In the world of early-stage startups, it is highly unlikely that earlier stage companies have adequate historical data in order to help determine future revenue levels. Seasonal purchasing decisions, trends, and the nature of early-stage startups can make it difficult for businesses to predict the levels of revenue that will come in. Recurring revenue, however, can help provide an estimate of future revenue.
What is Recurring Revenue?
Recurring revenue is the expected portion of revenue that a company brings in on a specific basis, typically monthly or annually. The consistent nature of recurring revenue can make it one metric to use when helping to predict future revenue levels.
Some businesses base their entire model around recurring revenue – like subscription boxes, creative software, and streaming services. These companies make it difficult to make a one-time purchase, and if they have a one-time purchase option, it is typically more expensive than the discounts a purchaser may receive for selecting longer term subscriptions.
Companies may choose to utilize a tiered subscription option, with added features and increased usage allotment as the subscription price increases. Others may elect to auto-renew subscriptions until the customer voluntarily cancels their subscription. There are many different forms of recurring revenue that we will outline below.
Models of Recurring Revenue
A standard subscription is a set period that a customer pays for a service. At the end of the period, the customer has the option to either stop the subscription or renew the subscription for the same or a different amount of time and/or money. One example of standard subscriptions are magazines that have a six month or one year subscription period. The customer pays the same amount each month for the period of the subscription.
Auto-renewing subscriptions follow the same model as standard subscriptions, but do not have an end date. Instead of opting-in to another year of the subscription, auto-renewing subscriptions continue on a set reoccurring time until the customer opts out of the product or service. Streaming audio and visual services like Netflix and Spotify follow this model, as users subscribe and pay monthly and are required to opt out of the subscription 30 days before cancelation.
Some companies choose to lock customers into longer-term contracts from 6 months in length all the way to two-, three-, or five-year contracts. Cell phone providers are one example of longer-term contracts, and many cell phone contracts are 1-2 years in length and are charged monthly.
Sunk cost products are those that have an initial investment into a product and require further purchases of specific items that only work with the original product. Keurig coffee makers are one example of sunk cost products. The Keurig machine is the initial investment, and purchasers are required to buy K-Cups that function in the Keurig machine. Other companies make aftermarket K-Cups that are not produced by the official Keurig company and can be a cheaper alternative, but the sunk cost has already been realized as customers purchase products that exclusively work with the initial investment.
Revenue from these models can be consistent, making recurring revenue a metric to segment out when predicting future revenue. The revenue from standard subscriptions and long-term contracts can be predictable, as there is a set contract or subscription length. Auto-renewing subscriptions and sunk cost products have the tendency to be more variable, but are still a metric used to forecast revenue.
Benefits of Recurring Revenue
One primary benefit of recurring revenue is the consistent revenue stream. The expected recurring revenue can help calculate future income. Additionally, customers purchasing a product over a longer period can be a sign of strong customer loyalty. Renewed subscriptions and contracts can lead to additional revenue and may be a sign of increasing customer loyalty. Recurring revenue can be a sign of scalability, as once the product is proven on a small scale, the recurring revenue can help businesses forecast future sales and growth while minimizing churn when expanding.
Challenges of Recurring Revenue
While recurring revenue can help forecast future revenue more than one-time purchases, it should not be held as an absolute indicator of future growth. Recurring revenue can vary from year to year and there can be unpredictable outcomes that affect the true levels of revenue. Additionally, there is less flexibility if the company decides to change their prices. Contract prices can’t change until the end of the contract, but auto-renewal subscriptions may have more flexibility as they can change their prices for the next billing cycle, which are typically shorter periods of time.
Measuring Recurring Revenue
One measure of recurring revenue is Monthly Recurring Revenue (MRR) which is the expected revenue by the business from all active subscriptions in a particular month. This excludes one-time fees and single purchases. MRR is calculated by multiplying the number of monthly subscribers by the average revenue per user (ARPU). For example, if a business has 100 subscribers that pay $35 a month, the MRR would be equal to 100 multiplied by $35, totaling $3500 in Monthly Recurring Revenue.
Additional calculations should be made to Monthly Recurring Revenue to account for subscription cancellation churn, new subscribers, tiered subscription customer pricing, and other variables.
Putting it All Together
Recurring revenue is a metric that tracks the expected portion of revenue that comes from repeat customers, subscribers, and other customers that purchase a product or service on a recurring basis. While recurring revenue is not always a consistent measure of revenue that will come in each month, it can provide insight into what future revenue could look like more than one-time purchases.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.