Why recurring revenue matters to investors? Why are startup investors so focused on recurring revenue?
Recurring revenue has increasingly been a feature and at least a part of the business model for startup companies.
It’s not just a hot trend. Many billion-dollar startups have leveraged this concept to build hugely popular market-dominating businesses.
Recurring revenue has also become a hot point for potential investors as well, for many good reasons.
Of course, not all recurring revenue is the same, and there can be pitfalls for entrepreneurs who blindly prioritize it.
There are ways to add it into your income mix, and common blunders to avoid for building a strong business and optimizing fundraising.
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What Is Recurring Revenue?
As the term suggests, this is revenues and cash coming into your startup on a regular basis. Typically, monthly, and from the same customers.
Though it could also be annually, or at any other interval. Think Amazon Prime, Netflix, or your monthly cellphone or utility bill.
The most obvious type of recurring income in today’s startup ecosystem is in the form of subscriptions. Though it isn’t the only way to generate it.
Recurring revenue can be great for startups and investors alike. Just make sure you understand the pros and cons and nuances.
Recurring Versus Traditional Revenues
The main difference between recurring and more traditional revenues is that recurrence. In general, you could say that businesses have set out to create a product and sell it.
They have often only been very transactional. Overpromising on the marketing and in sales pitches. Sometimes willing to do and say anything for that one-time sale.
This shortsightedness still exists, and often means burning what could be long-term, repeat customers and referral sources.
Recurring revenues often come in via smaller more frequent amounts than larger one-time purchases. Think selling a car for cash versus leasing.
That explains why you should take the time to understand why recurring revenue matters to investors.
The Most Important Type Of Revenue
Your company doesn’t have to only rely on one type of revenue. Perhaps it shouldn’t. Yet, recurring revenue can be a very important part of the mix.
It can provide regular incoming cash for young companies which need it even more than larger and more mature ones.
It enables you to potentially better plan your finances as a startup, and be more comfortable with making investments and expanding.
In many cases, it can be easier to secure more customers with a lower barrier to entry recurring revenue product, than a higher ticket price.
Most consumers are more payment and cash-conscious than price savvy. They are more likely to buy with a small initial monthly payment than putting a larger chunk of cash down.
Even more so if there are any free trials and introductory deals involved. This can be especially advantageous for startups who are desperate to prove themselves and gain customers.
In turn, a nice side benefit of this today is that you are probably going to end up selling your product for a whole lot more than if you had a fixed upfront price for it.
In fact, things may have grown so outrageously priced that the only way people could ever reasonably be able to afford many things is on a payment plan.
That may be a big red flag on its own. Though that is a whole other debate. A great example of this is when you see minimum wage workers sporting the latest iPhone and car.
It is pretty likely the only way they could afford that $1,200 phone or $50,000 vehicle was on a payment plan. It’s the only way they could become customers of those companies.
Though, by offering such a plan, those companies also get to gain access to masses of additional customers that would otherwise not be able to afford to be customers.
Aside from revenue, every entrepreneur should understand what investors look for in founding teams. If you’re ready for more information, check out this video I have created.
At least not without major and very deep price cuts.
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Why Investors Want Recurring Revenue
Recurring revenue is very desirable for investors.
The easier traction that this type of revenue can provide in a shorter period of time may act as a tighter feedback loop. And help startup companies to establish a track record of performance faster.
Not only may this help entrepreneurs and their startups to qualify for startup capital sooner, but it can also give their early investors much more confidence.
They will be more open to participating in following fundraising rounds, as well as referring other investors in their networks.
Recurring revenue is also seen as more sustainable and predictable than one-time sales. Having 1,000 customers paying $X a month may be far better than 10 customers, even if they pay more upfront.
If everything else is done right, it is logical that you’ll be likely to retain more of those customers over the long run.
No matter what the world throws at you or your customers, it is less likely you’ll end up in a financial crisis. If you lose half of your 10 customers that could bankrupt you.
Whereas if you still have 700 or 500 customers, you may not be nearly as affected. Recurring revenues also appear to make it easier to predict the future finances of a company, and its investment performance.
For strategic and private equity investors who are specifically investing for cash flow and yield, this just makes more sense too. That’s the reason why recurring revenue matters to investors.
Keep in mind that in fundraising, storytelling is everything. In this regard for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
How To Generate Recurring Revenues
There are actually a wide variety of methods to generate recurring revenue.
Subscriptions have become the most glaringly obvious and perhaps most common form of recurring revenues in modern startups.
Software As As Service (SaaS) has become huge. Investors have recently preferred these investments for more than hardware startups.
Subscriptions have popped up in an amazing number of industries today. There are food, apartment, vehicle, shaving, healthcare, and streaming video and music subscriptions.
Licensing your intellectual property is an often forgotten, but a well-established method of generating recurring revenue. You can license your inventions, software, brand name, content, and much more.
Franchising & Royalties
Franchising has been behind some of the world’s biggest and most successful brands. Think McDonald’s, Burger King, and many others.
