Revenue Model

What is a revenue model?

Revenue model (German: Umsatzmodell, also Erlösmodell or Ertragsmodell) describes the way in which a company earns revenue from its offering. It defines what customers pay for, how often they pay and what the price is based on. The revenue model is the revenue part of the business model; the latter additionally describes what benefit the company creates for which customers and with which resources it delivers its offering.

In every funding round and every company sale, the revenue model is among the first points reviewed. It determines how predictable future revenue is, what gross margin is achievable, how much capital growth ties up and by which method the company is valued. The business plan and the financial model depict the revenue logic, and due diligence checks whether the actual composition of revenue matches this depiction.

Types of revenue models

• Sale of goods: a one-off purchase price per order, typical of retail and online retail. The business is measured, among other things, by the average order value (AOV) and by how often customers reorder.
• Subscription: a recurring fee for access to a service over a period, for example monthly or annually. Recurring fees are measured as ARR, annual recurring revenue.
• Perpetual licence: a one-off fee for an unlimited right of use, often supplemented by a maintenance agreement with an annual fee for updates and support.
• Transaction fee: a fixed amount or percentage per processed transaction, for example per payment, booking or order. Revenue follows the customers' business volume.
• Usage-based billing: a fee per unit consumed, for example data volume, computing time or interface calls, often combined with a contractual minimum purchase.
• Marketplace and brokerage: a commission on the volume brokered through the platform, charged to buyers, sellers or both sides.
• Services by effort: billing by hours or days. Revenue grows only with additional staff.

In practice, hybrid forms are common, for example a base fee with a usage-based component or a subscription with a one-off set-up fee. For the assessment, the composition then counts: what share of revenue comes from which form and how the shares develop.

How investors assess revenue models

Predictability

Investors first ask what part of revenue recurs in the following year without a new sales decision. Subscriptions with a fixed term and high customer retention offer the greatest visibility here. Transaction and usage fees do recur, but fluctuate with the customers' business. Perpetual licences and projects have to be sold anew every year; only the maintenance share is predictable there.

Gross margin

The gross margin is the share of revenue that remains after the direct costs of delivering the service, for example for data centre, support, payment processing and implementation. The remaining amount in euros is called gross profit. Pure software revenue often achieves considerably higher gross margins than a services or hardware business. A high margin shows how much of each additional unit of revenue is available for sales, development and earnings. It thereby limits what return on sales, that is, what profit per euro of revenue, is achievable. At the same time, it shows whether the business can grow without costs growing to the same extent (scalability).

Capital tied up and valuation method

The revenue model also determines the payment flow. Annual prepayments help finance growth, while monthly billing with a payment term ties up capital in working capital, the capital tied up in day-to-day business, here in open customer receivables. For valuation, a two-way split often results: recurring software revenue is valued using revenue multiples (revenue multiple), project and services business rather using earnings multiples (EBITDA multiple).

Revenue recognition by type of revenue

The basic rule in the German Commercial Code (Handelsgesetzbuch, HGB) is the realisation principle: revenue arises only when the service has been performed, not already on conclusion of the contract, invoice or payment. When that is the case depends on the type of revenue. Subscription fees are recognised pro rata over the service period; amounts paid in advance for future periods are deferred as deferred income (passive Rechnungsabgrenzung). A perpetual licence generally leads to revenue on handover of the software and grant of the right of use, while the associated maintenance agreement is recognised pro rata. Transaction and usage fees arise with the respective transaction. Work performance, for example an implementation project agreed as a contract for work (Werkvertrag), is in principle realised under the HGB only on acceptance.

With marketplaces, it matters whether the platform acts as an intermediary or as a seller. If it merely brokers, its revenue is the commissions, not the brokered volume. If it buys and sells itself, it reports the full selling price as revenue and the purchase price as expense. For bundled contracts with several types of revenue, early coordination of the allocation with the tax adviser is advisable.

Worked example: three revenue models with the same revenue

Three technology companies each achieve revenue of EUR 3.0 million. The margins and the churn rate of 10% are assumptions for the example.

