What impact do metrics like MRR, net revenue churn, MRR expansion, and other revenue indicators have on the valuation of a business operating on a recurring revenue model? Learn how to value a recurring revenue business.
Whether planning an exit, looking for funding, establishing shareholder equity, courting investors, or considering an investment, knowing how to value a recurring revenue business is critical for success.
Lenders seek to assess the value and financial stability of a business before providing funding, while investors aim to optimise their return on investment by negotiating the most favourable purchase prices for the companies they acquire.
Therefore, it's crucial to know how much your business is worth at any given time. This entails keeping your finger on every recurring revenue metric and factors that can affect its value.
How to value a recurring revenue business.
There is no one way to value a recurring revenue business because there are many factors to consider. The two main factors usually considered are:
- Forecasted revenue over the next five years
- Perceived risk inherent in the business or its market.
As we will see below, recurring revenue and risk have an inverse relationship.
Recurring revenue infers low risk.
Value has an inverse relationship with risk. Risk abounds if a business's revenue and cash flow are unpredictable. Therefore, the more predictable your company's revenue is, the higher its potential valuation.
Investors will pay a higher multiple for businesses demonstrating consistent and sustainable income, usually through subscriptions or long-term contracts.Recurring revenue implies that a company can anticipate earning income consistently over the foreseeable future.
A business that relies on one-time sales is expensive to run. Such a revenue profile reflects a higher CAC (customer acquisition cost) than a business that earns most of its income from repeat customers.
Investors and lenders are likely to be cautious if your metrics indicate low repeat business, a high churn rate, and a low customer lifetime value. Such indicators suggest a risky investment, as they imply a reliance on the hope that customers will return for future purchases.
If your revenue is hard to predict and your cash flow is unstable, your business will be perceived as a high-risk investment, which leads to lower valuations. More predictable revenue and cash flows demonstrate income stability and lead to higher valuations.
So, how do you measure revenue predictability, cash flow, and income stability?
5 metrics that affect the value of a recurring business.
Below are the five metrics that demonstrate the income stability of a recurring revenue business.
1. Customer churn rate.
Churn measures the rate at which your business is losing customers. It determines the percentage of customers cancelling their subscriptions monthly or annually relative to the size of your subscriber base.
Acquiring a substantial number of new customers may not significantly grow your recurring revenue business if your churn rate is high. The loss of existing customers can offset the impact of new subscriptions on revenue growth.
In contrast, a low churn rate implies customer satisfaction and loyalty, which means revenue and cash flow stability. It means your business is not reliant on lead generation and that earnings from current customers will likely continue. Hence, your business is more valuable.
Investors also view businesses with revenue concentrated in a few clients as risky, regardless of cash flow stability. If such a business loses one or two key customers, it can face sudden cash flow challenges.
All factors considered, a business with revenue diversified across numerous customers holds greater value. It possesses heightened growth prospects owing to the ample opportunity to augment revenue. The loss of a few customers will not destabilise its cash flow.
2. Monthly recurring revenue (MRR).
Recurring revenue refers to sales income that will continue into the future. In that sense, MRR is revenue that recurs every month, meaning the same customers buy from you every month.
Investors regard MRR growth as a marker of market maturity. Consistent MRR is a sign of a mature or small total addressable market.
While it can also indicate that the company is struggling to grow its subscriber base, the effect is the same. It indicates that growth has plateaued, making the business a less attractive option for investors.
Consistent MRR growth has the opposite effect. It reflects a growing interest in your product, possibly coupled with a large potential market.
Although annual recurring revenue (ARR) revenue streams indicate greater revenue stability and are essential for planning and annual budgeting, MRR requires lower commitment levels from customers.
MRR is also a more practical valuation metric for D2C businesses whose target customers don't usually have their budgets sorted years in advance.
That said, investors typically value recurring revenue businesses based on a specific MRR/ARR ratio. They are drawn to growing businesses that can also demonstrate income stability over time. A 5:1 ratio often results in the highest valuation.
3. Revenue churn.
Net revenue churn measures the recurring revenue lost due to customer cancellations and downgrades after factoring in MRR gains from revenue subscription upgrades and add-ons.
While the churn rate indicates the percentage of customers lost in a given period, it does not show how much revenue you have lost, known as gross revenue churn.
Customer churn has varying effects on a business depending on the composition of its subscriber base. Importantly, the impact on revenue is less significant for a company with revenue spread across numerous customers compared to one heavily reliant on a few major clients for the majority of its sales.
However, gross revenue churn will always be positive and will, therefore, not provide clear insight into the effect of customer churn on revenue.