Royalties have been used for many more things, down to small switches in cars. You can even combine these strategies with upfront franchise fees, and ongoing royalty payments.
Long Term Contracts
Contracts are another form of recurring revenue. They may run a few quarters or several years. Contracts have long been valuable.
They can be used for obtaining financing and loans and can be seen as very valuable and represent a lower-risk investment opportunity for investors.
There are many types of contracts. Even software and hardware companies have been able to combine upfront sales, with ongoing recurring revenue from service and maintenance contracts.
The Cons Of Recurring Revenue
As with anything, there are pros and cons of focusing on recurring revenues. Recurring revenues tend to produce smaller amounts of income initially.
They can add up to more. Yet, startups are also always seeking more funding. Getting bigger amounts upfront, may actually be more beneficial in the short run.
It can help you bootstrap independently for longer, without having to stress about fundraising or dilute your equity.
Spreading the cost of your product over many months or even years means that you have to keep on wowing those customers month in and month out in order to keep them.
If you drop the ball, or they have a bad customer experience one month, you may lose them before you recoup your customer acquisition cost.
Of course, a few entrepreneurs see this as a positive as it constantly motivates them to do great work. At the same time, they must explore why recurring revenue matters to investors.
Ways To Augment Recurring Revenue
With the above in mind, there are ways to augment your smaller token recurring revenues with more income to enjoy the best of all worlds.
You’ll ensure you don’t starve your startup of cash in precarious early months and years.
Upsells & Add Ons
You can always bring in more lump sums of revenue with various upsells or add on products during your relationship. They can be small or large. They can even be additional forms of recurring revenue if you wish.
Just be wary of souring the relationship by holding back essentials that are expected to be a part of the deal.
We may have become accustomed to it, but having to pay to park at a hotel when you arrive on top of your room rate, taxes, and resort fees may make you feel robbed.
All of a sudden that $100 a night room is $125, plus taxes and fees. A 25% or more increase. What about having to pay extra for a charger or earphones for your phone. What use is a phone without a charger?
How about an automatic 18% gratuity on your dinner check?
Elon Musk appears to have become the master of this. He has had everything from flamethrowers to Tesla tequila. Other ideas may be occasional events, or special premium or VIP access upgrades.
Layered Recurring Payments
While it again could be something that could backfire, layering different recurring fees can work too. Such as annual memberships like credit card companies charge.
Condo associations have also become masters or evil geniuses of this. You might have a quarterly charge for your street, an annual charge for the master association, special assessments, and more.
Partner Paid Revenues
Other revenues can be paid by or subsidized by strategic and distribution partners. Like some mobile carriers and phone vendors may include services like Netflix.
They pay for the service, as a bundled offering, rather than the end consumer.
Advertisers & Sponsors
You can create a two-sided marketplace with advertisers or sponsors. Others have of course cashed in on selling users’ data.
All of these strategies are likely to interest potential funding sources. As an entrepreneur, take the time to understand why recurring revenue matters to investors.
Common Issues With Recurring Revenues
Subscriptions can produce lean revenues. Be sure the unit economics work and it is profitable.
Customer Retention & Lifetime Value
A lot can rely on how long you keep your customers. If you keep them for years, then it may not matter if you lose money for the first few months.
Though, if they bail after a month, each customer may end up being a money pit.
Sustainability Of Prices
You may lure in lots of customers with lower recurring payments, but can you keep your prices that low. If you raise prices later like Redbox or Netflix you could burn the vast majority of the customer base.
You’ll also lose out on the company value that you’ve built over years. It may not even be about value, it may be on principle. Loyal customers may not perceive your price hikes kindly.
Pressure Of Delivering Value
Can you keep up on delivering the value? For example; as a streaming video or content site, can you still deliver enough quality content for the duration of the period you need customers to stay?
If they watch everything, they just may cancel and hop onto the next channel’s subscription.
Relying On Upgrades
If your business model depends on customers upgrading you have to be able to deliver significantly more value every time.
Be wary of falling into the Apple issue. Some will always splurge on the new model each year, even if the new iPhone isn’t better than last year’s.
Many have gotten tired and may switch brands. Especially if other scandals come out.
The same applies to if you are betting on customers upgrading to a more expensive subscription. Many will never do it.
It doesn’t matter if it is an extra $1 a month. They’d rather not get caught up in more payments.
Perhaps the biggest threat to this model is subscription burnout. Trends and economics change in big ways. Just as we moved from hardware to SaaS.
Today, we have subscriptions for everything from food, to music to movies and news, and cars and houses. Thinking ahead, how many subscriptions can people handle?
Especially when they are now paying far more for everything than they used to. Will we encounter subscription burnout?
It was okay when we all had a few $5, $10, and $30 subscriptions we never used or noticed coming out of our bank accounts each month.
As that approaches thousands, is it going to be a sustainable business model? At a minimum, businesses may have to do far better at standing out and delivering that wow factor every month to maintain it.
Learn why recurring revenue matter to investors and how to show it in your pitch deck.
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