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When talking about startups, there’s one metric that everyone seems to have a different definition of but nobody ever defines clearly – recurring revenue (or sometimes called “freelance income”).
Mostly, it refers to companies that monetize their products via monthly or yearly subscriptions, as well as ones-time use services like subscription sites or apps (think Netflix, Spotify, etc.).
However, most large tech giants don’t fit this category because they retain all of their users in an ad-based model where you are constantly being marketed to for more content or service.
By defining recurring revenue more broadly, I believe we can get a better understanding of what kind of company each entity is. This will help us determine if their success is sustainable and how much risk they should undertake with future investments.
This article will go into more detail about why recurrent revenue is important and some hard numbers related to it. At the end, I'll include my takeaways and predictions for the future.
While both are important, there is a difference in how to value them. Customer loyalty is typically considered as more valuable than recurrent revenue if you’re looking at it from a pure financial perspective.
This makes sense because while recurring revenues can be good for your business, they don’t last very long! (Think of what would happen if every single person who bought a car insurance policy cancelled their coverage just before an accident happened.)
By contrast, most companies that rely heavily on customers spending money have solid customer loyalty. This is due to things like strong word-of-mouth advertising or regular direct contact with repeat buyers.
These types of businesses tend to keep up frequent communication even after the initial sale has finished – which is why they remain popular. However, investors usually discount the importance of customer loyalty when calculating the company’s true worth.
Why? Because investing is all about numbers and calculations, and thus far we've only talked about one number - how much money a business made over a given period of time.
Too often, people forget that the other major number - how many times a business broke even or lost money during this same period.
Another way to define recurrent income is ‘par for current you are’ or ‘what you have been doing well’ modified and structured in a way that rewards you for your past performance. This can be through paying you more, giving you greater responsibilities, higher pay-scale or changing the way you do business with you.
This is what most big companies do as they reward their employees for good performances in past times by giving them bigger budgets or titles, creating longer term employment opportunities, etc.
For example, Netflix offers its staff members an annual bonus based on their monthly earnings per employee. The amount is dependent on how much money each individual makes per month!
In fact, one of their top executives only received a $1 million award because he made over $10,000 per month at the time! He was not very happy about it but now he has his place among the company’s elite.
Another great example is Amazon which does an internal survey every year to see what people are buying and then gives out discounts (through price matching or via advertising) or free items (x number of purchases required) based on those findings.
By adding this feature to its service, Amazon encourages customers to reorder products they were before given special treatment for.
Many entrepreneurs and business owners make the mistake of focusing only on revenue in determining if their business is successful or not. What about how much money your business makes, however? This is called earnings before interest and taxes (or “profit” for those that prefer to use more common terms).
Many people also confuse the term ‘earnings’ with the term ‘ebitda.’ While both are important metrics, they offer different insights into the health of your company.
EBITDA is typically defined as income plus depreciation expenses divided by sales. The reason it is considered less informative than just using income alone is because it includes things like marketing costs, employee salaries, and office space. These things are good, but they can easily be outsourced or done efficiently so that you should not include them when calculating ROI.
By excluding these expenditures, you will likely under-estimate the true cost of running your business. For example, a business that sells products online may spend most of its time investing in advertisements instead of hiring employees.
These types of businesses would potentially get a lower ratio score due to this, even though they made enough profit to survive. More advanced users may opt to exclude investment related fees such as rent or legal fees since these usually go up consistently every year.
However, dropping either one of these categories can distort how well your business is doing depending on what you include in each.
The easiest way to determine if you have enough income to sustain your business is by looking at what we call average earnings before interest, taxes, depreciation and amortization (EBITDA). This is typically reported as the average total profit per month or yearly for a period of time. For example, if your business has been operating for one year then you would look at how much money it made in its first full month versus how much revenue it had to spend during that month to operate.
You can calculate this by taking your monthly gross revenues and dividing it by the number of months in the given time frame plus one more to account for fees such as payroll and marketing. Then take your monthly net profits and divide them by the same amount of months minus one to get an annualized version. Take these numbers and add them up to find your company’s EBITDA.
This isn't necessarily the most accurate measure of whether your business is profitable or not, but it does give you a good sense of whether or not your business is running at a level where it can survive. Because most investors will compare the profitability of a company against its own past performance, using EBITDA gives us all the same information with no extra assumptions needed.
When calculating how much revenue you’ll earn with your business, there is one important metric that most people forget about – their company’s net income (or earnings) per year.
This is also referred to as their ‘earnings before interest and taxes’ (EBITDA). While this may sound complicated, it isn’t! You can get some really helpful information here by comparing your own company's net income against that of your competitors'.
By looking at what they are earning each year and comparing it to yours, you will know whether or not you are in fact making more money than them every month! This gives you an idea of just how well you're doing with your business and if you need to look into other opportunities, you've got enough to stay ahead.
Having enough money to survive is not the same as having enough money to grow. You could spend your life staying in the competition, trying to outdo others with bigger budgets, but that will only set you back.
It’s like being in a race where you are always behind someone who has more money than you do.
You can still win, of course! But it won’t be because you made the best use of what you had, it will be because you gave up and stopped trying to compete with people who were better off than you.
That’s why I believe it’s so important for smart business owners to understand the difference between recurring revenue and earnings before tax profit (EBITDA).
We’ve discussed many times how important it is to run a low-cost business, but this time we’re going deeper.
Many entrepreneurs get hung up on whether or not they should focus more on building a sustainable business, or if they should also aim to make a quick profit.
They feel that if they keep investing in their company, then at some stage they will start earning more than they would by taking less risk now. That’s true — eventually.
But that doesn’t mean it’s the right thing to do now. And it very likely means that when you do earn more, you’ll lose control of your company.
‘Growing quickly’ is not the same as ‘growing rapidly’ or even just ‘growing’! If your business is growing faster than its current level of profitability, that may be fine for some time, but it could also indicate that things are out of control.
You need to look at whether this state of affairs can last indefinitely. Profitability should grow with growth, otherwise there will be a loss of confidence in the company and people will stop investing in it.
If investors no longer feel that the future looks bright, they won’t invest, which means that the economy will suffer and so will your business.
This doesn’t mean that rapid growth is always a bad thing, but if you aren’t able to maintain the level of profitability that you have now, then consider how much further you might have grown had you been more profitable from the start.
A large part of this comes down to how you define ‘revenue’. Many entrepreneurs seem to use average monthly revenue (AMR) – which is simply the average amount they earn per month over time -as their defining metric for what constitutes revenue.
But AMR can be tricky, especially when it doesn't make sense. For example, if we are in Month 4 of our business and your definition of revenue includes all the money we made last week, then yes, your measure of revenue has increased! But that isn't meaningful, is it?
It's like saying someone who just bought a house has a high income. Sure, they do, but what about next year when they don't get paid rent?!
Recovery season is typically around 6-9 months depending on the type of business. That means most SMEs will have missed out nearly half of their earnings since early 2018. And even more worryingly, some won’t recover at all.
We've gathered data on hundreds of startups to see what types of businesses experience recovery, and how long it takes them. Based on these findings, here are 5 things you should know about recurring revenues.
