How recurring revenue drives the success of your technology business
The landscape of the technology industry has, very obviously, changed dramatically over the last 20 years. The technology itself, within the disciplines of Information Technology (IT/MSP), Telephony, Surveillance, Security, and Office Equipment, has advanced at a mind-boggling pace. But we have also seen unprecedented changes in how our industry delivers its goods and services; what we sell, how we sell it, how we package or bundle it, and how we bill for it. Profitability of managed IT service providers varies greatly, with the industry average being 5-7% EBITDA and the better companies putting up 20% EBITDA or more, depending in no small part on their revenue mix and billing structure.
Our industry several decades ago was primarily built on large projects incorporating the sale and installation of hardware. Revenues in the aftermarket were a distant priority, usually sold on occasional maintenance agreements or service as needed on a break/fix basis. Even today, there is a large focus on the next big profitable project, which leads to the question; “Can we do this again next month? Next Quarter?” We always need to find the next project, the next opportunity, month after month and quarter after quarter to keep pace. Recurring revenue relieves us of having this burden of reinventing our business each period.
I often ask MSPs, why is recurring revenue so important? The answer most commonly heard is that recurring revenue provides stable, dependable income each month. But it is actually much more than that. By building a business that focuses first and foremost on building recurring revenues, you eventually make everything you do within that business more profitable. The most profitable companies in this industry are, without exception, those that have built a large base of recurring revenue.
Every entrepreneur seeks to achieve a profitability inflection point; a breakthrough where they see the proverbial “hockey stick” on the profit curve; the point at which instead of slowly increasing profitability by a percentage point (or fraction thereof) each year, they see multiple digit or even double digit gains in profitability. The point where the business is entirely past the point of managing cash flows, since the payroll and overhead are entirely and easily covered. Building recurring revenues moves your company forward to achieving that profitability breakthrough, a status we at Technology Assurance Group (TAG) have not-so-jokingly called “Nirvana”.
“Nirvana” is defined as when the recurring revenue covers every cost in the business. Every cost, excluding only product purchases for resale, is covered entirely out of our monthly recurring revenue. This means every dollar of employee payroll, benefits, vehicles, advertising, marketing, operating expenses, T&E, rent, utilities, and all other overhead is entirely paid for on the first of the month when the recurring billings hit your bank account. Cash flow pressure, for all intents and purposes, becomes a non-issue, because you already have these costs covered; no more managing cash to ensure payroll next week is made, or rent is remitted, because your MRR is banked and more than enough.
It may be nice to know that the bills are already covered, but you may be asking, “Why would getting to this Nirvana stage make us more profitable than we would be otherwise?”
The answer is that getting to this point IS the profitability breakthrough all entrepreneurs are seeking. Once this point is reached, everything we do becomes more profitable, creating that critical mass or “hockey stick” that allows a business to make large leaps in their EBITDA almost immediately. Every marginal dollar of revenue after we hit Nirvana goes mostly, or entirely, to the bottom line.
For example, assume we are covering all expenses in the business with recurring revenue. Then we go out and sell just one more hour of labor, at say, $150. How much of that $150 drops to the bottom line? Remember, we have covered our technician’s salary, benefits, and taxes with our recurring revenue, so the cost to deliver that hour of labor is already paid for. All $150 of that one additional hour drops to the bottom line as additional EBITDA.
Or what if we were to sell one more Managed Service IT contract after we have hit this inflection point? All of the new revenue from that MSP contract will drop to the bottom line, but for any marginal outsource product cost and direct sales commission.
Or if we were to go out and sell a large IT project. Since the labor and benefits are covered, all of the sudden 100% of the project revenue, after hardware purchase cost and perhaps a sales commission, will drop to the bottom line.
This continues until we hit a point in the business whereby we need to hire additional staff, but even then if the cost of the new employee is covered by recurring revenue, the trajectory will remain the same and the company will continue to enjoy the high profitability of these additional sales.
As I mentioned in the beginning, the industry average is 5-7% EBITDA. At TAG we see our Members regularly achieve 15%, and the top among them are in the 20% and even 30% range. These numbers also include a reasonable salary for ownership in the P&L. It bears noting that every single TAG Member that puts up 20% has achieved this breakthrough, whereby their recurring revenue covers every cost in the business. “Nirvana” is the #1 metric that we have our Membership focused on for enduring financial success, and common aspect of the most profitable companies in this industry.
At TAG, Tim is responsible for providing financial analysis, advice, and counseling to TAG Members. He drives profitability growth for TAG Members by delivering in depth financial and management training utilizing industry benchmarks and "best practices" in both group settings and one-on-one. With an extensive background in M&A, he provides advice and consultation with TAG Membership regarding acquisitions, company sales, and succession planning. He is tasked with development and initiation of strategic programs for the benefit of TAG Members. Tim also drives achievement of TAG's Mission, realization of its strategic plan, and manages its overall financial performance.
Tim holds a Bachelor's degree in Accountancy from San Diego State University.