Quality of Revenue

Prospective buyers of software and other technology companies assess a variety of factors when determining a valuation for a target company. One important factor is quality of revenue, that is, the stability, sustainability, and profitability of a company's revenue streams. Prospective buyers typically are not just interested in the size of a selling company's revenue. They also want to determine whether the selling company is likely to continue generating a high level of revenue and profit in the future.

Various elements go into a quality of revenue assessment, such as whether the revenue is recurring or one-time, whether the revenue comes from products or services that are cloud-based or on the customer's premises, and the rate of customer attrition ("churn") the selling company experiences over a period of time. If you are a tech company owner planning to put your company on the M&A market it's important to understand and, if possible, improve your quality of revenue because it can lead to a higher valuation for your company by prospective buyers. Even if you are not planning to enter the M&A market, focusing on your company's quality of revenue, can help you make decisions that ensure sustainable growth and long-term financial stability.

Let's look at some of the factors involved in quality of revenue.

Revenue model

Your revenue model can significantly impact quality of revenue. Buyers tend to rate a revenue model based on its predictability, recurring nature, and associated costs.

Software as a Service

Buyers tend to give a Software as a Service (SaaS) model the highest revenue quality value. In a SaaS model, customers pay a recurring fee (or subscription) for on-demand access to resources, such as software, services, and technologies, that you host on your servers. A SaaS-based revenue model has a high revenue quality value because it generates revenue that is predictable and stable, delivering revenue over a much longer period of time than companies that depend on other revenue models, such as perpetual licenses. Also, a SaaS model often has high gross margins, something that contributes to greater profitability.

Buyers view SaaS when paired with cloud-based deployment as having a particularly high quality of revenue value. That’s because the recurring subscription revenue that a SaaS-plus-cloud deployment generates creates an annuity stream, that is, a series of regular payments over time ‒ something that buyers highly desire.

On-premise recurring software revenue

On-premise recurring software (or maintenance) revenue has the next highest value. In this model, revenue is generated from subscriptions or maintenance fees associated with licenses for software that is installed and run on the customer's servers or hardware. On-premise software requires customers to manage and provide support for their own infrastructure. This model has a relatively high value because the revenue is recurring, but it is viewed as less valuable than a SaaS model because it relies on initial license purchases and potential maintenance contracts which are more variable and less scalable revenue streams than a SaaS model.

Recurring support maintenance revenue

Lower still in value is the recurring support maintenance revenue model, where revenue is generated by providing ongoing support and maintenance services for products or services, typically through subscriptions or contracts. This model is not valued as highly as a SaaS-based or on-premise recurring revenue model because of some perceived limitations. For instance, support and maintenance often involves direct labor costs and potential on-site visits, leading to lower profit margins than pure SaaS subscriptions or other high-margin recurring revenue streams. In addition, customers may switch providers for slightly cheaper maintenance, impacting long-term revenue stability.

Non-recurring revenue models

Non-recurring revenue models such as perpetual software licenses, which grant customers the right to use a specific version of software indefinitely after a one-time purchase; and service revenue, where the customer pays only when a specific service is provided, are seen as having the lowest value because they don't offer stable, recurring income.

Recurring revenue versus follow-on revenue

Buyers generally value recurring revenue more highly than follow-on revenue. Recurring revenue is a stream of income that a company receives regularly and predictably, often from subscription-based services or contracts. Follow-on revenue is one-time revenue that comes from a customer after their initial purchase or contract.

Recurring revenue provides a stable and predictable cash flow that is highly attractive to buyers. By comparison, follow-on revenue is unpredictable and presents a higher risk to buyers. While you may be able to count on customers to come back and ask for more products and services after their initial purchase or contract, they are not obliged to do that. Follow-on revenue is uncertain and can disappear for any reason; it is not under your control. For these reasons, it is not valued highly by an acquirer.

Software versus service

What happens when your biggest customer offers you a giant sum of money to customize your software and deploy it to them as a managed service? Or they are willing to pay you a generous rate for extensive additional implementation services? These scenarios may sound attractive, but they lock you into providing maintenance, support, and enhancements over time. In essence, you are reducing your recurring software business by taking on a large support burden. Tech company acquirers tend to avoid or penalize companies that are dependent on support-related business because of the high variable costs associated with providing support.

Churn

Churn, the rate at which customers stop doing business with a company, is a strong indicator of revenue quality. A low churn rate indicates a solid, loyal customer base, factors that contribute to high revenue quality. However, a high churn rate is problematic because it means the company is losing customers faster than they are acquiring new ones – something that lowers revenue quality.

Typically, a churn rate that reduces revenue over 10% compared to the recurring revenue at the beginning of the analyzed period is considered problematic for most buyers regardless of the ultimate cause of that churn.

Understanding quality of revenue and the buyer's perspective of your quality of revenue are vital if you are entering the M&A market. A high quality of revenue increases the perceived value of your business and puts you in a good negotiation position with prospective buyers. While a low quality of revenue can negatively impact the valuation of your company and lead to a lower offer price.