Recurring revenue is often seen as the “holy grail” of business statistics-- The one where you must go after the business if it has recurring revenue. It is a surefire way to perk up investor ears and get your transaction funded. It’s even true in larger, private equity transactions. Recurring revenue is a proxy for predictability, stability, and cyclicality, which are excellent traits we’d want in any business. Especially one that’s highly levered with debt like most of the SBA 7a loan transactions that we teach at SMBootcamp. But, not all recurring revenue is created equal. These days it appears that recurring revenue is often thought of in a binary way—it is simply recurring or it is not. For many acquisition entrepreneurs, there isn’t a second thought after the classification of revenue as recurring. Reality is many businesses fall somewhere on the revenue quality spectrum despite all having “recurring” revenue— many recurring revenue streams lack some of the key characteristics that provide for high revenue quality. Further, many recurring revenue streams are merely subscription-like payment terms without other high revenue quality traits traditionally associated with recurring revenue. Recurring revenue is still extremely valuable, but it’s important to recognize the difference between more subscription-based revenue and high-quality recurring revenue to accurately reflect the risk of the business opportunity you’re pursuing.

Recurring revenue has traditionally been associated with a few traits in addition to a predictable payment schedule or subscription-base. These traits are:

If the business has recurring revenue, the thought process is that there is high predictability of revenue (i.e. high revenue quality). But it appears that there has been a meaningful shift in the definition in both private equity and SMB acquisitions, which has effectively relegated recurring revenue to a single characteristic: predictable payment schedule or subscription-based.

One of the key advantages to recurring revenue is the idea that customers pay on a highly predictable schedule. Perhaps the most prevalent in subscription-based expense for American consumers is the Netflix subscription. Every month, you will pay $10 on the same day, month after month for access to the platform. From Netflix’s perspective, it is highly likely that a customer today will be a customer a month from now, a year from now. Netflix is able to provide a ton of value to customers at such a low price point that is unlikely to be canceled in tough macro environments; $120 a year is hardly a difference maker in the grand scheme of budgets despite not having a long-term contract with customers. With clear revenue visibility into the future, Netflix is able to develop growth strategy and manage expenditures extremely effectively. Unlike a project-based business like a building contractor, their revenue (and cash flow) is stable month after month after month. For the building contractor, a single project over a 6 month period could produce any amount of the total project revenue in a given month. If the project stalls in one month, it could put the business in a precarious cash flow position even if it catches up the next month. Netflix and to some extent all majority recurring subscription-based businesses, do not have this issue. Minority recurring subscription-based revenue businesses at the very least have a consistent cash flow buffer.

From the customer’s perspective, subscription-based services can be a distinct advantage. They’re lower cost than payments delivered in one large slug, which generally makes it more tenable for consumers and businesses to spend. This phenomenon has exploded the last few decades with many companies taking advantage of this type of spending behavior. There is simply a subscription for everything now—streaming platforms, HVAC preventative maintenance, garage doors preventative maintenance, pool care, carwashes, groceries, ubers, etc. Every subscription expense in isolation is only a small fraction of a customer’s total expenditure, but combined they can really add up. Despite each of these examples having a predictable payment schedule, it would be hard to make the case that many of these share the traditionally associated traits: non-cyclical, non-discretionary, and sticky with high-switching costs. In fact all of these examples are perhaps the exact opposite of the traits traditionally associated with recurring revenue. When times are tough, are you really going to pay for a weekly carwash and preventative maintenance for your garage door? These are highly discretionary and cyclical expenditures that have virtually no switching or cancellation costs. These examples are focused on consumer-facing businesses, but they exist for commercial businesses too. When times are tough the frequency of janitorial service and landscaping is cut back. Non-essential software subscriptions are reduced or downgraded. Despite being relatively small monthly expense hits, even these “recurring” revenue streams are prone to disruption in the absence of the other key traits.

Recurring revenue can be a powerful driver of business value, but only when it comes with the right supporting traits—the traditionally associated traits. Predictable billing alone doesn’t justify a premium multiple and signal a far lower-risk investment. To really reduce risk, recurring revenue must be non-discretionary, non-cyclical, and sticky.

The best examples are businesses where customers simply cannot operate without the service. Think payroll providers like ADP. Employers can’t just “pause” payroll in a recession, and switching providers involves execution risk and time-intensive onboarding. That’s high-quality recurring revenue.

Another strong example is software deeply embedded in day-to-day work. Microsoft 365, any CRM, or ERP isn’t optional when budget cuts are coming. Fundamentally they’re the backbone of how employees do their jobs. Even if the economy turns, companies rarely cancel them (or can’t due to long-term contracts), and switching comes with major friction.

Admittedly, these are a bit outside the scope of what we think of when it comes to SMB acquisitions, but the takeaway remains the same. Recurring revenue only defined by a subscription-based or predictable payment model may not be as recurring as you think. It must be further analyzed to contextualize the likelihood that revenue is going to continue into the future.

Many SMBs are marketed as having recurring revenue (see appendix A for a bunch of common examples): car washes, HVAC, plumbing, garage doors, janitorial/cleaning, roofing, etc. even when the truth has more nuance. It’s important to remember that the job of a business broker, M&A advisor, or investment banker is to sell the business for the highest price possible; their job is to market the business with a story that drives valuation up for their client (and thus the advisor’s fee). When analyzing recurring revenue of a business, you must dive deeper than the billing structure to truly identify how predictable the revenue is, and if it should command a premium valuation. A few key questions that I’d suggest you ask are:

If the “recurring revenue” fails any of these categories, it might not be as recurring as you think and may better be classified as “subscription” revenue with the only advantage of improved cash flow dynamics (which admittedly counts for something). Further, a business without predictable billing can exhibit these traits, and ultimately provide for higher revenue quality than a seemingly recurring revenue business.

When evaluating SMB transactions, the ultimate metric is revenue quality, which can exist with or without recurring revenue streams. Especially in the context of highly levered transactions, you must ensure that revenue today is revenue tomorrow, next month, next year, and so on. It dives much deeper than a simple payment structure and must be evaluated on a deeper level.

If you know someone exploring small business ownership, we’d love if you shared The Playbook with them and to show our appreciation, we’ve got a few referral rewards along the way.

If you're ready to take your acquisition journey further, check out our programs below. We've designed them specifically to give you actionable, real-world frameworks and support to successfully buy and grow your own small business.