TM#020 - Not all revenue is the same

Most amateur founders when they hear the terms MRR or ARR simply take their monthly or yearly revenue averages and call it that. I know because we initially made that mistake too (come on guys, everybody knows we Pakistani founders aren’t that savvy … initially).

Needless to say, that’s not what recurring revenue is.

But first, why even differentiate? What’s wrong with taking that average? Isn’t it a proof that you’ll be able to repeat this very average, definitely not overblown, figure in the future too?

Depends. If you’ve been at it for 100 years and the trend has mostly held up. I might believe you.

But nobody has been at it for 100 years (except those generational restaurants in Japan, maybe). How about 50, 20, years?

The sleight of hand in that line of thinking is forgetting that markets change. Your business cycle is merely an abstraction built atop industry cycles that are built on top of market cycles that are on top of .. you get the point. It turtles all the way down.

So, no matter how conservative your averages might seem, they are not recurring revenue and cannot be counted on.

And that’s the key phrase: counting on.

I’ve often said that $2000 in recurring revenue is better than $20,000 one-time revenue. Even if the former only recurs until a duration which equalizes the two. Here’s why:

1. When you have truly recurring revenue, you have peace of mind. You have successfully escaped the feast and famine cycle so endemic to the services industry. Congratulations.
2. You can actually decide your expenses and allot budget accordingly. This is important. Because the $20,000 one-time you are likely to either over-spend or under-spend depending on your temperament. The risk-takers will spend it all on winning similar deals, the risk-averse will prefer to save it all because they don’t know if they’ll win a similar deal. If you’re in the mythical middle, you will have no clarity on what kind of marketing campaign you should run because your spend is time-boxed in a very hard, concrete fashion. That’s not a good environment for experimentation (and marketing requires experimentation).
3. Corollary to the previous point but deserves to be said: you’ll know when to hire and how much to spend on the hire.
4. You now have a valuation. Yes, gentlemen, valuations are generally multiples of your ARR. If you don’t have recurring revenue, you don’t have a valuation. It may not be super important to you if you want to run your agency like a family business, but for those looking to get acquired at some point or go IPO, having a mindset of recurring revenue will definitely help you achieve your goal faster.

Now, what exactly is recurring revenue?

I’ll admit, it’s not super easy to compute recurring revenue unless all your contracts are indefinite and binding. In most cases however, you have one of the two: your contracts are either definite or they are non-binding.

In those situations, in order to compute your true recurring revenue, you need your sales data to pitch in. What’s your quarterly close rate, what does your churn look like, what’s the upselling potential etc.

You put all those figures together in a complicated formula that factors the average duration of your contract (if definite) with your close rate divided by your churn rate (which gives you a ratio of how much business you will lose versus gain — if you gain more than you lose, you get a higher recurring revenue).

What does that formula look like?

Ask your CFO to make one that suits your business. The point is, there are no hard and fast answers. It’s in your best interest to know your finances and your real recurring revenue so that you can make better decisions faster.

That’s it for today’s?Tech Consulting 101. Be sure to subscribe to get weekly updates right in your inbox.