Revenue quality is an area of focus for buyers and venture capital/private equity investors. High revenue quality companies are valued higher than low quality revenue companies. But what does this really mean and why is this?
It is simply a question of risk. High quality revenues reduce risk and therefore result in a higher valuation. What are high quality revenues? Primarily it is about revenue continuity (i.e the expectation that today’s revenues will still be here tomorrow) but it is also about revenue diversity and margins/profitability.
Long term customer contracts provide future revenue predictability. In many cases capital projects will not get financed without long term customer contracts. But what if you don’t have long term contracts, what else can give an investor or financier comfort that revenues will stick around? Questions that get at this answer include: How much of an “annuity” does your business model have? What percentage of revenues can be counted on to recur every year? Is the product/solution mission critical? Is it embedded in your customers’ businesses? Are switching costs high?
As an example, cloud based Software as a Service (“SaaS”) solutions such as Salesforce, Workday or NetSuite are often sold on a per seat, monthly subscription basis. In some cases upfront customization is required and in all cases customers have to learn how to use the new software. Once customers have adopted such a solution, they will not switch very quickly. The solution becomes embedded in another business’ processes which results in high switching costs. As a result, its recurring revenues are usually quite stable.
There are a number of ways to grow recurring revenues; license or lease your product or technology instead of selling it outright, sell products that need periodic supplies or maintenance, sell service or maintenance agreements, franchise, etc.
The greater the customer concentration the greater the risk. The opportunity to supply a major retailer (i.e. Wal-Mart or Home Depot) or a major manufacturer (Ford or GE) can be a tremendous opportunity for a small company but it can also drain a lot of resources and result in pressure on margins and tremendous customer concentration. While the growth that it drives will increase value, the associated risk of these revenues will reduce value.
Early-stage companies tend to have only a few customers that make up a large portion of revenues but, over time, they must strive to build a diverse revenue base. Ideally no customer generates more than 10% of revenues.
If you operate in a low barrier to entry, fragmented market, then it will be hard to increase prices and produce sustainably strong margins. Of course different business models generate different margins. For example, a grocery business will have a lower gross margin than a cloud based SaaS business which can generate gross margins of over 70%. Over time, competition will put pressure on margins but under certain circumstances, such as first-to-market solutions, proprietary products and processes or patents, companies can sustain high margins for a considerable period of time.
Most entrepreneurs will say they have excellent customer relationships and that certain customers would not leave them no matter what. But stuff happens. Maybe this belief is based on personal relationships which cannot be sold with the business. There are always opportunities to improve revenue quality, whether it is to extend revenue continuity, increase revenue diversity or to improve margin. Improving revenue quality should be an ongoing priority for business owners as it is a strong contributor to company value.
Real World Implications for Revenue Quality
In the private M&A market, we are seeing buyers looking for third party quality of earnings reports as a requirement to closing a transaction. Especially when third party financing is required to fund the deal. Companies that don’t produce audited statements should expect the closing process to take an extra three to five weeks to accommodate an earnings quality review.
For more blog posts, please see Private Company Mergers and Acquisitions.