Recurring Revenue

How Does Recurring Revenue Work?

The standard business model of a SaaS or subscription-based company is oriented around the generation of recurring revenue.

Since recurring revenue is predictable and consistent, practitioners in the SaaS industry perceive revenue with a recurring component to be of higher quality relative to a one-time purchase (i.e. “not all revenue is created equal”).

In a recurring revenue business model, customers pay the company on a consistent, predictable basis rather than issuing a one-time payment.

Historically, the traditional software pricing model consisted of one-off sales (i.e. non-recurring transactions).

However, in recent times, the SaaS industry and subscription business model shifted over time to favor revenue models that offer a high level of predictability and consistency in the future.

Considering the revenue is near certain to be collected, barring extraordinary circumstances—such as the customer becoming insolvent—software companies with more recurring revenue are able to fetch higher valuation multiples.

Hence, the market-leading recurring revenue businesses that “go public” via an initial public offering (IPO)—or direct listing (e.g. Spotify)—become listed on a stock exchange trade at a significant premium.

Why Does Recurring Revenue Matter in the SaaS Industry?

SaaS startups and early-stage subscription businesses deemed market leaders in a segment within the private markets can raise a significant amount of capital from early-stage and growth-stage investors.

Likewise, late-stage SaaS companies are often the acquisition target of private equity firms for a potential leveraged buyout (LBO) and are acquired with a substantial control premium embedded in the purchase price (i.e. excess over fair value of assets).

SaaS and subscription-based businesses frequently require substantial time to research the end market to understand their customer profile, including the process of implementing continuous improvements to the business model and honing their customer acquisition strategies to achieve profitable growth.

However, once the SaaS company starts to gain market traction, securing predictable revenue streams can initiate the attainment of substantial revenue growth and scale (i.e. expansion into new end markets).

The customer payment is collected at regular intervals based on the terms per the terms set by the contractual agreement between the company and the customer.

Therefore, the predictability of the income stream can offer visibility into the pro-forma operating performance of a high-growth SaaS company, which most investors in the market view favorably (and are willing to pay a premium for).

How to Improve Recurring Revenue

The generation of predictable and recurring revenue stems from offering a differentiated product and value proposition to the customer base.

The value received by customers must not only meet but exceed their expectations to establish a recurring revenue stream.

If the product offering is unmatched in quality and a tier above the rest of the competition, the outcome is the acquisition of more recurring customers at lower customer acquisition costs.

However, the concept of churn, or “attrition”, is the hurdle encountered by most, which contrasts securing recurring subscriptions and customer retention.

There are methods by which churn can be analyzed:

• Customer Churn ➝ “What percentage of customers were lost since the start of the period?”
• Revenue Churn ➝ “What percentage of monthly recurring revenue (MRR) was lost since the start of the period?”

Where:

• Churned Customers ➝ Inactive Accounts (i.e. Lost Customers)
• Beginning Customers ➝ Number of Customers at Start of Period

The revenue churn, or MRR churn, is a metric used to track the reduction in recurring revenue caused by customer cancellations or downgrades, expressed as a percentage.

Where:

• Churned MRR ➝ Lost MRR from Customer Cancellations and Downgrades (Lower Tier)
• Expansion MRR ➝ Incremental MRR Generated from Existing Customer Base
• Beginning MRR ➝ MRR at the End of the Prior Period

In practice, there are a multitude of avenues for which a SaaS business can obtain a stream of recurring revenue, such as offering subscription plans and long-term contracts with customers.

The recurring revenue model retrieves customer payments on a recurring basis, with monthly and annual billing being the most common periodicities.

• B2C Market ➝ The B2C market serves individual consumers who seldom subscribe to annual subscriptions. Instead, consumers tend to prefer monthly subscriptions, as the subscriber data from the SEC filings of Netflix confirms.
• B2B Market ➝ The B2B market, on the other hand, is normally only presented with the option to sign an annual or multi-year agreement. Considering the cost of installation and services to support new customer onboarding, a B2B SaaS provider like Salesforce (CRM) offering a monthly subscription plan would be irrational.

SaaS and subscription companies actively implement measures to improve customer retention and reduce churn, which are two inversely related metrics.

• Retention Rate (%) = (Ending Customers – New Customers) ÷ Beginning Customers
• Churn Rate (%) = Churned Customers ÷ Beginning Customers
• Retention Rate (%) = 1 – Churn Rate (%)

The standard method of charging customers is an automated billing system, which charges the customer the amount owed at the end of each billing cycle (or interval) for continued access to the product or service.

Recurring Revenue: What are the Characteristics?

