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Building a Recurring Revenue Strategy
Jim Godsey
Craig Hanson
Denver Software Club 9.19.05
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Agenda
• Industry Trends
• Definitions
• Subscription vs. Perpetual Licensing
• Setting Prices
• Launching Subscription Licensing
• The Investor & Acquirer’s Perspective
• Impact on Valuation
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Movement toward subscription-based software
• “We define ‘On Demand’ as . . Term based licensing and outsourced delivery . . We expect more customers to opt for term or subscription based licensing versus the traditional perpetual model and move toward outsourced solutions. Very simply put, software in an On Demand world will change the way customers buy, vendors sell, and investors invest.”– Merrill Lynch
• “It is clear that the traditional software business model is unwinding . . ‘On demand’ is becoming the preferred method for licensing and deploying software. The impact on valuations and creating sustainable shareholder wealth are enormous.” – Credit Suisse First Boston
• ‘By 2008, over 50% of software purchases will be via Software-as-a-Service’ – Gartner
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Movement toward subscription-based software
• 33% of ISVs already offer subscription-based pricing. Within next 2 years, 52% expect to offer subscription-based pricing as their primary sales model – Source: SIIA, “Key Trends in Software Pricing and Licensing”– Figure was 21% just a year ago, according to VARBusiness 2005 State of
Software
• Greater initial adoption by small and mid-size customers– Most successful technology attacks start at the low end – Clayton Christensen
idea
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Definitions
• Licensing– Perpetual– Subscription– Utility
• Pricing– Site– Per Unit– Value
• Deployment– In-house– Hosted
Pick one from each
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Subscription vs. perpetual
Subscription• Limited license term
• Lower short term revenue, but higher long term revenue
• Improved revenue visibility & consistency
• Slower revenue growth
• Shorter ROI time scale
• Requires adjustments to reseller networks
Perpetual• No license term
• Larger transaction amounts up front
• Choppy quarter on quarter revenue behavior
• Separate maintenance revenue stream
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What is your value add?
Customer’s Business
Requirements
YourOffering
YourValue Add
Customer’s Business
Requirements
YourOffering
YourValue Add
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What is your value add?
Customer’s Business
Requirements
Competitor Offering
YourOffering
CommodityNo value add
CompetitorValue Add
YourValue Add
Customer’s Business
Requirements
Competitor Offering
YourOffering
CommodityNo value add
CompetitorValue Add
YourValue Add
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What is your value add worth?
Next best alternative to your solution- competitor’s offering- do nothing
Switching costs
Your Value Add Set yourPrice
in here
ROI
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Calculating subscription price
• Typical:1 year subscription price = perpetual price / 3
Note: Perpetual price includes 3 years of maintenance. Maintenance fees are between 15% - 22% of list software fees.
– Subscription price includes maintenance and support– Deployment costs (i.e. installation, configuration, customization)
are not included
• Example:– Siebel CRM on Demand = $70 per user per month– $70 * 36 = $2,540– Perpetual license per user list price = $1,800
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Launching subscription pricing
• Determine value
• Prepare revenue accounting procedures
• Prepare contracts
• Prepare contract administration and billing systems
• Establish term & set price
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Why do investors and acquirers like recurring revenue models?
• Predictable, compounding revenue stream– Less volatility, better ability to plan
• No end-of-quarter frenzied pricing discounts = better margin potential
• Shorter commitment period hastens customer adoption
• Chance for new entrants to steal market share from publicly-traded competitors, which have a harder time taking the one-time hit for the switch to subscriptions
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. . . The downside
• Slower revenue growth
• Slower cash inflow
• Therefore, more cash required to fund company to breakeven
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Recurring revenue is more highly valued by the market
• Wall Street and private investors attach a premium multiple to recurring - preferably contractual - revenue
• More debt financing ability– Lenders willing to provide more debt with safer cash inflow, and will
sometimes lend off this rather than AR or tangible assets
• VCs increasingly favor this model– Jamcracker estimates that 90% of new software companies funded by
VCs have SaaS models
• Acquisitions of recurring revenue companies are heating up
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Valuation impact – comparable metrics
• Is subscription pricing a net positive or net negative in your company’s valuation? Two ways to compare.
• #1: Can use different valuation metrics.• Under subscription model, revenue is booked upon
signing the contract, but recognized ratably over the subscription term.
• These future revenues show up on balance sheet as deferred revenue.
• Over time, deferred subscription revenue is transferred to the income statement.
• Therefore, a better metric is Bookings Growth – Bookings Growth = reported revenue + changes in deferred revenue
• Over time, cash flow growth rate becomes good indicator
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Valuation impact – recurring revenue premium
• #2: Valuation premium attached to recurring revenue companies – but does it justify the switch?
• Hard to isolate the valuation differential• Rough calculation shows average public software
company trading at 3.4x 2005 revenue• Small sample universe of recurring revenue software
companies trade at 4.9x 2005 revenue (40% premium)• Similar Price-to-Free Cash Flow multiple premium of 36%
(19x vs. 26x)• For early stage companies, how much of a premium?• With these multiples, valuation can take a net hit in the
early stages of a company, but will attain a net premium as revenue grows and compounds
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Considerations for early stage companies
• For early stage companies, how much of a premium do they get from VCs?
• Factors to consider: – Not as simple as 3x product pricing translating into valuation premium,
because, increasingly, revenue under subscription model bolstered by past bookings;
– Perpetual model gives you (most of) the cash upfront, and results in quicker cash flow breakeven, and less capital needed;
– VCs also look at prospective valuation of the next round, so the calculation depends on how soon the company’s deferred revenue + valuation premium can catch up to a perpetual model;
– Another important factor is renewal rates / expected life of subscriber; without longevity, model doesn’t work;
– Calculation ultimately dependant on the company’s particular business model
• Bottom line: Think of what is best for your company in the long-term – revenue, competitive advantage, exit valuation - not just the valuation you’ll receive from your first venture round.
