Last week, I had a discussion with a business owner about the pros and cons of putting all business revenue received on the tax return – this is the error that many business owners make when they don’t record and report all cash payments thinking they are saving taxes when in reality they are short changing their future business value.
I told her the story of a young couple I’d worked with that wanted to buy a local pizza shop that was in a active neighborhood with over a hundred regular customers that had “super pizza ” memberships – think like a loyalty card at a coffee shop. The sale price was three times the gross revenue and the business was barely profitable on paper. When the couple took their dream business plan to the bank for funding, the first, second and third bank all said “NO” because it was overpriced, the cash flow wouldn’t support the loan and it was barely profitable. That was when I met them and they explained to me that the owner told them he always took cash out of the drawer as he needed, “It wasn’t a problem”, well it was.
One of the biggest factors in determining the value of your company is the extent to which an acquirer can see where your sales will come from in the future. A recurring revenue stream acts like a powerful pair of binoculars for you – and your potential acquirer – to see months or years into the future; creating an annuity stream is the best way to increase the desirability and value of your company.
The surer your future revenue is, the higher the value the market will place on your business. Here is the hierarchy of recurring revenue presented from least to most valuable in the eyes of an acquirer.
No. 6: Consumables (e.g., shampoo, toothpaste) These are disposable items that customers purchase regularly, but they have no particular motivation to repurchase from one seller or to be brand loyal. Loyalty cards are very effective with customers – think like coffee shops and restaurants.
No. 5: Sunk-money consumables (e.g., razor blades) This is where the customer first makes an investment in a platform. For example, once you buy a razor you have a vested interest in buying compatible blades.
No. 4: Renewable subscriptions (e.g., magazines) Typically, subscriptions are paid for in advance, creating a positive cash-flow cycle.
No. 3: Sunk-money renewable subscriptions (e.g., the Bloomberg Terminal) Traders and money managers swear by their Bloomberg Terminal; and they have to first buy or lease the terminal in order to subscribe to Bloomberg’s financial information.
No. 2: Automatic-renewal subscriptions (e.g., document storage) When you store documents with Iron Mountain, you are automatically charged a fee each month as long as you continue to use the service.
No. 1: Contracts (e.g., wireless phones) As much as we may despise being tied to them, wireless companies have mastered the art of recurring revenue. Many give customers free phones if they lock into a two or three-year contract.
When you put your business up for sale, you’re selling the future, not just the present. So if you don’t have a recurring revenue stream, consider how best to create one, given your type of business. It will increase the predictability of your revenue, the value of your business, and the interest of potential acquirers as they look to the future.
My young couple, now pizza shop owners for 10 years, had to figure the future and count on the loyalty of the current pizza lovers. They sat across the street from the pizza shop for two weeks straight and counted the number of pizzas sold! Multiplication by price gave them a good idea of Revenue in and expenses were already close to actual. Now they had primary data to give to the bank and eventually, the owner accepted an offer of
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Great article….and a timely one too. Businesses often short change themselves in order to save tax money but it ends up hurting them in the end when they try to get financing or sell their business. Thanks for your words of wisdom!