The common characteristics of recurring revenue are as follows:

• Predictable Revenue Stream ➝ Recurring revenue generates consistent, predictable income by charging customers on a regular, ongoing basis. The approach allows businesses to forecast revenue more accurately, improving financial planning and budgeting. Predictability helps with managing cash flow, making long-term projections, and reducing the risk of delayed payments.
• Customer Retention ➝ Recurring revenue models inherently emphasize customer retention over acquisition. Consistently retaining loyal customers who continue to make payments is more cost-effective than acquiring new ones. However, businesses must continually deliver value and foster long-term relationships to retain customers (or else, the customer will churn).
• Flexibility for Customers ➝ Recurring revenue often provides greater flexibility and affordability for customers, particularly with subscriptions or memberships. Customers can access products or services that might be expensive to purchase outright for a predictable recurring fee. This model can expand the customer base by making the offerings more accessible.
• Upselling and Cross-Selling ➝ With ongoing customer relationships, businesses have more opportunities to offer additional premium services or complementary products, increasing the revenue per customer. Continuous contact builds trust, making it easier to sell to existing customers. The strategy can significantly enhance the profitability of the business.
• Scalability ➝ Recurring revenue models, especially in digital or service-based businesses, are often highly scalable. As the customer base grows, the business can increase revenue without necessarily needing to proportionally increase resources or costs. Scalability allows for substantial growth potential with relatively low incremental costs (i.e. economies of scale).

Recurring Revenue Model: What are the Different Types?

The different types of recurring revenue models are as follows:

• Subscription-Based Model ➝ Customers pay a recurring fee to access a product or service, commonly seen with companies like Netflix, Hulu, Disney+, and Adobe Creative Cloud. The subscription model offers multiple tiers to cater to the specific needs of different consumers, further establishing a predictable revenue stream (and reducing customer churn). Companies can leverage subscriber data for enhanced user experience to improve the platform based on feedback. Subscription-based models facilitate long-term customer relationships and recurring revenue through continuous improvements to the product or service.
• Usage-Based Model ➝ Customers are billed based on their actual usage of a product or service, as demonstrated by Amazon Web Services (AWS). The usage-based pricing model provides flexibility for users to scale usage up or down on a need-basis, which appeals to price-sensitive customers. While the usage-based model carries more variability each billing cycle, the company was able to acquire a long-term customer that can easily become a scalable revenue stream that grows in tandem with customer demand (i.e. “pay-as-you-go”). The fluctuating pricing model is preferable over a fixed subscription plan in certain markets, which should improve the customer retention rate (and reduce attrition).
• Membership Model ➝ Customers pay a recurring fee for access to exclusive benefits, discounts, or communities, as seen with Costco. The membership-based model fosters customer loyalty and generates reliable revenue from membership fees. Membership models create a sense of belonging in a community and exclusive value for customers, which coincides with brand loyalty (and repeat purchases).
• Hard Contracts ➝ Customers commit to a contract with recurring payments for a specific period, common in mobile phone contracts. The model guarantees revenue over the contract duration but risks dissatisfaction and early termination penalties. Hard contracts provide businesses with a predictable income source but require “hands-on” customer support, which is less convenient relative to the other recurring revenue models and causes the company to incur more monetary and non-monetary costs (i.e., time and resources).

Recurring Revenue Formula

In the SaaS industry, the two fundamental KPI metrics for measuring recurring revenue are monthly recurring revenue (MRR) and annual recurring revenue (ARR).

• MRR ➝ “Monthly Recurring Revenue”
• ARR ➝ “Annual Recurring Revenue”

The MRR and ARR reflect only the recurring component since the recurring income reflects the revenue quality and financial state of the SaaS company, which determines the long-term viability of the current business model.

While neither MRR nor ARR are formally recognized by the SEC, industry practitioners like SaaS investors prioritize the two recurring revenue metrics compared to traditional GAAP-based metrics, such as net income, as MRR and ARR are viewed as more reliable proxies for cash flow and operating performance.

The monthly recurring revenue (MRR) of a SaaS business can be calculated by multiplying the total number of active subscribers by the average revenue per account (ARPA), expressed on a monthly basis.

Where:

• Number of Active Users = Beginning Active Users + New Subscribers – Churned Users
• Monthly ARPA = Monthly Recurring Revenue (MRR) ÷ Total Number of Active Users

The number of active users is the total number of users with active subscriptions at the start of the billing cycle (and net of churned subscribers).

The average revenue per account (ARPA) metric could be switched out with average revenue per user (ARPU) as the two are interchangeable — the distinction is immaterial.

The annual recurring revenue (ARR) metric measures the recurring revenue of a SaaS company, expressed on an annualized basis.

The formula for calculating annual recurring revenue (ARR) multiplies the monthly recurring revenue (MRR) by twelve months.

Therefore, the annual recurring revenue (ARR) metric is merely the annualized monthly recurring revenue (MRR) of a SaaS or subscription business.

What is Excluded from Recurring Revenue?

The recurring revenue of a company must be adjusted to exclude the following items for the MRR or ARR to reflect only the recurring component of a company’s revenue production.

For each item excluded, the intuition is that each item is one-time in nature and non-recurring.

• One-Time Fees ➝ One-time payments, such as late fees, should be excluded from the Annual Recurring Revenue (ARR) calculation. ARR measures the total recurring revenue generated in a year, and therefore, one-time fees do not contribute to this metric.
• Set-Up Fees (Installation) ➝ Set-up fees are single payments made by the customer to establish the service (e.g. installation fees, consulting fees). Since these one-time fees are not recurring, the income should be excluded from the ARR metric.
• Non-Recurring Add-Ons ➝ Businesses may offer both recurring and non-recurring add-ons. While recurring add-ons should be included in the ARR calculation, non-recurring add-ons (i.e. one-time purchases) are excluded. Only the revenue from recurring add-ons contributes to the ARR, as the revenue stream represents consistent recurring revenue.

