In a traditional business, customers buy your product or service once and it is up to you to convince them to buy it again in the future. But in a subscription business, you have what I call "automatic customers," who agree to purchase from you into the future as long as you keep providing your service or product. Through the research for my new book, The Automatic Customer, I've discovered that there are nine subscription models that can be leveraged by businesses ranging from lawn-care companies to a market research firms to a manufacturing concerns.
Why Subscribers Make Your Company More Valuable
Recurring revenue--the hallmark of a subscription business--is attractive to acquirers and therefore makes your business more valuable. How much more valuable? To answer that, we must first look at how your business will be valued without a subscription offering.
In my experience, the most common methodology used to value a small to midsize business is discounted cash flow. This methodology forecasts your future stream of profits and then "discounts" it back to what your future profit is worth to an investor in today's dollars, given the time value of money. This investment theory may sound like MBA talk, but discounted cash flow valuation is something you have likely applied in your own personal life without knowing it. For example, what would you pay today for an investment that you hope will be worth $100 one year from now? You would likely "discount" the $100 by your expectation for a return on investment. If you expect to earn a 7 percent return on your money each year, you'd pay $93.46 ($100 divided by 1.07) today for an investment you expect to be worth $100 in 12 months.
Using the discounted cash flow valuation methodology, the more profit the acquirer expects your company to make in the future--and the more reliable your estimates--the more your company is worth.
Therefore, to improve the value of a traditional business, the two most important levers you have are 1) how much profit you expect to make in the future, and 2) the reliability of those estimates.
At SellabilityScore.com, we see the effect of this valuation methodology every day. Since 2012, we have been tracking the offers received by business owners who complete our questionnaire.
During that time, the average business with at least $3 million in revenue has been offered 4.6 times its pretax profit.
Therefore, a traditional business churning out 10 percent of pretax profit on $5 million in revenue may reasonably expect to be worth around $2,300,000 ($5,000,000 x 10 percent x 4.6).
Now let's compare the traditional company with the value of a subscription business. When an acquirer looks at a healthy subscription company, she sees an annuity stream of revenue throwing off years of profit into the future. This predictable stream of future profits means she is willing to pay a significant premium over what she would pay for a traditional company. How much of a premium depends on the industry; some of the biggest premiums today go to companies in the software industry.
To understand what is going on in the valuation of subscription-based software companies, I spoke with Dmitry Buterin. Buterin runs a subscription software company called Wild Apricot. He also formed one of the world's first mastermind groups of small and midsize subscription company founders. Each month, the group meets to discuss strategies for running a subscription business.
Members of the group were constantly raising money or being courted by investors, so the topic of valuation came up a lot in their conversations. Buterin found the consensus valuation range being offered to his members' companies to be between 24 and 60 times monthly recurring revenue (MRR), which is equivalent to two to five times annual recurring revenue (ARR).
I wanted to validate Buterin's numbers, so I met with another guru from the world of subscription-based software companies named Zane Tarence. Tarence is a partner with Birmingham, Alabama-based Founders Investment Banking; the company specializes in selling software companies that use the subscription business model. Tarence estimates the valuation ranges he sees as belonging in one of three buckets:
24-48 x MRR (2-4 x ARR)
These are typically very small software companies with less than $5 million in recurring annual revenue. Companies in this first bucket are usually growing modestly, with subscription cancellation rates (i.e., "churn") in the area of 2-4 percent per month.
48-72 x MRR (4-6 x ARR)
These are larger software companies with recurring revenue of at least $5 million annually, which they are growing at the rate of 25-50 percent per year. Their net churn is typically below 1.5 percent per month.
72-96 x MRR (6-8 x ARR)
These are the rare, fast-growth software companies that are growing more than 50 percent per year, with at least $5 million in annual revenue and net churn below 1 percent per month. These companies usually offer a solution (typically an industry-specific one) that their customers need to use to get their jobs done.
The software business is an extreme example of the benefits of subscription revenue, but no matter what industry you're in, your company will likely command a premium if it enjoys recurring revenue.
Security businesses that monitor alarm systems and charge a recurring monthly monitoring fee to do so are worth around double what security businesses that just do system installations are worth. Retail pharmacies with a large pool of prescriptions for drugs people take every day, like Lipitor and Lozol, command a premium over a traditional retailer because customers re-up their pills on a regular basis, creating a recurring revenue stream for the pharmacist.
Even tiny companies are worth more because of their subscription revenue. When my colleagues over at the Sellability Score analyzed very small businesses with less than $500,000 in sales, they found that the average offer these small businesses attract is 2.6 times pretax profit. Compare that to the average Mosquito Squad franchise.
Mosquito Squad is a Richmond, Virginia-based company that offers to keep bugs off your patio by spraying your backyard regularly with a proprietary chemical recipe approved by the Environmental Protection Agency. Mosquito Squad franchisees target affluent home owners with an average home value north of $500,000 who entertain in their backyard and don't want to be bothered by mosquitoes.
Instead of you calling when you need them, Mosquito Squad operates on a subscription basis. You subscribe to a season of spraying, which includes 8 to 12 sprays, depending on how buggy it is where you live.
Mosquito Squad is a franchise business, and the impact of its recurring revenue model on its valuation is remarkable. According to Scott Zide, the president of Mosquito Squad's parent company, Outdoor Living Brands, Mosquito Squad franchises that changed hands over the most recent five-year period had revenue of $463,223 and sold for 3.7 times their pretax profit. That's a 42 percent premium over the traditional value of a company with less than $500,000 in sales, mostly because Mosquito Squad operates on a recurring subscription model and 73 percent of its annual spraying contracts renew each year.
Whether you plan to build a subscription-based software application or the simplest personal services business, having recurring revenue will boost the value of your most important asset.
This article is adapted from the new book The Automatic Customer by John Warrillow. The book is published by Portfolio, an imprint of Penguin Random House, and is available wherever books are sold. Copyright John Warrillow, 2015.