My kids love the book “Leo the Late Bloomer”. As the story goes, Leo was a tiger cub who hadn’t quite hit his stride yet.
Leo couldn’t do anything right. He couldn’t read. He couldn’t write. He was a sloppy eater…
Leo’s father, playing the classic fatherly role, was very concerned. He couldn’t figure out what was wrong with Leo. He feared that “Leo would never bloom” and raised his concerns with Leo’s mother. Leo’s mother was not phased, saying to Leo’s father:
Leo is a late bloomer.
Being the dutiful father, Leo’s father continued to watch Leo for “signs of blooming”. Seeing none, he asked Leo’s mother:
Are you sure Leo is a bloomer?
To which Leo’s mother responded succinctly:
Leo’s father eventually gave up and stopped watching Leo for signs of blooming.
Like any child, Leo was on a one-way path toward adulthood and beyond. No going sideways, no turning back; one way. Company building doesn’t work that way, success is not in the future for every early stage business. Some fail, some go on to greatness. But regardless of the outcome, as a category, recurring-revenue businesses are late bloomers. Why? Unfortunately, the recurring-revenue model, with all its advantages, has its drawbacks; the biggest being that early in their development, the income statement profile of these businesses rarely reflects the value that has been created.
Product companies have a distinct advantage in this area; sell something and record it as revenue and profit in the period sold. All the value of the relationship with the customer is reflected on the income statement in the period in which the product is sold. Quite the contrary, in recurring revenue businesses; very little of the value is reflected on the income statement in the period the service is sold. Here is an example.
Suppose you sell storage equipment. You sell a tape back-up system to a small business and charge $1,000 for the equipment. You make a 40% gross profit margin on the product. In the period you sold the back-up system, you record $1,000 of revenue and $400 of gross profit on the income statement. Now suppose you change business models and decide to sell storage as a service. You sell under a three-year contract and charge the customer $50 per month; you make a 50% gross margin on your services. In the first month of billing, you book $50 if revenue and incremental gross profit of $25. In the first year, the storage service provider would book $600 in revenue and $300 in gross margin. Comparing these two business models on the basis of income statement performance only, the recurring revenue service company’s income statement looks less attractive than the product companies for first 12-18 months.
This issue leads to what I’ve referrred to as the Valley of Death in fundraising for SaaS and other recurring-revenue businesses.
Apples, Oranges and Late Bloomers
The trouble with the example above is that it compares apples and oranges. You really can’t compare the income statement performance of a product company to that of a recurring-revenue services business. We need another measurement that puts these business models on equal footing. I have a strong preference for one metric, the lifetime value of a customer. In the product example above, the lifetime value of the customer is $400, presuming the customer never buys another piece of storage equipment from you. The entire value of the customer relationship is recognized on the income statement in the period in which the product is sold. The lifetime value of the “contract” in the service example is $600, the gross profit the company will earn over the three-year contract term. Contract value is an important measure, but only if the contract can’t be cancelled by the customer. More important is the lifetime value of the customer, which requires a more complicated set of calculations including customer acquisition costs, churn, etc. On this basis, ignoring time value of money considerations, I often find that recurring revenue services businesses capture more value per customer than product companies. The example highlights the point.
Customer lifetime value provides an alternative way to measure value that has been created. It is a concept that barely exists in product businesses. However, it is critical to recurring revenue businesses, precisely because – from an income statement perspective – recurring revenue businesses are late bloomers. If you are a recurring-revenue business operator you must measure customer lifetime value and the aggregate value of the all of the customer you have aggregated. If you don’t, can’t or won’t measure it, you are seriously short-changing the value of your enterprise.
Patience, Patience, Patience
Eventually, as they mature and scale, services business show great income statement profiles. Sticky, profitable, long-term contracts with customers lead to that. But because the economics are back-end loaded, it takes a while, and a great deal of patience. Leo’s mother understood that Leo would eventually bloom; she was patient. As the story goes, one day – somewhat miraculously in the eyes of Leo’s father - Leo bloomed. When he did, he turned into one heck of a tiger.
If your recurring-revenue business has a strong product in a big market segment and great customer lifetime economics, it too will bloom. But until it does, best to measure the value of the customers you have acquired so that you know you are creating value before your income statement shows it.
(Cross-posted @ Non-Linear VC )