricing and valuation. It may also help you come up with your own ideas to launch your own IR (intangible recurent) business model.
Most businesses need to rely on both recurring and nonrecurring income to survive. Nonrecurring revenues are great, but they do not last – we as business owners have to work hard to get them every month or year.
Recurring revenues are much more stable and easier to obtain. These are products and services that people pay for over an extended period of time. This can be monthly subscriptions, yearly memberships, or even lifetime packages.
By adding this type of income into your financial statements, you take extra care to allocate enough value in the short term and long term.
This article will discuss how to calculate the value of recurring revenue in a company’s balance sheet.
The length of the contract is an important factor in determining how much value you should put into recurring revenue. This information comes in two forms, it’s either found directly under the ‘Term’ column or it can be determined by calculating the average working time for each stage of the business.
The average working time is typically one year per stage, so if your company has three stages, then divide all three years together to get the total amount of time needed to reach profitability. From there, deduct this number from what we called the lifetime of the business earlier!
This effectively takes out any potential growth that might happen after the initial year, as well as any need to invest in additional equipment or facilities. By looking at only the first year of profitability, you are giving less weight to future growth, which is very likely the biggest part of the business!
By using these numbers as a basis, you can calculate how long the normal operating mode will last. Most companies with recurring income have a period of six months where they test the waters before investing more heavily into the business- this is why early investors make money!
By adding up all these terms and dividing by 2, you get the average life of the company without considering any possible changes. For example, if a company switches from monthly subscriptions to yearly ones, their lifespan would increase substantially.
The next step in calculating the value of recurring revenue is determining how long the vendor will be working with you. You can calculate the average duration of the relationship by taking the total amount of time that the vendor has been working with you, and dividing it into an estimated sale or conversion rate.
For example, if a vendor works for your company for one month, and they have a 10 percent sales conversion ratio, then you would divide 100 pieces (one month) by 0.1 (conversion percentage) to get ten conversions per month.
So, in this case, the calculation would be 200 pieces (two months) divided by 0.10 (conversion percentage) which equals twenty conversions per month.
If we assume that these twenty conversions are for two years, then the value of the recurring revenue model is equal to 2 years times $20 per conversion = $40,000!
This seems very high, but remember – this is only an estimate! A more accurate way to determine the longevity of the recurring revenue model is finding out how many purchases the vendors made before while under your brand’s umbrella.
By looking at past transactions, you can find out whether or not this product/vendor is truly a moving ball that keeps rolling forward or if there is a natural breaking point where it stops functioning.
A key part of determining the value of recurring revenue is calculating how large of an audience there are for your product or service. If you're thinking about investing in IR, make sure you have enough people using your product or service to justify the investment!
There two main ways to calculate this – by annual sales or monthly users. When calculating yearly sales, look at how much money your company made per year from the service or product. Divide that number by 12 to get the average person spending per month.
When calculating monthly users, use the same method but instead divide it by 30 to get the average user per month.
A good way to value a business with recurring revenues is to look at how much money it will make in the future. It’s easy to count up how many purchases you made this month, but figuring out how long that spending binge will last? That gets tricky.
However, if we assume that your buying habits are steady, then we can use that information to generate an estimate of what the future income of the business will be.
A recurring revenue business models are great for two reasons. First, they give you more time to build your brand before you need to worry about getting new customers. Second, they offer greater stability as an income source because it is not dependent on having lots of individual transactions each month.
With this type of business model, you don’t have to worry about whether or not you will get a big transaction every once in a while. You get paid even if there is no activity during a given period!
This can be a lot less stressful than running a business that depends heavily on one large sale per month. It also gives you more time to focus on other things like building the organization and finding new vendors and partners.
By separating the timing from the source of the money, you mitigate some of the stress related to the initial launch and growth stage of the business.
A good way to determine the value of recurring income streams is to look at how much revenue they produce in the past and extrapolate that number out into the future.
A common method for calculating this is by using an exponential function. This calculates a product of two numbers, e (approximately 2.718) and t, where t is the time period being calculated. The product of these two values becomes the new base or exponent of the equation.
The reason why we use an exponential function as our basis is because it grows quickly, very rapidly in fact. As you add more items to the equation, the result will grow faster than linearly. In other words, if your business has monthly revenues of $1,000 per month, then project that it will have monthly revenues of $10,000 one year from now!
This can be difficult to do without having historical data, which is not easy to come by unless you are already running a business. Luckily, there are some great free tools online that can help you calculate this.
There are also many different ways to round off this calculation so that you get the same results.
A common mistake business owners make when trying to determine the value of their business is thinking about how much they would be willing to spend to acquire a service or product that provides similar benefits as what their business offers.
This may seem like a logical way to calculate the value of your company, but it will not give you accurate results.
The problem with this method is that most people do not actively look for services and products that provide valuable benefits.
Most individuals are too focused on saving money to consider paying more for something that seems just as good (or even better) than the one they have now.
Furthermore, many people dont believe there is enough difference in price between two similar goods to matter.
They assume that since both items cost the same amount, then there is no need to compare prices.