Building a Recurring Revenue Strategy

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Building a Recurring Revenue Strategy Jim
Godsey Craig Hanson Denver Software Club 9.19.05
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Agenda

• Industry Trends
• Definitions
• Subscription vs. Perpetual Licensing
• Setting Prices
• Launching Subscription Licensing
• The Investor Acquirers Perspective
• Impact on Valuation

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Movement toward subscription-based software

• We define On Demand as . . Term based
  licensing and outsourced delivery . . We expect
  more customers to opt for term or subscription
  based licensing versus the traditional perpetual
  model and move toward outsourced solutions. Very
  simply put, software in an On Demand world will
  change the way customers buy, vendors sell, and
  investors invest.
• Merrill Lynch
• It is clear that the traditional software
  business model is unwinding . . On demand is
  becoming the preferred method for licensing and
  deploying software. The impact on valuations and
  creating sustainable shareholder wealth are
  enormous.
• Credit Suisse First Boston
• By 2008, over 50 of software purchases will be
  via Software-as-a-Service
• Gartner

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Movement toward subscription-based software

• 33 of ISVs already offer subscription-based
  pricing. Within next 2 years, 52 expect to
  offer subscription-based pricing as their primary
  sales model
• Source SIIA, Key Trends in Software Pricing and
  Licensing
• Figure was 21 just a year ago, according to
  VARBusiness 2005 State of Software
• Greater initial adoption by small and mid-size
  customers
• Most successful technology attacks start at the
  low end Clayton Christensen idea

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Definitions

• Licensing
• Perpetual
• Subscription
• Utility
• Pricing
• Site
• Per Unit
• Value
• Deployment
• In-house
• Hosted

Pick one from each
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Subscription vs. perpetual

• Perpetual
• No license term
• Larger transaction amounts up front
• Choppy quarter on quarter revenue behavior
• Separate maintenance revenue stream

• Subscription
• Limited license term
• Lower short term revenue, but higher long term
  revenue
• Improved revenue visibility consistency
• Slower revenue growth
• Shorter ROI time scale
• Requires adjustments to reseller networks

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What is your value add?
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What is your value add?
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What is your value add worth?
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Calculating subscription price
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Launching subscription pricing

• Determine value
• Prepare revenue accounting procedures
• Prepare contracts
• Prepare contract administration and billing
  systems
• Establish term set price

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Why do investors and acquirers like recurring
revenue models?

• Predictable, compounding revenue stream
• Less volatility, better ability to plan
• No end-of-quarter frenzied pricing discounts
  better margin potential
• Shorter commitment period hastens customer
  adoption
• Chance for new entrants to steal market share
  from publicly-traded competitors, which have a
  harder time taking the one-time hit for the
  switch to subscriptions

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. . . The downside

• Slower revenue growth
• Slower cash inflow
• Therefore, more cash required to fund company to
  breakeven

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Recurring revenue is more highly valued by the
market

• Wall Street and private investors attach a
  premium multiple to recurring - preferably
  contractual - revenue
• More debt financing ability
• Lenders willing to provide more debt with safer
  cash inflow, and will sometimes lend off this
  rather than AR or tangible assets
• VCs increasingly favor this model
• Jamcracker estimates that 90 of new software
  companies funded by VCs have SaaS models
• Acquisitions of recurring revenue companies are
  heating up

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Valuation impact comparable metrics

• Is subscription pricing a net positive or net
  negative in your companys valuation? Two ways
  to compare.
• 1 Can use different valuation metrics.
• Under subscription model, revenue is booked upon
  signing the contract, but recognized ratably over
  the subscription term.
• These future revenues show up on balance sheet as
  deferred revenue.
• Over time, deferred subscription revenue is
  transferred to the income statement.
• Therefore, a better metric is Bookings Growth
• Bookings Growth reported revenue changes in
  deferred revenue
• Over time, cash flow growth rate becomes good
  indicator

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Valuation impact recurring revenue premium

• 2 Valuation premium attached to recurring
  revenue companies but does it justify the
  switch?
• Hard to isolate the valuation differential
• Rough calculation shows average public software
  company trading at 3.4x 2005 revenue
• Small sample universe of recurring revenue
  software companies trade at 4.9x 2005 revenue
  (40 premium)
• Similar Price-to-Free Cash Flow multiple premium
  of 36 (19x vs. 26x)
• For early stage companies, how much of a premium?
• With these multiples, valuation can take a net
  hit in the early stages of a company, but will
  attain a net premium as revenue grows and
  compounds

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Considerations for early stage companies

• For early stage companies, how much of a premium
  do they get from VCs?
• Factors to consider
• Not as simple as 3x product pricing translating
  into valuation premium, because, increasingly,
  revenue under subscription model bolstered by
  past bookings
• Perpetual model gives you (most of) the cash
  upfront, and results in quicker cash flow
  breakeven, and less capital needed
• VCs also look at prospective valuation of the
  next round, so the calculation depends on how
  soon the companys deferred revenue valuation
  premium can catch up to a perpetual model
• Another important factor is renewal rates /
  expected life of subscriber without longevity,
  model doesnt work
• Calculation ultimately dependant on the companys
  particular business model
• Bottom line Think of what is best for your
  company in the long-term revenue, competitive
  advantage, exit valuation - not just the
  valuation youll receive from your first venture
  round.

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Thank you

• Jim Godsey
• jdgodsey1_at_comcast.net
• Craig Hanson
• Vista Ventures
• craig_at_vistavc.com