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  • All Revenue Streams are Not Equal in Business Valuation

    May 13, 2021

    IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses.  The following blog has been provided by Kelly Deis of Soundpoint Consulting (www.soundpointconsulting.com).

    All Revenue Streams are Not Equal in Business Valuation

    A dollar is a dollar. That’s true. And, all revenue is equal. Right? Well no, not in an investor’s or potential buyer’s eye. So what makes some revenue good and other revenue better?

    Recurring

    Recurring revenue is highly desirable because it is known and predictable. The best example of this is an auto-renewal fee or service charge periodically charged directly to a customer’s credit card. Once the initial sale is complete there are no more costs to acquire a customer. The revenue stream is much like an annuity. Continue to provide the goods or services as promised and the revenue keeps coming in.

    Great examples of this are insurance premiums and streaming fees. Once customers have decided to purchase the product – and assuming they remain content, they are happy to have their credit card billed automatically.

    In contrast, consulting and attorney fees are often one-time in nature. Revenue ceases when the project is complete and the engagement ends.

    High Switching Costs

    Revenue generated from products or services that have high switching costs are more reliable than from those which do not. Switching costs can vary from technical reliance to data lock-up to high start-up costs with a new vendor.

    A great example of high switching costs includes services which are outsourced, such as payroll processing. The cost to bring the work in-house is significant as you would have to hire and train a staff of people for this function.  Likewise, a bank account with automatic bill pay also has high switching costs, as unwinding those (recurring) transactions is a pain in the neck!

    High switching costs in combination with recurring revenue results in some very high quality revenue. Take for example, my relationship with Constant Contact which reliably sends these monthly newsletters to you on my behalf. My credit card is billed monthly. And, it would be a quite an undertaking to transfer my email list to another email provider. Do you think Constant Contact is at risk of losing my revenue? Absolutely not!

    Loyal Customers

    Revenue from a loyal customer base is extremely valuable. Not only does it guarantee repeat business but it potentially means additional business from referrals, thus significantly reducing the overall need for marketing and advertising spend.

    Good examples of this are a trusted relationship with your tax preparer or a favorite clothing store. Although switching costs may not be high, loyalty keeps you from looking elsewhere.

    Consider two comparable stores with the only difference being the loyalty of the customer base. The store with the more loyal customers has less customer churn and doesn’t have to work as hard for every dollar of revenue. Conversely, the store without the loyal customers has to work hard for every dollar earned. Not surprisingly, the investor/banker/ potential buyer will value the first store more.

    What are you doing to earn and keep the loyalty of your customers?

    High Margins

    All businesses have revenue streams with different margins. Revenue that generates higher gross margins is more valuable than revenue which generates lower margins. Makes sense. You cannot generate much income from a revenue stream that is saddled with large variable costs.

    And, if a revenue stream costs more to produce than the dollars it generates, well that is not good. It’s like giving someone $1 in exchange for 85¢. Do this in too often and you will soon be out of business.

    The bottom line – know and manage your unit costs. Try to divert revenue from your lower margin products to those with higher margins.

    Diversified

    Just like an investment portfolio, a diversified customer and supplier base is less risky than if you are highly dependent upon a handful of them.

    If one of your largest customers were to transfer business to a competitor, how quickly can your business recover? Or, if your largest suppliers were to run into financial difficulties, could you weather the storm?

    If your business model is highly dependent upon Google, Amazon or Microsoft, what happens if they change how they do business with companies such as yours? Trust me, you do not have much negotiating power with these guys.

    A good rule of thumb is that your top 5 customers should not be responsible for more than 15% of your total revenue. A similar metric should hold for suppliers.

    If you would like assistance improving the quality of your revenue, please give me a call. I would be happy to help.

    If you have questions relating to the content of this article, Kelly Deis, CVA, CEPA and President of Soundpoint Consulting, a business valuation and consulting firm specializing in business valuations, exit planning, strategy and operations business consulting, and financial services for marital dissolutions, would welcome inquiries. Kelly Deis can be reached at 206.842.4922, or kelly@soundpointbusinessconsulting.com

    IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.

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