Contracted Revenue vs. Recurring Revenue - How Do You Underwrite It?

When underwriting contracted versus recurring revenue, here's how professionals in PE, IB, corp dev, or search typically approach it:

1. Contracted Revenue Analysis:

   • Contracted revenue refers to revenue tied to formal agreements, but the key is whether these contracts auto-renew or require active renewal. Contracts that don’t auto-renew are less predictable and carry more risk.
   • The percentage of revenue under contract is a critical metric. While there’s no universal minimum, higher percentages (e.g., 70%+) generally provide more comfort, especially in industries where revenue predictability is valued.

2. Historical Renewal Rates:

   • Historical renewal rates are a strong indicator of customer stickiness. If renewal rates are consistently high (e.g., 90%+), even non-auto-renewing contracts can be treated as quasi-recurring revenue.
   • It’s essential to analyze renewal rates by customer cohort, contract type, and tenure to identify patterns or risks.

3. Customer Tenure and Behavior:

   • Long-tenured customers who have renewed multiple times often behave like recurring revenue, even without formal renewal clauses. This behavior can be factored into underwriting, but it’s crucial to validate it through customer interviews or surveys.
   • Understanding customer reliance on the product/service and switching costs is key. High switching costs or mission-critical services increase the likelihood of renewal.

4. Weighting Contracted vs. Recurring Revenue:

   • During diligence, contracted revenue is often discounted based on renewal risk. For example, revenue from contracts with low renewal rates or short tenures might be treated as less reliable.
   • Recurring revenue, especially from auto-renewing contracts, is typically weighted more heavily in valuation models due to its predictability.

5. Diligence Best Practices:

   • Customer Churn Analysis: Break down churn by reason (e.g., competitive loss, budget cuts) to assess risks.
   • Contract Terms: Review clauses like termination rights, renewal terms, and pricing escalators.
   • Customer Concentration: High concentration increases risk, even if contracts are in place.
   • Market Dynamics: Assess industry trends that could impact renewal rates or customer behavior.

Ultimately, the approach depends on the specific business and industry. For example, in SaaS or subscription-based businesses, recurring revenue is often the gold standard, while in other industries, contracted revenue with strong renewal rates may suffice.

Sources: PE recruiting technical questions (software specific), Q&A - Infrastructure PE & IBD, Q&A: SVP with 15+ YOE BB -> MM -> MC (all M&A): A Long & Strange Trip