To get a clearer picture of your revenue performance and the actual value of your business, you have to obtain your net revenue churn, which accounts for the revenue gained from subscription expansions. You have to factor in the contributions of the customers you successfully retained.
Expansion revenue helps to offset the revenue losses from downgrades and cancellations. It is a vital indicator of your ability to retain customers and increase customer lifetime value.
Additionally, expanding existing customer relationships incurs lower costs compared to acquiring new customers. Consequently, a recurring revenue business exhibiting a net negative churn rate holds greater value than one with a net positive revenue churn rate, suggesting that the revenue lost to cancellations and downgrades outweighs the expansion revenue.
4. Customer acquisition cost (CAC).
Your customer acquisition cost will need to be significantly lower, and your acquisition channels will be exceptionally diverse than the industry average if you have net positive revenue churn.
Even that will not clear the perception of your business as a high-risk investment. The consensus among investors and funders is that the business's risk profile is unsustainable.
In general, how you acquire your customers or where you meet them for the first time contributes significantly to the value of your business. Some acquisition channels, like organic search, are valuable marketing assets, while others, like paid social media, PPC, and influencer marketing, can be costly and unsustainable.
The combination of costly lead generation channels and a high price point that renders your product inaccessible to many individuals will further diminish the value of your business.
A recurring revenue business has the potential for higher valuation if it acquires its customers from multiple channels. Acquiring the bulk of your customers from organic search traffic (SEO), content marketing, social media, and word of mouth will also boost the value of your business. Such a mix lowers the overall customer acquisition cost.
Having diverse customer acquisition channels lowers risk. If PPC costs rise compared to its contribution to revenue, you can feel more confident about closing that channel if you have leads trickling in from other channels.
Investors and lenders may consider other valuation metrics depending on the type of recurring business and the market in which it operates. These include:
- Total addressable market (TAM) or overall market size,
- Serviceable addressable market (SAM) is the percentage of the TAM that you can access due to location and other barriers.
- Serviceable obtainable market refers to the share of the TAM held by the competition that you can realistically capture.
So, how do we use these metrics to calculate the value of a recurring revenue business?
Valuation formulae for a recurring revenue business.
Again, different formulas are used to calculate the value of a recurring business. The exercise is too complex, and too many factors are involved to distil it into an exact science.
Typically, the final valuation will be an average of multiple values. The three primary values often considered in the valuation process are asset value, earnings value, and market value:
(i) Assets value.
This valuation method, also referred to as the liquidation value and akin to the book value approach, assesses the net worth of your business's assets. It contemplates the residual value remaining if your business's assets were liquidated, and a portion of those proceeds were allocated to settle your liabilities.
The biggest weakness of this valuation, which makes it unsuitable for valuing a recurring revenue business, is that it ignores the value of recurring revenue. Recurring revenue guarantees income stability into the future and is more valuable than some business assets.
(ii) Market value.
Market value is a subjective valuation method. It considers previous deal prices for recurring revenue businesses of the same size and profitability, not the totality of the business's assets, brand equity, and earning potential.
(iii) Earnings value.
Known as the Times Revenue method, this valuation criteria applies revenue generated over a certain period to a multiplier. The industry, revenue model, purchasing patterns, and customer profile determine the multiplier.
Recurring revenue businesses in tech generally have higher multiples. The revenue multiplier method suits high-growth businesses with unstable monthly profits.
The main weakness of the revenue multiplier is that it only focuses on revenue, neglecting profitability, debt management, and other factors, which gives an inaccurate representation of a business's value.
There is no perfect way to value a recurring revenue business, which is why most investors will settle on an average of the three we discussed above.
The revenue multiplier typically yields the highest valuation and sets the upper limit for pricing. Since many SaaS and D2C subscription businesses have relatively low capital requirements and few significant assets, their asset-based valuations tend to be similarly low.
Therefore, the true value of your recurring business will be somewhere between the asset and earnings values. More often than not, this is also what the market is willing to pay.
What is the Rule of 40 valuation method?
The Rule of 40 method of valuing a business asserts that the sum of revenue growth and profit margin must exceed 40%; otherwise, the company is a risky investment.
So, if your ARR growth is 15%, your profit margin must exceed 25%.
Investors will use the Rule of 40 to determine if a recurring revenue business is worth investing in, even before they calculate its value.
Accelerate your recurring business's growth with Intasend.
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Automatic billing eliminates billing errors and helps to plug revenue leakages. Automating subscription management makes it easy to track product usage patterns and identify upsell and cross-sell opportunities.
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