Rocket Valuation - Long Term Contracts

We started our discussions about recurring revenue and how it can exponentially increase the value of your business last Monday. We also provided a hierarchy of the types of recurring revenue. Today, we are going to focus on the most effective type of recurring revenue, long-term contracts. Long-term contracts, though subject to breach risk, are the most effective type of recurring revenue because they embody a commitment from your customers for more than a year to purchase your product and service. However, not all long-term contracts are the same and there are certain factors that buyers will evaluate when looking at your long-term contracts and deciding how to price their offer.

The first item that an acquirer will look at is the term of the contract. The longer the term of the contract, the more valuable the contract is. A financial buyer is going to price your company higher if your contracts have a term of three to five years. The five-year commitment is important because most private equity firms try to flip their investment in the company around the five-year anniversary of their acquisition of the company. If your contracts have a term of less than three to five years, you should try to negotiate an extension with your clients or customers so that the quality of your revenue stream will present extremely well to an acquirer.

The second item that an acquirer will look at is the client or customers’ ability to fulfill the financial commitments in the contract. The finances, the credit score, and the client or customer’s history of making timely payments in accordance with the contractual terms are important elements to consider. A strong history of timely payments is important (especially in the final year) because this speaks to their current and future ability to pay for items under the contract.

The third item that an acquirer will look at is whether there is any potential growth in the long-term contract. The acquirer will look at the company’s industry trends to see if the industry is showing growth on a year-over-year basis. Assuming that the industry is growing well, the acquiror will want to review the client’s marketing and sale’s teams to determine whether they are able to secure more work from the client or customer that should be seeing increasing demand from their customers. The acquirer will also want to consider whether the client is poised to service or produce the volume that industry growth would require without being stretched too thin and making mistakes.

Acquirers have a strong interest in whether the Acquiree generates a strong portion of revenue from Long-Term contracts. Subject to breach risk, which will also be looked at by the acquirer, long-term contracts provide almost guaranteed revenue streams for the acquiror. It is important to note that you will have other multiple problems if you primarily rely on one or a few customers’ long-term contracts for a large portion of sales. The goal is to have long term contracts with clients or customers without having too much risk through customer concentration issues. Please call me at (860) 303-8929 or email me at [email protected] to set up a 30 minute discussion on recurring revenue.