Shoutout: I would like to thank Rajiv Tarigopula for his contributions to this piece. Rajiv is the founder/owner of Blueridge CFO. He is the rare CFO that is 1) a former CEO 2) has mastered the strategic and technical elements of finance 3) is astoundingly hilarious.

The problem with revenue quality and recognition

After spending a few hundred thousand dollars on a business school education, I was shocked to learn that Revenue = Price * Quantity (thanks Becky Lester!). As the equation might suggest, growing revenue quickly requires generating lots of value in large volumes. So the essential steps to building a great business are simple:

1. Do something valuable, and do it frequently

2. Charge lots of $$ for it (and don’t spend much $$)

3. Profit

4. Avoid committing accounting or investor fraud

As of late, we’re more worried about that last step in the technology and tech-enabled services ecosystems. As artificial intelligence (or “AI”, as the kids call it) changes how companies price and deliver value, revenue recognition is moving from fixed access, recurring value structures toward variable value structures like consumption. Further, the line between technology solutions and services is blurring. Investors, boards, operators, and employees must clearly understand the distinction.

While not every product or service requires a recurring revenue model, it is possible to design consumption-based and technology-enabled services pricing models that emphasize recurring revenue, strong margins, and result in greater enterprise value. We spend a lot of time helping companies design revenue models and contract structures that ensure variable revenues behave like recurring revenues: predictable, renewable, and defensible.

There are many types of revenue

Most companies want to recognize the largest volume of revenue with the highest quality. Not all revenue is created equal, and neither investors nor regulatory entities treat it as such. For the sake of this discussion, we will specifically focus on the distinction between annual recurring revenue (ARR) and every other type of revenue. Bookings are not ARR. Pay-as-you-go usage is not ARR. Implied ARR is not ARR. Vibe revenue is not ARR. ARR is specific. It is the contracted annual value of recurring revenue that you can reasonably count on going forward. Ultimately, most these definitions are “make-believe” fairytales, but they are real enough for the market to use them as a shared language for collaboration and value-alignment.

**Note on GAAP Revenue: GAAP revenue shows up on your income statement, and it is the standard set by FASB, relied upon by the IRS and SEC for taxation and regulation. It helps to create a standard way of measuring economic value delivered over time across businesses and industries. GAAP comes from one simple rule: businesses can only count money as revenue when they have delivered what they promised to customers. As you can see, the metrics above have little to do with GAAP revenue and more to do with operational performance and enterprise value.

Why do the different types of revenue matter?

For a good business, it’s cheaper and easier to maintain existing customers and revenue than it is to find new customers and revenue. Recurring revenue also indicates better business quality and stability because it suggests that customers have ongoing needs and are likely to stick around. As such, recurring revenue is more predictable, and that predictability builds confidence in planning across hiring, product development, and capital allocation. It also creates a common way to compare these businesses and business models. And because investors often value recurring revenue businesses on a multiple of revenue instead of profit, ARR can lead to substantially higher valuations. 

Occasionally, businesses without contractually recurring revenue have far better and more reliable revenue than those that are recurring. Revenue quality is both an art and a science, and not all valuation methodologies capture this nuance. Regardless, these businesses are often best served both in terms of valuation and operational stability by converting one-time revenue into contractually recurring revenue.

So why does all of this matter when it comes to pricing and revenue model design?

Many people incorrectly believe that recurring revenue is something you either have or you don’t. The bias suggests that software companies have it, service businesses don’t, and businesses that sell hardware and goods definitely do not. This is dangerous and wrong. It is true that some products and services more naturally align to point-in-time rather than recurring value. However, it is possible to design most products and services to create and capture recurring value if you so choose and if your market accepts it.

What is not ARR…

• One-time implementation fees or professional services

• Usage-based revenue

• Hardware purchased upfront

• Implied ARR (ex: MRR * 12 that ignores churn, contraction, expansion, etc.)

What can be ARR…

• Managed services or retainers with recurring annual contract (i.e. Accounting Firms)

• Annual usage minimums and flat fees (i.e. OpenAI APIs)

• Implementation and maintenance that is bundled into and amortized in an annual subscription (i.e. Enterprise Software)

• Hardware subscriptions (i.e. Samsara)

How does your pricing model impact your revenue model and revenue recognition?

Ultimately, your market, customers, and solution determine whether there is an opportunity to create recurring value, and thus, to capture recurring revenue. You see it everywhere: from Amazon creating toothpaste subscriptions to private equity firms turning legal services into annual subscriptions. Companies can exercise control over the price metric (i.e. what you charge per) and structure (i.e. how price changes with time, volume, and frequency), and therefore, the revenue quality. It is possible to grow the value of your company substantially by simply shifting your pricing and value delivery model.

But what if our customers only want to pay for what they use, when they use it?

Answer: include a pay-as-you-go option and charge more for it per unit. Think about how gyms or public transit price their offerings: they allow you to price your own risk and usage. Single use, 10 uses, unlimited uses. Recognize that it is possible (and often even desirable by both parties) to sell recurring contracts with good margins in a hybrid AI and services world. Further, as price metrics (i.e. charging for credits vs. seats) shift, it is still possible to deliver consistent and predictable pricing that results in higher quality revenue. The days of charging for “access” to software are fading (rightly so) and creating opportunities for value-aligned models.

We expect recurring revenue will stick around in software and tech-enabled services for many years to come because it aligns to customer demand and preferences. For example, it is rare for high-spend customers to want their bill to be fully variable and based entirely on volatile consumption patterns. In a B2B context, it’s organizationally challenging and risky to budget this way. In a consumer context, you see that high-spend customers often prefer to purchase high-use or unlimited subscriptions over pay-as-you-go usage models (i.e. phone plans, metro card passes, gym memberships). Most customers value at least some consistency (i.e. the bill to be the same each period) and predictability (i.e. their bill to be easily calculated each period). As such, recurring, quality revenue is still a desirable and aligned model for companies and consumers even as new technologies and business models emerge.

Get in touch

Crescendo works with medium-sized software companies to improve their pricing, packaging, and promotion strategies. If you’d like to book a quick consult, reach out at [email protected] or schedule time via the button below.