3 Pitfalls for Monthly Recurring Revenue Businesses

Most people don’t get all hot and bothered by accounting terms, but monthly recurring revenue, or MRR, is a sizzling topic. Who doesn’t want “mailbox money” that just shows up month after month? Valuations for MRR business models are enormous, and with customer preferences moving toward subscription models, the shift to MRR will continue to increase.

Unfortunately, a move to MRR has a few pitfalls which, if not understood, can destroy a business. If you’re managing or starting an MRR business, you need to recognize problems and know how to cope.

Pitfall 1: Fast Growth in MRR

Fast growth sounds great, but in a monthly recurring revenue business, it can kill you. Businesses fail because they run out of cash. Got a great idea, product, people and culture? Without cash, none of it matters.

With cash, a business can continue to build, refine and grow. The challenge of MRR is the cash-spend to acquire customers comes first, well in advance of the revenues, which come later in small pieces over many months. That means a company needs to understand its Cost to Acquire a Customer (“CAC”) regarding cash and also understand the timing of revenues from that customer to pay back the CAC (“Payback Period”) also regarding cash.

It’s easier than it sounds. Take the expenses to acquire customers for a single month and divide by the number of customers acquired, and you have your CAC. Next, figure out the length of time it takes cash receipts from each customer to pay back the CAC, and you know your Payback Period. This should let you know how quickly you can safely acquire customers with the cash you have available.

Pitfall 2: Undervaluing Customers

It’s easy to underestimate the value of a customer in a monthly recurring revenue business. I believe if businesses truly understood the lifetime value (“LTV”) of their customers, they would treat them very differently. LTV is a measure of how much revenue a customer generates over its lifetime, and that number can be increased by upselling the customer, so its monthly payment is higher, or lengthening the life of the customer, so it pays for a longer period.

Sophisticated investors understand that there is enormous lifetime value in a monthly recurring revenue customer, but businesses new to MRR don’t appreciate this — and it shows. Often partners don’t expend the time to retain customers by rewarding them for tenure or by offering them perks similar to those new customers receive. Another mistake is not viewing customer support as a revenue-generating activity.

If your customer LTV could increase by five or 10 times, would you double your effort? Of course you would.

The challenge is knowing how long a customer lifetime can be when the business is still not old enough to have reached that lifetime. Our master agent business is 14 years old, and we still bill customers that started with us in that first year. These are customers who signed with an initial 12- or 24-month commitment! Is the customer lifetime 15 years, 20 years, more?

We don’t know, but our customer LTV continues to increase. Underestimating the potential LTV of a customer means you’ll also limit your investment in retaining and growing customers, thereby losing a huge portion in the value of your MRR business.

Pitfall 3: Delayed Reactions

The insidious nature of a monthly recurring-revenue business is that revenue can continue to grow even as the business is crumbling. For simplicity, consider a company with only a single sale. If the company made this single sale in June 2015, that sale will provision and bill for a maximum of six months during 2015, possibly fewer if the install time is slow. The six months of revenue in 2015 will be a full 12 months of revenue in 2016, creating the illusion that the company is growing from 2015 to 2016. Revenue is a lagging indicator and, therefore, a poor measure of company health.

Protect against this illusion by focusing on sales that yield new MRR each month. New MRR is a much earlier indicator of growth or decline and allows a manager to take action more quickly.

An even better measure of the health of the business is “New to Book,” which I’ll cover in my next column.

Are you managing a monthly recurring revenue business? What issues do you face? I’d love to hear them.

Adam Edwards is a co-founder and chief executive officer of Telarus. His day-to-day responsibilities include all aspects of the business related to strategy and culture. Prior to co-founding Telarus in 2002, Adam was vice president of Finance for Quest Manufacturing. He also served as the VP of Finance for Silicon Film Technologies and was an auditor at KPMG.