Cash In on Cash Flow
Not all recurring revenue business models are equally valuable. You can think of it as a scale with five levels where the higher your business model falls on the scale, the more valuable it is. And the key to value, in this case, is making it hard for competitors to take your customers while also making it undesirable for your customers to switch their business.
In a prior post, we talked about the power of recurring revenue. But some recurring revenue business models are more valuable than other kinds. You can think of it as a pyramid with five levels where the higher your business model falls on the scale, the more valuable it is. And the key to value, in this case, is making it hard for competitors to take your customers while also making it undesirable for your customers to switch their business.
Repeat Customers are Good
What we’ll call Level One of the pyramid is a business model based on Repeat Customers, say something like a grocery store. Having folks around the neighborhood stop by every few days to pick up their staples like milk and eggs is a great thing. By providing solid customer service, you can hope to attract those same customers on a weekly basis for years. The rub is that there is really nothing stopping your customers from stopping by a new store that opens on the other side of town. Other than the possible cost of fuel, there are no switching costs for that customer. So, while having repeat customers is far better than not having them, your revenue stream remains risky because you can’t count on your customers to stick with you. Many firms in this mode have built affinity programs, like frequent flyer cards to create stronger brand preference and make their offers stickier.
A Network Effect is Better
That leads us to Level Two of the pyramid, which is called Repeat Revenue with a Network Effect. What this means is that the more someone uses the company’s product or service, the more each individual customer gets out of the experience- something called the network effect- which creates a barrier to that customer leaving because no other network is as good. Consider the appeal of a company like eBay. Regardless of whether you are a buyer or a seller, the more people that participate in the company’s online auctions, the more valuable it becomes for you to the point that you wouldn’t even consider switching to a competing offering. Can you even name a viable competitor to eBay these days?
Sequenced Product Purchases are Great Revenue
The next level up is Level Three: the Sequential Revenue Model. The idea behind this approach is to create recurring income by encouraging your customers to consistently upgrade to new products and service offerings. Consider the example of a company like Constant Contact, which starts customers out on a basic plan that costs $10 a month. As you begin to use the system more, you can then upgrade if you like, spending an additional $5 a month to get unlimited image storage or the ability to input a larger number of contacts. In other words, the more you use the system, and the more valuable it becomes to you, the more you’re willing to pay. This model also works where companies may offer a free service as a way to attract new customers, something known as a ‘freemium’ model. DropBox, for example, has both a free service and a premium service where customers can access advanced features. Even if the company can convert just a fraction of its customers over to the premium service, it can create an extremely valuable recurring revenue stream.
Good Until Cancelled Revenue is Really Great
Level Four of the pyramid is called Good Until Cancelled Recurring Revenue, where you find examples like insurance agencies or your cable company. What makes this model powerful is that it’s based on an “opt-out” model where the customer has to terminate your relationship with them. Think about when you sign up for your auto insurance policy: You agree to pay a certain amount of money every month until you cancel, which makes for a fine source of recurring revenue. You actually have to make an effort to stop using the insurance. Credit card or bank account billing, where the customer pays their bill automatically, is an extremely powerful way of keeping customers over the long haul.
Contractual Recurring Revenue is the Best
Level Five, the highest level of the pyramid, is Recurring Revenue with a Contract. Think about the contract you signed when you got your new cell phone. Not only did you agree to pay a certain amount of money each month depending on the plan you selected, but you also agreed to keep paying for something like two years. Sure, you can change your phone provider, but this time it will cost you, say, a $175 switching fee. That makes changing a little more painful for you as a customer, which, in turn, makes for a better business model. The phone company also runs promotions where it offers you a discounted new phone every year or so. Of course, there’s a catch: You need to sign a new two-year contract to take advantage of the offer. Again, this is an extremely valuable model because you can predict with a higher level of certainty what your recurring revenues will be both in the short-term, as well as over the longer term.
In our next post, we’ll talk about some of the strategies you can use to build recurring revenue into your existing business model.
