Generating profits through new business models with recurring revenues
As analysed in the previous article, many companies that were used to selling one-time projects are seeing the interest of developing new, often data-based, recurring revenues to serve their clients. Let’s explore how you can define the financial income through those new models.
The revenue generation ladder enabled through Industry 4.0 as defined by Fraunhofer Institut (Geschäftsmodelle für die Logistik 4.0, accessible here) defines the following models:
1- Client pays for the product
- Revenue model: Usually one-time buy (single projects typically)
- Revenue pitch: Focus on product features
2- Client pays for the service
- Revenue model: Can be recurring (maintenance, spare parts)
- Revenue pitch: Focus on generated benefits
3- Participation to cost savings
- Revenue model: Must be recurring (energy or raw material savings)
- Revenue pitch: Focus on process improvements, with KPIs
4- Platform remuneration
- Revenue model: Can be recurring (shared revenues)
- Revenue pitch: Solution serves as an intermediary for other providers
5- Revenue increase through data exploitation
- Revenue model: Must be recurring (data-driven improvement recommendations)
- Revenue pitch: Data are used to optimise process and service for the entire client base
When it comes to the recurring model, how can we define the best way to monetise the new service?
McKinsey (“Industry 4.0 How to navigate digitization of the manufacturing sector”, available here) suggests looking at 4 main trends: as-a-service models, platforms, intellectual property rights, and data-driven business models:
It seems clear in the short term that the most realistic form of new business model your company might implement will be based on SaaS. Therefore, you need to take into account the fact that SaaS-oriented business models have a very specific way to look at costs, recognise revenue and perform financial analysis. If, as an example, we look at the templates provided by the excellent website “The SaaS CFO” (https://www.thesaascfo.com/saas-metrics/), we’d need to build hypothesis for costs and revenues:
- Costs: Cost of service (R&D salaries, support, maintenance, hosting, account management and client success salaries), Cost of sales (Sales & marketing salaries, marketing costs), Administrative costs, Client churn
- Revenues: Average Recurring Revenues (ARR), minus churn, One-time services
Obviously, those metrics will be vastly different from one product to another, but they need to be anticipated and planned for at the beginning of the project, notably because, as the financial data of most Cloud-based software companies show, it takes time before a SaaS model becomes profitable.
From a financial point of view, a SaaS model generates high costs at the beginning of the client acquisition, but with a cumulative revenue stream during the lifetime of the client relationship. This is particularly interesting for you as it means that after an initial significant investment to develop the new products, the recurring revenue model will increase over time, thus multiplying the ROI.
If we want to look at the impact for the company, or at least for a group of customers, from the software conception to the first years of go-to-market, we need to consider the significant investments in R&D before the software is in the market, but as soon as the product is sold, we can define break-even per client (from Joel York’s blog here) when
Cost of Acquisition = Annual Recurring Revenue — Annual Cost of Service
“At any given time, the rate at which a SaaS company generates profit is given by the following formula:
Profit = P(t) = [ ARR — ACS ] C (t) — CAC ΔCnew(t)
Where C is the number of customers and ΔCnew is the new customer acquisition rate. Time to profit occurs when this expression changes from a loss to a profit, or when profit is equal to zero.” (Joel York). ARR is the Average Recurring Revenue, and ACS is the Average Cost of Sales.
While one-time services only bring revenues when the contract is signed, SaaS models bring in revenue over time, and the sales effort adds to pre-existing subscriptions, hence adding revenues every year. In addition, the support and maintenance aren’t decoupled from the license costs of the software.
In conclusion, you need to carefully map out your one-time, recurring, and client-specific costs as well as predict accurately your recurring revenues in order to properly anticipate your cash burn and calculate your time to profitability. It can be interesting to identify parallel sources of revenue to mitigate risks, such as consulting or training services, but this can only be limited as those aren’t recurring and you don’t want to lose focus either.
Part 1: Defining your value proposition to generate recurring revenues and launch new business models
Part 3: Managing new client relationships in a recurring business model
