4.4 Revenue Model

Revenue Model, the third pillar of PECCS™ is also an important determinant of the valuation of a private company, as a company’s sales volatility can be explained through the type of revenue model. In this chapter, the different types of revenue models are discussed, and guidance is provided on how private companies can be classified into the proposed classes. 

Types of Revenue Models

Revenue models refer to the key principles that underlie a company’s sales. Or, in other words, how does a company earn its revenue? For example, a software company that sells an operating system can sell its product in multiple ways:

1. The company can choose to sell the software as a subscription service requiring a periodic payment from its customers - a subscription model.

2. The company can sell its software as a one-time sale, either offering support services or not - a licensing model.

3. The company can also distribute its software for free, but then earn revenue through the sale of bundled advertising in its software - an advertising model.

The choice of revenue model has implications for the sustainability, scalability, and predictability of the revenue. Even accounting policies such as revenue recognition, cash and inventory management, capital structure choices, etc., that rely on the type of revenue model, can be a significant component of a company’s valuation. 

Although the exhaustive list of revenue models is numerous and some of these models are constantly evolving, the below approach is adopted to categorise private companies, where revenue models that are similar in terms of their value potential, sustainability, and customer loyalty, are combined into one group. Such an approach leads to the below classes:

1. Advertising model: A model in which businesses generate the majority of their revenue (i.e., greater than 50%) from advertising, such as selling ad spaces in both digital and non-digital media Also, includes digital businesses such as marketplaces, where the revenue arises from advertisements, and affiliate models, wherein a company earns revenue by referring to a third-party’s product or service and earns a commission on the sale of such product/service.

Some examples include those that operate in media, publishing, broadcasting, search engines, social media, billboards, yellow pages, and affiliate marketing. Private companies are further identified as belonging to one of these three advertising subclasses of affiliate models, marketplaces with ads, and conventional advertisements.

2. Production model: In this model, a company produces or manufactures a new product or service, thereby generating revenue from a customer who purchases it. Compared to the reselling model, the cost of goods will form a smaller proportion of revenues in the production model, and the product or service is significantly value-added when compared to the supplier inputs. 

The direct sales model, wherein a company directly sells its products or service through the deployment of its sales force or marketing channels including digital channels (e.g., web sales), is part of the production model. 

Also includes companies that sell complementary products or services where one of these is sold at cost or at a discount while the company relies on generating profits by also selling a complementary product or service (e.g., razors and blades, consoles and video games, etc).

Few examples include companies involved in activities that include manufacturing, energy producers, hospitals, restaurants, pharmaceutical companies, telecommunication services, and producers of durable and nondurable products, computer hardware, and mobile phones. This class includes subclasses of complementary models, direct sales, and conventional production.

3. Reselling model: The majority of the revenue of companies in this class is generated through surcharges to the cost of goods or services sold from a supplier or wholesaler, without any significant value addition to the product or service. The goods or services are generally purchased at a wholesale price, and then a markup is added to the wholesale price before being sold to their customers (e.g., Altexsoft, 2022).

Commission-based revenue models are also part of markup models, wherein the company sells or promotes a product or service and earns a commission on closing a sale (e.g., real estate agencies).

Thus, examples include companies that operate in retail, distribution, wholesalers trading companies, real estate brokers, and similar companies. Interestingly, by this criterion, we can also include commercial banks and lending institutions as operating on a reselling model - they too borrow at a lower rate and make loans at a higher rate. In the same vein, stock and financial brokers can also be considered as adhering to the reselling model.

So here subclasses of commission-based, financials, and retail are included.

4. Subscription model: A model in which a customer pays a single time or recurringly in regular intervals of time for access to a product or service (e.g., Schüritz et al., 2017). Moreover, the marginal cost of producing one more unit is negligible. There are multiple types of subscription models including the below:

i) Franchise model: The company earns its revenue by allowing another entity to use its brand, business model, suppliers products, and services to earn revenue. The source of revenue for the original company can be either fixed or variable or a combination of both based on the sales of the franchising entity.

ii) Freemium model: In a freemium model, a product or service is sold in multiple tiers with minimum features/characteristics offered as free, but enhanced features or characteristics are charged as subscriptions.

iii) Licensing model: A payment is made a single time and access to the product and service is availed for a longer period of time or indefinitely. Such licensing models are included as a subclass of the subscription class.

iv) Pay-per-user/usage model: A customer pays a price for using a product or service to the extent they need to. This is also a type of subscription model where the product or service is used a single time. For example, road tolls fall under this type.

v) Conventional subscription model: This represents the classic model in which a customer signs up for using the product or service for a longer period of time with renewal of the amount they are charged over each period. Such models are more sustainable for the private company and hence are usually regarded as valuable by investors. Emerging models are included here such as kickstarters where a customer pays a price for a product or service under development and secures first/priority access when it is ready (e.g., Ng, 2010).

Thus, in the subscription class, examples of companies include those that derive revenues from operating SaaS (software as a service), selling software solutions, cloud-based solutions, and media companies deriving revenue from subscribing users, rental, and leasing companies. The below table provides a summary of these revenue models.

_{AltexSoft. (2022). Revenue model types: Choosing the right revenue model for your business. AltexSoft. Retrieved from https://www.altexsoft.com/blog/revenue-model-types/}

_{Schüritz, R., Seebacher, S., & Dorner, R. (2017, January 4). Capturing value from data: Revenue models for data-driven services. In Proceedings of the 50th Hawaii International Conference on System Sciences. http://hdl.handle.net/10125/41810}

_{Ng, I. C. L. (2010). The future of pricing and revenue models. Journal of Revenue and Pricing Management, 9(3), 276-281. https://doi.org/10.1057/rpm.2010.15}