• A, subscription: EUR 2.7 million subscription at 80% gross margin and EUR 0.3 million implementation projects at 20% gross margin. Gross profit: 2.16 + 0.06 = EUR 2.22 million, that is, 74%. Predictable from the existing base in the following year: 2.7 × 90% = EUR 2.43 million, that is, 81% of revenue.
• B, perpetual licence: EUR 2.4 million licences at 90% gross margin and EUR 0.6 million maintenance at 80% gross margin. Gross profit: 2.16 + 0.48 = EUR 2.64 million, that is, 88%. Predictable from the existing base: 0.6 × 90% = EUR 0.54 million, that is, 18% of revenue.
• C, marketplace: EUR 30 million brokered volume at a 10% commission gives EUR 3.0 million revenue. Payment processing costs of 2% of volume amount to EUR 0.6 million. Gross profit: 3.0 minus 0.6 = EUR 2.4 million, that is, 80%.

B has the highest margin but starts the following year with less than a fifth of secured revenue. A starts with roughly four fifths and is therefore usually valued higher on a revenue basis. At C, predictability rests on the recurrence of transactions; what is valued is the commission revenue of EUR 3.0 million, not the brokered volume of EUR 30 million.

Distinction: revenue, business, pricing and sales model

• Business model: the broader term. It describes benefit, target customers, delivery and revenue; the revenue model is only the revenue part of it.
• Pricing model: the concrete design within a revenue model, for example price tiers, price per user or a permanently free entry tier (freemium).
• Sales model: the route to the customer, for example personal sales or self-service within the product (product-led growth). Revenue model and sales model must fit together.
• Unit economics: the profitability per customer or transaction. It shows whether a revenue model is viable at the actual costs of customer acquisition and delivery.

Common mistakes

• Brokered volume as revenue. Anyone who places the trading volume of a marketplace next to other companies' revenue overstates the size of the business many times over.
• One-off revenue shown as recurring. Implementation projects and perpetual licences in recurring revenue are noticed in due diligence and reduce the credibility of the financial model.
• Billing by effort where results are sold. If the company becomes more efficient, revenue falls under this kind of billing although the customer receives the same benefit.
• Too many pricing logics side by side. Several parallel models make sales, billing and planning more difficult and make metrics hard to compare.
• Payment terms overlooked. Two models with the same annual revenue can have very different liquidity needs, depending on whether billing is in advance or monthly with a payment term.

Frequently asked questions

Can a company change its revenue model later?

Yes, usually step by step. It is common to put new customers on the new model immediately and to switch existing customers at the next contract renewal. When moving from a perpetual licence to a subscription, revenue and liquidity initially fall, because a one-off amount is replaced by annual instalments; the financial model must depict this transition phase.

Which revenue model do investors prefer?

There is no generally preferred model. Recurring revenue with a high gross margin is valued highest on a revenue basis, but it must fit the customers' purchasing behaviour. A forced subscription for a service that customers need only once leads to high churn.

How is the revenue model described in the business plan?

With a few concrete statements: what customers pay for, what the price is based on, how often billing takes place and what share of revenue comes from each type of revenue. This includes the payment method and the metric by which the model is measured, for example ARR, average order value or commission rate. A sentence such as “Subscription per user, billed annually in advance, 85% of revenue; implementation projects 15%” says more than a general description.

Is a discount for annual prepayment worthwhile?

That depends on the financing costs. A discount for prepayment is economically financing by the customer, and a high discount corresponds to a high interest rate. Anyone who grants a 10% discount on an annual fee otherwise paid monthly, for payment in advance, effectively pays an annual interest rate of more than 20%. The discount is therefore worthwhile only if other sources of financing are more expensive or not available.

The Roemer Capital view

The revenue model stands at the start of every equity story that we develop with clients, that is, the reasoning why the company will gain in value. It determines which companies investors and acquirers compare with and by which method they value. In the financial model, we separate the types of revenue into their own lines, each with its own gross margin and its own assumption on recurrence.

This makes visible which part of revenue carries the multiple and which does not. If a client plans to change the model, we run the transition phase through before the start of the process in the base case, the cautious case and the optimistic case. The temporary decline in revenue and liquidity is then explained before investors ask about it.