How to Analyze Recurring Revenue

The LTV/CAC ratio is a SaaS KPI that measures the cost-efficiency and sustainability of a company’s customer acquisition strategies.

By comparing the customer lifetime value (LTV) to the customer acquisition cost (CAC), a SaaS company can estimate the return on investment (ROI) of their customer acquisition strategies, such as the performance of the sales and marketing (S&M) team.

Components of the LTV/CAC Ratio

• Lifetime Value (LTV) ➝ LTV represents the total revenue a business expects to earn from a customer over the entire duration of their relationship.
• Customer Acquisition Cost (CAC) ➝ CAC is the total cost of acquiring a new customer, including all sales and marketing expenses. The cost is calculated by dividing the total sales and marketing expenses by the number of new customers acquired during a specific period.

The formula used to calculate the LTV/CAC ratio divides the customer lifetime value (LTV) by the customer acquisition cost (CAC).

Where:

• Customer Lifetime Value (CLV) = (ARPA × Gross Margin) ÷ Churn Rate
• Customer Acquisition Cost (CAC) = Σ Sales and Marketing (S&M) Expenses ÷ Number of New Customers Acquired

The management team and institutional investors—such as venture capital (VC) firms, growth equity firms, and private equity firms—often use the lifetime value (LTV) to customer acquisition cost (CAC) ratio to analyze a company’s financial condition and growth potential.

Therefore, the higher the LTV to CAC ratio, the more recurring revenue generated per customer outweighs the cost of acquiring the customer, which is integral to achieving profitable growth.

SaaS Industry Benchmark

• 1:1 LTV to CAC Ratio ➝ 1.0x LTV/CAC indicates that the business is spending as much on acquiring customers as it earns from them, leading to no profit.
• 3:1 LTV to CAC Ratio ➝ 3.0x LTV/CAC is the industry standard benchmark that implies efficient and sustainable customer acquisition strategies.
• >5:1 LTV to CAC Ratio ➝ 5.0x+ LTV/CAC raises concerns about the limited spending on sales and marketing initiatives (i.e. potentially missing out on growth opportunities).

Furthermore, a higher LTV/CAC ratio can fetch higher valuations for early-stage startups and late-stage companies.

A SaaS company with an LTV of $12,000 and a CAC of $4,000 would have an LTV/CAC ratio of 3:1.

• LTV Ratio = $12,000 ÷ $4,000 = 3:1

The standard target for the LTV to CAC ratio is 3.0x, which implies that the business earns $3 per dollar spent to acquire a customer. Therefore, the current customer acquisition strategy is sustainable and a profitable trade-off.

Recurring Revenue Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Recurring Revenue Calculation Example

Suppose we’re tasked with calculating the annual recurring revenue (ARR) of a SaaS company.

In Month 1 of 2024, the SaaS company generated $50k in initial MRR (i.e., the ending MRR in the prior month).

To reiterate from earlier, MRR represents the predictable revenue a company expects to receive monthly from its subscribers, whereas ARR is the annualized version of MRR, providing a longer-term view of revenue predictability.

In constructing the ARR model, several components need to be considered: New MRR, Expansion MRR, Churned MRR, and Contraction MRR.

Monthly Recurring Revenue (MRR) Components

• New MRR ➝ The revenue earned from the acquisition of new customers.
• Expansion MRR ➝ The revenue earned from existing customers upgrading their plans (i.e., higher-tier plans).
• Churned MRR ➝ The revenue lost from customers canceling subscriptions.
• Contraction MRR ➝ The revenue that accounts for revenue lost from downgrades (i.e., lower-tier plans).

The roll-forward formula to calculate the net new MRR is as follows:

The projected monthly figures for Month 1 are $10k for New MRR, $5k for Expansion MRR, $3k for Churned MRR, and $1k for Contraction MRR.

With that said, the Net New MRR for Month 1 is equal to $11k.

• Net New MRR = $10k + $5k – $3k – $1k = $11k

2. Monthly Recurring Revenue (MRR) Calculation Example

In the next section, we’ll add the Net New MRR to the initial MRR to arrive at $61k for MRR at the end of Month 1.

• MRR, Month 1 = $50k + $11k = $61k

To complete our MRR revenue build, the roll-forward mechanics update each month by adding the Net New MRR to the prior period MRR.

Since we’ve determined the net new MRR each month, we’ll add each figure to the initial MRR to calculate the ending MRR for each month.

3. Annual Recurring Revenue (ARR) Calculation Example

After projecting MRR for 12 months using the following assumptions, the implied ARR can be calculated.

For example, the implied ARR as of the most recent month (Month 12) is approximately $2.22 million.

• Annual Recurring Revenue (ARR), Month 12 = $185k MRR × 12 Months = $2.22 million

The complete MRR revenue build and the implied ARR per month are stated in the following table.