Recurring Revenue Is Overrated

Why Predictable Cash Flow Is What Really Matters

Here’s the typical list of criteria for most search funds: recurring revenue, no customer concentration, >20% EBITDA margins and ideally >$1mm EBITDA. That’s pretty much what ours looked like as well. When I was still contemplating whether to search, I presented that list to small business veteran and he said good luck finding a unicorn.

Exaggeration aside, there are certainly businesses that match all the criteria on the list. However, in the current market environment they are likely going to trade for significantly more than searchers (especially self-funded ones) can pay. You are trying to buy a Ferrari for the price of a Prius.

The difficulty only increases as you introduce criteria like industry and location. If you find a business that matches all the criteria above, it’s most likely not located in your target geography or industry. Knowing you might have to be flexible with some criteria, which ones should they be?

What really matters is revenue predictability. Recurring revenue is just one version of predictable revenue.

I have written about why you should start with the widest tolerable criteria regarding geography and industry to increase your odds of finding a company. Assuming you are already using your widest possible range for those two criteria, below is my hierarchy of acquisition needs¹.

Having recurring revenue as a nice-to-have rather than a must-have is contrary to most searchers and investors. They would rather compromise on size or customer concentration than recurring revenue.

There is a good reason that the search fund industry has such a focus on recurring revenue. It’s the easiest proxy for predictable cash flows. SBA 7a deals are usually massively leveraged with up to 90% the purchase price financed by debt. The high leverage means that most of the cash flow goes to service debt and even relatively small declines in cash flow can result in defaults. That’s why in general cash flow risk and leverage risk should balance each other. Real estate cash flows are very predictable and recurring (rent), so high leverage is not a problem. Biotech or oil and gas businesses usually have low or no debt because their cash flows are volatile.

Since the high returns for search fund investors and searchers depend on high leverage, it makes sense to focus on businesses with predictable cash flows (and therefore liking recurring revenue businesses). However, focusing only on recurring revenue and ignoring other versions of predictable revenue causes several issues:

True recurring revenue is scarce and overvalued

True recurring revenue comes in two general types: mission critical software or service and low cost, convenience based products / services.

The first bucket includes EPR and CRM systems as well as government mandated inspections and turnarounds. The software or service are so essential that the business could not function without them.

The second bucket includes home service businesses like lawn care, pest control, pool service etc. Customers buy for the convenience and because the cost of the service is relatively low compared to the income / revenue.

Over the past 20 years, venture capital has pushed up the valuations for recurring revenue software business to incredible heights. This has caused the valuations for recurring revenue businesses in general to follow suit.

One example is the current generation of HVAC roll-ups started by Collin Hathaway’s Wrench Group where we have seen even single digit EBITDA businesses trade at 15x, with larger players trading at 20x. In other words, you are not the only one that likes recurring revenue, but everyone else has deeper pockets.

One of the HVAC businesses we looked at had $750k of seller discretionary earnings and traded at 8.25x SDE. As a searcher, that’s a price you can’t pay. But for a private equity fund with a platform in the space they bought for 15x, that purchase helps them average down their purchase multiple.

As a result, you probably have to either go small (<$500k EBITDA), proprietary (hope to get an off market deal) or pay up and likely reduce your equity stake in the company. This is not meant to say that searchers aren’t sometimes successful in buying recurring revenue businesses at a great price. The point is that true recurring revenue businesses are rare and in high demand. As a searcher unable to pay big multiples you’re bringing a knife to a gun fight.

If your customers are sticky, so are your competitors’

From a lender perspective, recurring revenue is certainly the most desirable - highly predictable, low downside. However, equity holders should not only minimize downside, but also maximize upside, which can be challenging with recurring revenue.

What makes certain software and services highly recurring is generally the high costs for customers to switch relative to the cost of the software or service (i.e. changing an ERP system is painful and costly). This causes long sales cycles and high customers acquisition costs for new customers. In some cases software sales have lead times of multiples years to the point where the customer acquisition costs starts to resemble capex (large upfront investment with multiple years of useful life).

So while you can sleep soundly at night knowing your recurring revenue business is not going to fall off a cliff, it’s also really hard to hit a home run, because luring away customers from competitors is slow and costly.

This dynamic is obviously less pronounced in the second recurring revenue type like the one of home services businesses. But in reality that just means the revenue is less recurring than in software. In the end, the stickier your customers, the stickier your competitors’ customers and vice versa.

Granted, new unencumbered customers can soften the issue (i.e. home service businesses in areas with significant population growth are particularly attractive)

Recurring revenue businesses are recession-resistant, but not recession-proof

The last issue with recurring revenue businesses is the misconception that they are recession proof, meaning the business won’t decline no matter what happens in the boarder economy.

The general idea is directionally accurate. If you’re business depends on a certain software to function, you can’t drop the software if sales decline 20%. Set aside the extreme recession where you’re customers start going bankrupt, a mission critical software business is indeed almost recession proof.

However, given the market dynamics we discussed above, a searcher is very unlikely to actually end up with one of those businesses. So let’s talk about a more realistic option like a home services business.

In a great Think Like An Owner Episode, Collin Hathaway outlines that most investors assume home services industries are recession proof because of their recurring revenue. In reality, customers delay replacements, cut premium options and add-ons and reduce the amount of visits when their wallet gets pinched. A more accurate way to describe those businesses is recession resistant. You’re not going to go out of business, but it’s still going to be a battle.

Finding Predictable Cash Flow Businesses

As I mentioned in the beginning, recurring revenue is an easy proxy for predictable cash flow, but there are plenty of businesses that have reoccurring or even non-recurring revenue with predictable cash flows.

It takes significantly more diligence to proof the predictable cash flows for those businesses. For reoccurring revenue businesses (long-term customers reorder your products / services) the analysis has to be focused on the future outlook for the customers and where you can get replaced. Let’s take a CNC shop that delivers precision parts for Tesla’s current Model S. Since it takes a long time to get qualified for a certain model, manufacturers almost never get switched out during the program. The companies orders will simply track Tesla’s orders. So if you believe Tesla will continue to sell more cars, you have good visibility into the cash flow of the CNC shop.

For non-recurring revenue business, the analysis starts with aggregate demand for the product or service and understanding what market share you can capture. This is what we used for our artificial turf business. There are long term tailwinds from population growth in our service area and a secular shift from grass to turf. The company we acquired was the premier provider that was best positioned to capture that growth. In the case of a downturn, we talked to several marketing firms to confirm it would be economic for us to buy jobs (cost per lead x conversion rate). Since we have a relatively small market share (fragmented market), even a 20-30% drop in demand would still leave 6x more jobs than we would need to hit budget. Taken all together, we know that in a recession we can buy the jobs we need, meaning we have relatively predictable cash flow.

To be fair, for reoccurring or non-recurring businesses your predictability of cash flow is only as good as your analysis and assumptions. However, being able to analyze those businesses multiplies the number of available companies and greatly increases your odds of finding a business to buy. And if you do, your upside is probably a lot greater.

1. Obviously there are other factors like competition, history, management, etc. But this framework is useful to illustrate why I would rather compromise on recurring revenue than the other factors.