7 Levels of Recurring Revenue
The most successful companies put tremendous emphasis on having recurring revenue streams. Are you looking at recurring revenue in the right way? Which type of recurring revenue drives increases your business valuation the most ? The higher the level of recurring revenue, the more predictable your revenue stream becomes. The more predictable your revenue stream, the better you scale your operations. The higher the level and greater the volume, the higher you valuation goes. Every company should be constantly asking “How can we strengthen our recurring revenue position?”
Not all recurring revenue is equal. Think of it as pyramid-shaped. The higher up the pyramid you move, the more valuable your company becomes. Think of the pyramid as a way to first increase consistency and predictability, then business scalability, and ultimately market-share dominance, where customers find switching providers more costly or problematic.
Level 1 – Basic Repeat Customers
At this level you have customers that like doing business with you and come back to you repeatedly even though there is no contractual obligation to do so. A good example is a supermarket or gas station. The problem with level one is the barriers and switching costs are usually limited. So, while having repeat customers is far better than not having them, your revenue stream remains risky because you can’t count on your customers sticking with you. Many firms in this mode have built loyalty programs or personally branded products in an attempt to create stronger brand preference and make their offers “stickier”.
Level 2 – Network Effect
What this means is that the more someone uses the company’s product or service, the more each individual customer gets out of the experience. This “network effect” creates a barrier to that customer leaving, namely, the perception that no other network is as good. Automobile Association of America (AAA) Membership or AARP are good examples. You may consider joining other networks, but for anyone who is already a member, it makes no sense to switch because their membership bases are so large that their value streams have pay their members back in multiples. With that said, the cost of switching is still low, and while you can differentiate who is in your network, everyone has access to multiple networks that can provide similar benefits.
Level 3 – Capital Investment with Consumables
In this case a customer has made an investment in a product, and now they need to keep buying consumables to support their investment. The longest standing product and stickiest product in this category is the copier. Later followers to take advantage of this strategy have been desktop printers and coffee machines. However, these later examples failed to really be as sticky because the price point to buy new ones at the consumer level is not high enough to prevent someone from jumping ship. And when it comes to coffeemakers, if they like your coffee, you still get to provide the consumables, just in a different machine. Consumables are usually a high-profit recurring revenue item.
Level 4 – Capital Investments – Subscriptions
Customers make a sizable investment in capital equipment and then pay subscriptions to use the equipment. In this case, they usually do not buy the equipment. They lease the equipment due to the significant expense for the equipment, software, maintenance, and upgrades required. Great examples are WestLawNext or Bloomberg which are staples in the legal and investment communities, respectively.
Level 5 – Sequenced Product Purchases or Service Subscriptions
The idea behind this approach is to create recurring income by encouraging your customers to consistently upgrade to new product and service offerings. Consider the example of Google Drive. It starts out as free. As you begin to use it more and more to store your data, you must pay to upgrade for more storage. Next thing you know, you are using Google Photos, and they have captured another revenue opportunity. Even if the company can convert just a fraction of its customers over to the premium service, it can create an extremely valuable recurring revenue stream. This revenue stream tends to be stickier because your customer prefers (knows how to use) your product, and the cost of switching in terms of time, effort, and costs outweighs the simplicity of staying with the current vendor.
Level 6 – Good-Until-Canceled Revenue
The best examples are bank accounts and credit cards. What makes this model powerful is when it’s based on an “opt-out” model where the customer has to terminate your relationship with them. For instance, I hate my bank. They send me a new credit card almost every 4 months because of their so-called “fraud protection” department’s suspicions. So every 4 months I have to change every recurring payment to come from the new account number. It is a nightmare! Plus, they send policy changes every 6 months, usually raising fees and reducing benefits. But do we change providers? No!, because of the trouble and loss of credit history. How often do people cancel their credit cards or close a bank account? Credit cards or bank accounts are an extremely powerful way of keeping customers over the long haul.
Level 7 – Longer-Term Contracts
The longer the contract the better! Think about the contract you signed when you got your new cell phone. I do not know about you, but I feel like when I signed on with Verizon I married the mob! Not only did you agree to pay a certain amount of money each month depending on the plan you select, you usually agree to keep paying for two years. If you are like me, each family member starts at a different time, so to get out gets prohibitively expensive, becomes a family debate, possible new phones get involved, and tons of time dealing with it. I just got chills thinking about it. This is an extremely valuable model because you can predict with a higher level of certainty what your recurring revenues will be both in the short-term, as well as over the longer term.
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