Recurring revenue is talked about like it’s the golden ticket in levered acquisitions. If a business has it, investors perk up, lenders nod along, and buyers feel like they’ve struck gold. But here’s the truth: simply labeling something “recurring” doesn’t make it predictable, stable, or high-quality.
Your Recurring Revenue Isn’t Really Recurring
Introduction
Recurring revenue is often seen as the “holy grail” of business statistics-- The one where you must go after the business if it has recurring revenue. It is a surefire way to perk up investor ears and get your transaction funded. It’s even true in larger, private equity transactions. Recurring revenue is a proxy for predictability, stability, and cyclicality, which are excellent traits we’d want in any business. Especially one that’s highly levered with debt like most of our SBA 7a loan transactions that we teach at SMBootcamp. But, not all recurring revenue is created equal. These days it appears that recurring revenue is often thought of in a binary way—it is simply recurring or it is not. For many acquisition entrepreneurs, there isn’t a second thought after the classification of revenue as recurring. Reality is many businesses fall somewhere on the revenue quality spectrum despite all having “recurring” revenue. That said, many recurring revenue streams lack some of the key characteristics that provide for high revenue quality. Further, many recurring revenue streams are merely subscription-like payment terms without traditionally recognized high revenue quality traits traditionally associated with recurring revenue. Recurring revenue is still extremely valuable, but it’s important to recognize the difference between subscription-based revenue and true recurring revenue to accurately reflect the risk of the business opportunity you’re pursuing.
Defining Recurring revenue
True recurring revenue has traditionally been associated with a few traits in addition to a predictable payment schedule or subscription-base. These traits are:
If the business has recurring revenue, the thought process is that there is meaningful predictability of revenue (i.e. high revenue quality). That said, it appears that there has been a meaningful shift in the definition in both private equity and SMB acquisitions, which has effectively relegated recurring revenue to a single characteristic: predictable payment schedule or subscription-based.
Predictable Payment Schedule
One of the key advantages to recurring revenue is the idea that customers pay on a highly predictable schedule. Perhaps the most prevalent in subscription-based expense for American consumers is the Netflix subscription. Every month, you will pay $10 on the same day, month after month for access to the platform. From Netflix’s perspective, it is highly likely that a customer today will be a customer a month from now, a year from now. Netflix is able to provide a ton of value to customers at such a low price point that is highly unlikely to be canceled in tough macro environments; $120 a year is hardly a difference maker in the grand scheme of budgets. With clear revenue visibility into the future, Netflix is able to develop growth strategy and manage expenditures extremely effectively. Unlike a project-based business like a building contractor, their revenue (and cash flow) is stable month after month after month. For the building contractor, a single project over a 6 month period could produce any amount of the total project revenue in a given month. If the project stalls in one month, it could put the business in a precarious cash flow position even if it catches up the next month. Netflix and to some extent all majority recurring subscription-based businesses, do not have this issue. Minority recurring subscription-based revenue businesses at the very least have a consistent cash flow buffer.
Customer Psychology and Subscription Fatigue
From the customers’ perspective, subscription-based services can be a distinct advantage. They’re lower cost than payments delivered in one large slug, which generally makes it more tenable for consumers and businesses to spend. This phenomenon has exploded the last few decades with many companies taking advantage of this type of spending behavior. There is simply a subscription for everything now—streaming platforms, HVAC preventative maintenance, garage doors preventative maintenance, pool care, carwashes, groceries, ubers, etc. Every subscription expense in isolation is only a small fraction of a customers’ total expenditure, but combined they can really add up. Despite each of these examples having a predictable payment schedule, it would be hard to make the case that many of these share the traditionally associated traits: non-cyclical, non-discretionary, and sticky with high-switching costs. In fact all of these examples are perhaps the exact opposite of the traits traditionally associated with recurring revenue. When times are tough, are you really going to pay for a weekly carwash and preventative maintenance for your garage door? These are highly discretionary and cyclical expenditures that have virtually no switching or cancellation costs. These examples are focused on consumer-facing businesses, but they exist for commercial businesses too. When times are tough the frequency of janitorial service and landscaping is cut back. Non-essential software subscriptions are reduced or downgraded. Despite being relatively small monthly expense hits, even these “recurring” revenue streams are prone to disruption in the absence of the other key traits.
When Recurring Revenue Truly Adds Value
Recurring revenue can be a powerful driver of business value, but only when it comes with the right supporting traits—the traditionally associated traits. Predictable billing alone doesn’t justify a premium multiple and signal a far lower-risk investment. To really reduce risk, recurring revenue must be non-discretionary, non-cyclical, and sticky.
The best examples are businesses where customers simply cannot operate without the service. Think payroll providers like ADP. Employers can’t just “pause” payroll in a recession, and switching providers involves execution risk and time-intensive onboarding. That’s true recurring revenue.
Another strong example is software deeply embedded in day-to-day work. Microsoft 365, any CRM, or ERP isn’t optional when budget cuts are coming. Fundamentally they’re the backbone of how employees do their jobs. Even if the economy turns, companies rarely cancel them (or can’t due to long-term contracts), and switching comes with major friction.
Admittedly, these are a bit outside the scope of what we think of when it comes to SMB acquisitions, but the takeaway remains the same. Recurring revenue only defined by a subscription-based or predictable payment model is not inherently recurring. It must be further analyzed to contextualize the likelihood that revenue is going to continue into the future.
How it Applies to SMB Deals
Many SMBs are marketed as having recurring revenue (see appendix A for a bunch of common examples): car washes, HVAC, plumbing, garage doors, janitorial/cleaning, roofing, etc. even when the truth has more nuance. It’s important to remember that the job of a business broker, M&A advisor, or investment banker is to sell the business for the highest price possible; their job is to market the business with a story that drives valuation up for their client (and thus the advisor’s fee). When analyzing recurring revenue of a business, you must dive deeper than the billing structure to truly identify how predictable the revenue is, and if it should command a premium valuation. A few key questions that I’d suggest you ask are:
How easily can a customer cancel this service (i.e. is there a contract)?
How critical is this service to daily function of a business or a consumer’s life?
Does this service depend on macroeconomic environment?
If the “recurring revenue” fails any of these categories, it might not actually be recurring revenue and may better be classified as “subscription” revenue whose only advantage is improved cash flow dynamics. Further, a business without predictable billing can exhibit these traits, and ultimately provide for higher revenue quality than a seemingly recurring revenue business.
Conclusion
When evaluating SMB transactions, the ultimate metric is revenue quality, which can exist with or without recurring revenue streams. Especially in the context of highly levered transactions, you must ensure that revenue today is revenue tomorrow, next month, next year, and so on. It dives much deeper than a simple payment structure and must be evaluated on a deeper level.
Appendix A
Note: This list is designed to encompass many SMB acquisitions, but the list is not comprehensive
Zach began his career at Crosstree Capital, a boutique investment bank in Tampa, FL, specializing in buy-side advisory and M&A consulting. After Crosstree Capital, Zach joined Raymond Jame's investment banking, focusing on middle-market M&A transactions generating between $20M to $80M of EBITDA in the Commercial & Industrial Services and Building Products & Distribution sectors with $1.3B+ in total transaction value. Prior to his investment banking experience, Zach gained hands-on experience in small business working for family-owned general contracting and roofing businesses in Southeast Virginia.
