The Recurring Revenue Virtuous Cycle
By Fernando Okumura, Venture Builder | Former McKinsey and JPMorgan M&A
Recurring Revenue is a business model that allows companies to leverage ongoing customer relationships to constantly fine tune offerings and identify adjacent business opportunities.
Recurring Revenue is powerful because of its self-reinforcing virtuous cycle. It starts with the ongoing relationship companies have with their customers and the vast amount of information that comes from it. Software-as-a-Service companies for example, can monitor in real time what product features are popular among its client segments, test new feature adoptions, and quickly learn about their evolving needs. In addition to hard data, these companies can also obtain anecdotal information through ongoing personal interactions with clients through their Client Success teams. Customers will often give direct feedback on product shortcomings and suggest new features or products based on their evolving needs.
Data Science teams can then process this data, extract valuable customer insights, and transmit them to agile software development teams that incorporate them into product adjustments or new features. This dynamic ensures product-client fit is always present despite the dynamic nature of customer preferences. As a result, these companies enjoy greater loyalty and build emotional connections with customers that constitute barriers to entry in their cash cow segments. In doing so, these companies have the piece of mind to increase the customer base in an organized manner, which in turn yields additional ongoing relationships and the cycle repeats itself.
As the customer base grows, insights become richer and companies can use them not only to fine tune existing offerings, but also to launch new products that will further increase their share of wallet and switching costs for its clients. At some point, the customer base gets large enough for companies to cluster clients into discrete segments and start parallel cycles for each one of them.
At times, customer data may yield insights into business opportunities beyond the company’s current capabilities of value capture (e.g. other economic sectors). In such cases, recurring revenue players can establish strategic partnerships with other companies to seize at least part of the value created or they can venture into new sectors themselves. Google’s launch of Gmail and Chrome, and Alibaba’s payment solution (Alipay) and financial platform (Yuebao) are examples of this dynamic. These new products not only increased their share of wallet of their existing customer base, but also expanded it into other sectors, refueling the cycle.
In this context, it is worth noting that incumbents can find both partners and competitors in other industries. Sector boundaries are blurring and winning over peers is no longer enough. Companies now need to learn how to position themselves in a broader ecosystem to stay relevant in their customers’ minds and be able to capture a significant portion of the aggregate value created. We will explore more of this topic in the following chapters.
Looking from a more financial point of view, recurring revenue companies produce steadier revenue streams as periodical client payments smooths out seasonality and decreases sales variance. They also have more predictable demand that allows for more effective and efficient cost management.
Subscription commerce, for example, benefits from higher margins and greater predictability, both in terms of demand and costs. Having a more accurate prediction of how much stock the company needs, allows it to hold lower inventory levels while suffering from fewer stockouts. When focused on specific product verticals, these companies may also enjoy earlier economies of scale when purchasing.
Consistent revenues and predictable costs decrease business risk, lowering the cost of capital, and increasing business valuation. Growth capital becomes more accessible and the company can expand its operations, grow its customer base and repeat the cycle.
Fernando Okumura has been a serial entrepreneur, investor and digital venture builder for 14 years. Backed by VCs (e.g., Accel) and Corporates (Groupon). Former strategy consultant at BCG and McKinsey, and M&A banker at JPMorgan. Attorney at law.
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