Ask anyone in private equity what they look for in a new investment. A strong management team and a growing market are a given, but then you will hear something along the lines of recurring revenue, contracted income or a subscription model.
These are attractive business models – once a customer is signed up, the hard work is done and when they want to move on, more often than not, it proves to be more of a hassle to cancel or change provider than it is to move to a new one. There’s nothing new in it, we have all signed up to a 12-month gym membership in January with the best intentions, only to fall back into bad habits in February.
But the subscription model has become fashionable of late with buzzwords like ‘SaaS’ and ‘disruptive technology’ being thrown around the board room like David Brent on overdrive. Outside of the tech sector, all parts of the market have taken note and now there are all kinds of quirky subscriptions, such as vegetable boxes delivered to your front door and different tea bags through the post. In the menswear and male grooming markets, the appeal of simplicity and not having to go to the shops has proven popular for normally mundane everyday items such as razors, socks and underwear.
Even routine services we have been using for years such as window cleaning and taxis are being marketed as a monthly subscription with no upfront fee! Uber is now looking to charge users in America $15 a month for a ‘ride pass’ which offers discounted fares. It feels as though the success of Amazon Prime, Netflix and Spotify have made paying small monthly subscriptions appear acceptable and just something we all now do.
It is true that typically, companies with recurring revenue models are valued much higher than companies without a subscription model but it is equally important to demonstrate a captive base of customers paying monthly fees with low levels of attrition after the trial period or honeymoon phase. Here are the top three reasons private equity love to subscribe:
A predictable revenue stream allows subscription-based businesses to make decisions and invest for growth, particularly in the current uncertain economic climate.
Subscription-based businesses disrupt the market with lower up-front costs and greater flexibility. Whilst all companies are vulnerable to losing customers to their competitors, it takes an aggressive and strong offering to steal market share in a subscription environment.
Subscription models have much better visibility of the customer from their ongoing monthly interactions which should, by definition, mean a keen insight into the needs of customers and a better-quality service. The customer has the added benefit of spreading the cost and convenience.
Whilst profit is the main goal of any successful enterprise and we love to talk about EBITDA, it can be a very poor indicator of the value of a growing business, particularly a subscription business in the early stage of growth.
A high operating profit in a growing business could be a signal that the company is not keeping pace with sales and marketing spend or the need for continued improvement of its proposition to stay ahead of the crowd. The metrics that matter most to subscription businesses, are more likely to be annual recurring revenue, lifetime customer value, churn and acquisition cost and these can invariably be tracked in real-time providing critical management information.
So….recurring revenue models are not a panacea. But they can create very successful businesses which attract high valuations if they can be scaled successfully. Just what private equity investors are looking for!