Quality of Recurring EarningsNov 17, 2015
strategy customers cashflow
Great businesses print money. Whether you go to work, stay home, mess around in the garage inventing a new gizmo, go for a surf or swan around the vineyards of Europe, the cash pours in. Who doesn’t want that?
Well it turns out we didn’t when we started out. Like many others we left a job and started consulting. All the downsides of a job - like having to turn up to get paid and natural limits on what you can be paid. Plus a couple of significant extras. If you get sick the money stops. If you don’t sell the money stops. We had no recurring earnings. We had no plans to build recurring earnings and we certainly had no clue as to the quality of recurring earnings.
When I finally got around to sorting out the business my advisor hammered four letters into my head. Q.O.R.E. Quality of Recurring Earnings. If you want cash pouring in regardless of how you spend your day it pays to get your head around recurring earnings, how quality of earnings varies and how to get some for yourself.
This is probably explained by looking at some examples. Let’s look at recurring earnings we’re all familiar with:
Bank interest. You get paid on savings you hold in a bank account. High quality in the sense that it’s predictable. Low quality in the sense that it takes a bucketload of cash to get an income stream above the poverty line and then the value of that cash gets chewed away by inflation.
Share dividends. You get paid out a share of the profits of a business you invest in. Each company you invest in will have totally different recurring revenue sources and qualities which flows through to you as a shareholder. Analysts spend their days looking at this to figure out which companies have the best cost/revenue models and whether the price paid to invest justifies the likely revenue now and in the future. We’ll look at some of the parameters they use shortly - they will be the same things the small business owner is likely to think about.
Rent from investment property. You get paid rent each week by a tenant living in your property. New, inner city property in a booming city with low vacancy rates is likely more predictable, higher quality recurring revenue than an old seasonal holiday rental in a waning country town.
Phone services. The phone company gets paid for line rental and calls made. It is relatively predictable when averaged across a huge number of subscribers. Churn rate, the rate at which subscribers move to another provider, affects the quality.
Consulting services. Many consulting firms use a retainer structure where they offer a lower hourly rate to their clients in return for a minimum spend each month over a minimum number of months. Not bad - the revenue becomes more predictable. But you still need smart people to actually deliver the consulting and smart people tend to be awkward to manage because they have strong opinions about how to do things.
Software maintenance fees. Enterprise software has typically been sold with an upfront license fee and then ongoing annual support and maintenance fees to entitle the customer to upgrades etc. If the software is easy to replace (e.g. a rostering tool for a single department) then the maintenance revenue is lower grade compared with software which is hard to replace such as an ERP. I have heard that an ERP is like a tattoo - the pain of removal far exceeds the pain of installation - so the maintenance revenue keeps flowing.
In each case, recurring earnings are earnings which have a very high probability of arriving in your bank account in spite of everything you do in the short term. There are a few factors that determine the quality of recurring revenue.
Effort: Do you have to have a lot of manpower to deliver against the revenue? For example, a consulting retainer requires a consultant to do something useful to maintain the revenue, whereas no human is directly needed to deliver a phone call.
Capital: Do you need to tie up a lot of capital to receive the earnings? While no human is directly needed to deliver a phone call, a lot of very expensive infrastructure is.
Risk: What is the risk involved in delivering the service? Does the revenue justify this risk? I would want to be very well paid if I was responsible for monitoring aircraft engines and potentially liable for an air accident. Complexity creates risk too. If I need 20 opinionated experts to deliver complex projects the likelihood of things going smoothly is nil*.
Predictability: Do I have a very low variance between forecast recurring earnings and actual? A phone company can predict earnings with a high degree of accuracy due to the averaging effect across a large number of subscribers. A holiday rental less so.
Sustainability: Can something happen to kill off my earnings over a short time period. For example, mobile phones replacing landlines or government legislation driving the price of thermal coal down.
So how do I get some high quality recurring earnings for myself?**
That’s a great question and the answer is, annoyingly, “It depends”. It depends on what you currently do, it depends on the markets you serve, it depends on your skills, capabilities and risk tolerance, it depends on access to capital and so many other things. But the trick is to identify the parts of your business that can systematically and repeatedly result in a benefit to your customers, package that up and teach others to sell and deliver it.
Too easy. Time for a surf.
* You could argue that complex projects don’t represent recurring earnings. They could, though, if you have been contracted to deliver installations across 300 sites for a single customer over 5 years.
** Of course, if you are the founders of some hugely successful social networking startup, high quality recurring earnings are the last thing you need as they may be used to value your business sensibly. Instagram, anyone?