Customers on A Philosopher and A Businessman

Quality of Recurring Earnings

Tue, 17 Nov 2015 00:00:00 +0000

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?

Oops - The Gorilla Just Sat On Me

Sun, 15 Nov 2015 00:00:00 +0000

You’ve been sweating on that big deal for weeks. The gorilla deal. The one which will change the face of the company. Revenues will double overnight and all kinds of exciting things are about to happen. After arguing over the fine details of the contracts - conceding a few points here and there and winning a few elsewhere (but not many…) you finally get it over the line. Woo-hoo, we’re made!

Now back to reality.

Yes - this deal will indeed change the face of the company. It will either grow and succeed or crash and burn. There’s no half measures with a gorilla deal.

A good part of my working life has been spent building, selling and implementing business software so today we’re going to have a look at how big companies accidentally stifle or kill small software vendors. I’m sure this applies to all small technology vendors, and I’m sure most of this applies to all small vendors of any kind.

A deal isn’t a deal until you have the purchase order.

You go through the trials and tribulations of presenting, running demos, doing technical evaluations, having some forensic accountant delve into your books to confirm you are a viable entity and you come out victorious. You have a signed contract to supply the gorilla. As soon as you have recovered from the champagne hangover you go on a hiring spree to service the workload. Then you wait. Nothing’s happening… Not quite nothing - your cash is draining out of the bank account paying for all the new hires.

So what’s going on?

Possibly one of many things, but fundamentally you are dealing with different parts of a large organisation to pull off a big deal and a lot needs to be synchronised for things to happen quickly. For example, the procurement team will be working on multiple contracts and the line of business buyer will have forgotten what they were doing by the time the procurement team has finalised negotiations, fixed up terms and conditions and all kind of other legal minutiae and executed contracts with you. The line of business buyer then has to get back on track and start organising themselves around a project, but some operational issue has blown up in the meantime. So they get back on track and start the project a second time around, at which point they remember they need to issue purchase orders against the original contract to get something to happen. Meanwhile you’ve gone bust. The gorilla just accidentally sat on you.

What can you do about it?

Well, first of all, don’t get excited and start expanding before you see the initial contract turn into a commitment to pay. To support this you need to tie cost to revenue in the contracts. If you have to hire, hold resources or buy raw materials to service the contract then you need to be paid for it. If the gorilla customer won’t pay in advance then you don’t hold resources or lock in your costs. Non-negotiable. This is the kind of thing you will lose your house and family over.

Accounting revenue does not equal cash

Side lesson #1: You can book earned income (e.g. hours spent on a project, widgets shipped) and you can calculate profits but until the customer transfers the money you do not have the ability to spend that money on important things like rent and salaries.

Side lesson #2: Gorillas have two important attributes. They are dominating and they are slow. They dominate your management time and your resources and should dominate your revenue. However, they are slow moving, particularly with their accounts payable. That means a significant portion of your revenue may not convert to cash for some time. This is fine if you have a bloated bank account, but more than likely you will not have the money to spend on important things like rent and salaries.

Now gorillas generally aren’t slow because they want to be. They have internal processes to ensure people aren’t stealing money or spending it on stupid things like office dishwashers and bribing government officials. These processes can move slowly, particularly if key approvers are on vacation. They also have things called payment runs which may only happen every couple of weeks. If you miss one you have to wait for the next one to get your cash. Yes, I know we are well into the 21^st Century but it does still happen like this.

Gorillas also sometimes convince themselves they should implement ERP systems. These projects are big and complex and kill off accounts payable functions for months at a time.

What can you do about it?

If you are in the middle of this it is tough. The emotional and reputational pressure to keep working is intense. However, as a founder/director/senior manager of your company you have a duty to keep your company solvent. This gives you the “higher authority” you need to have the tough conversations with your customer.

If you need to camp outside their CEO’s office to get your invoices paid then that’s what you must do. If you need to divert all of your resources to fast sources of cash then that’s what you must do. And you should explain to the representatives of the customer you interact with what you are doing and why, and that you really don’t want to but under corporation law you have no choice.

An ounce of prevention is better than a ton of cure. Multiple calls to accounts payable and the customer’s nominated representative the second a payment is late sets the tone for the relationship - that you are professional and on top of the admin side of the business. And that you won’t tolerate being given the run around. Divert the project team for a day to another account, or onto internal projects to show you mean business. Again, you can lose your house and family over a gorilla’s glacial payment system so take it seriously and show you take it seriously.

“I insist on fixed cost even if it kills me too”

Big companies seem to think that fixed cost projects are lower risk to them. And they may be when dealing with mature vendors with mature technology who have done a hundred similar projects and have enough cash in the bank to get through the odd project overrun without losing their shirt. If you are a small vendor, however, you absolutely need to negotiate out of this for your sake and theirs. A large, fixed cost project can kill your business. Here’s how:

Big customers typically have big project management systems. These introduce way, way more overhead than you ever imagined possible as a small, agile vendor. In the contracts you skim over the clause which says you will abide by the customer’s project management systems. That one simple clause contains a world of pain. Change control documentation, acceptance testing, test evidence and on it goes. You can probably throw in the odd half day safety induction for each of your team members if you are working in that kind of industry.

You didn’t price in this overhead so you didn’t see the 40% extra cost coming your way.

Small vendors normally have a technical guy leading a project who thinks every new feature is a cool idea. When the customer says “Can we add a new screen which shows how late we are with the project?”, your technical guy says “Hey, that would be cool. Yes it should be in there - I’ll have it done next week”. Instead of: “That’s outside the project scope. If you send through a change request we’ll let you know impact on the price and schedule by mid next week and you can decide if you want to proceed”. The project never ends. Your costs never end. But your revenue grinds to a halt.

One of two things then happens.

You lose interest in the project which is haemorrhaging cash and it never gets finished - not good for the gorilla customer.
You go out of business and the project never gets finished - also not good for the gorilla customer.

Armed with this it should be possible, though not easy, to negotiate your way out of a fixed price engagement. Once you have done a few similar projects and know what’s involved and have reasonable working capital available by all means go fixed price - the margins can be way better when done properly. Just not for the first few.

Gorilla deals can kill your business in many other ways. Big companies like to ~~take over~~ have input into your development roadmaps so your products end up being designed for a single customer, not for a market. There goes your growth potential.

Big companies like to insist on locking your key staff into their projects. Congratulations - you just became ~~the gorilla’s bitch~~ a bodies-for-hire company, not a product company. There goes your growth potential again.

Big companies retrospectively insist on certified quality management systems. There goes another chunk of your shrinking margin. And on it goes.

A huge deal with a big customer can be a company maker, it’s true. But if you go in unprepared these huge deals will be a company breaker. If you don’t have anyone on your team who has the grey hair and scars from this kind of deal in the past, tread carefully. You will almost always be better off building capability, cash and experience with a few smaller, friendlier customers.

Photo credit: frank-wouters