Revenue Streams

How Do Revenue Streams Work?

The revenue streams of a company represent the sources of income from sales of products and services to customers.

The strategies and underlying mechanisms that facilitate revenue generation determine a company’s business model’s economic viability.

In short, the revenue model is the income-generating framework that establishes a company’s long-term sustainability of its core business activities.

The effective management of each revenue stream is critical to the continued attainment of positive growth because each source of income is akin to a business line from a broad perspective.

The income statement, or profit and loss statement (P&L), starts with revenue (i.e. the “top line”), from which cost of goods sold (COGS), operating expenses (SG&A), and non-operating expenses such as interest and income taxes are deducted.

While the cost structure—i.e. the composition of fixed and variable costs incurred from operations—varies widely per company (and is contingent on industry-specific factors), the fact that revenue supports the long-term sustainability of a company’s business model is irrefutable.

Under accrual accounting, revenue reflects the total value recognized via the sale and delivery of goods and services in a specified period. However, as the saying goes, not all revenue is created equal.

Far too often, a revenue model prioritizes achieving outsized revenue growth, which is understandable for early-stage startups and growth-stage companies.

However, the sustainability of the methods by which revenue is generated becomes increasingly important with time as a company reaches the later stages of its lifecycle—which is where the importance of the concept of revenue streams comes in.

What are the Different Types of Revenue Streams?

There are a multitude of revenue streams across various industries (and sectors). However, the following types of revenue streams are the most common categories under which most can be classified.

1. Subscription-Based Model (Recurring Revenue)

The subscription-based pricing model is oriented around establishing a recurring revenue stream. Most companies nowadays, particularly SaaS businesses, perceive recurring revenue to be of higher quality, considering the fact that operating performance becomes more predictable and stable since customers will continuously need (and thus pay for) the products and services offered.

• Subscription-Based Model (SaaS) ➝ The secular shift toward subscription-based pricing models has become an inherent part of the modern business model, as exhibited by B2B enterprise software licenses (e.g., CRM, ERP) and B2C subscription-based service access (e.g., Netflix, Hulu). Hence, SaaS providers and subscription-based companies offer incentives to entice customers to commit to a longer-term arrangement.
• Membership Model ➝ Certain stores and retailers offer memberships to frequent shoppers to promote loyalty and repeat purchases, with the incentive of discounted pricing (e.g., Costco, Sam’s Club).
• Subscription Box System ➝ Subscription boxes deliver curated products to customers on a regular basis (e.g. Dollar Shave Club, HelloFresh, Birchbox, Blue Apron) — albeit, the trend has become somewhat of a “fad”.
• Brokerage Model ➝ The brokerage model is underpinned by a platform that brings sellers and buyers together to engage in transactions. The recurring revenue comes from earning commissions on each transaction as compensation for facilitating, maintaining, and monitoring the platform (e.g., E*TRADE, Fidelity).

2. Transaction-Based Revenue (One-Time Sale)

The transaction-based revenue model is a more traditional strategy for a business to earn revenue. The pitfall to the transaction-based model is that each transaction—the exchange of goods or services for monetary resources—is a one-time sale instead of recurring. In effect, one-time sales are viewed as riskier and less stable than the recurring revenue model.

• One-Time Product Sales ➝ The conversion of a non-paying customer to a paying customer for one-time sales generates revenue for at least one transaction. Hence, the one-time purchase carries less predictability, causing the long-term planning of the sale and distribution of products and services to be reliant on continuously maintaining the current pace of sales, often from new customers (and selling to new customers is more challenging and costly than selling to existing customers).
• Project Revenue ➝ The revenue earned from completing specific projects, such as a construction or consulting project, is cyclical and influenced by market demand. In particular, companies that operate in cyclical industries, such as retail and those tied to new housing, are influenced by cyclicality risk, which causes their operating performance to fluctuate widely.

3. Service-Oriented Revenue

Service-oriented revenue is comparable to one-time sales, but rather than the sale of a product (i.e. one-time purchase). The revenue generated from providing services to customers is constrained by the availability of labor (or human capital) and is often measured based on time spent working on the job rather than the total number of services delivered.

• Consulting Fees ➝ Consultants charge clients (and issue invoices) for delivering their professional services and guidance on a per-project basis rather than based on performance — exceptions aside.
• Transaction Fees ➝ Investment banks are paid fees based on the set percentage of the deal size. With that said, the unpredictable outcome of a proposed merger or acquisition causes the fees collected (and revenue generated) to be variable.
• Audit Fees ➝ Accountants and accounting firms alike receive compensation for providing services like auditing the books of clients and taxes, comparable to consulting fees. The fees are charged to the client based on the time spent on the task, not the outcome.

4. Licensing Revenue

A company’s licensing revenue is based on granting customers the right to access technology, such as software programs, protected by intellectual property (IP) and proprietary functions.

• Software Licenses ➝ Software companies or vendors charge fixed subscription fees to users to access a particular software product or platform (e.g., Microsoft Office 365). The licensing model involves charging B2C customers or B2B enterprise clients for the right to access and use intellectual property (IP) or patented software for a stated time frame (e.g., Oracle, SAP).
• Media Licensing ➝ The media industry is known for licensing out the right to use content in various media as long as the payment obligations are continuously met.
• Franchise Fees ➝ The Income from franchising a business model, such as McDonald’s or Starbucks. However, the party in possession of intellectual property (IP) and trademark can ultimately dictate the operating performance of a franchise.

5. Ancillary Revenue

Auxiliary revenue refers to supplementary income from non-core business operations (i.e. side income sources).

• Baggage Fees ➝ Airlines nowadays charge penalties for passengers that did not adhere to the policies outlined in the original agreement.
• In-Flight Services ➝ The income earned on the side from the sale of food and beverages amid flights is considered a non-core business activity.
• Real Estate ➝ The ancillary revenue a property manager generates from tenants, namely access to amenities and non-refundable lease application processing fees.

6. Freemium Model

The freemium model offers a basic version of a product, usually with limited features, at no cost. The objective is to deliver sufficient value to the free users to convince them to become paying users for premium features.

• Free Ad-Based Model ➝ The product can be used free of charge, with the catch being ads — with access to the no-ad version being the premium product (e.g. Hulu, Spotify).
• Limited Product Functionalities ➝ Certain providers deliberately limit the product’s functionalities so that “power users” will upgrade and pay for the additional features (e.g. Dropbox).

7. Usage-Based Pricing Model (Metered Service)

The usage-based model refers to changing customers based on the measured amount of the product or service used.

• Usage-Based Pricing Model ➝ The fees incurred each period by a customer are based upon the product or service usage, such as cloud services priced on a pay-per-use basis. The central theme is that the pro forma revenue projections are less reliable relative to recurring revenue that is practically “fixed” because of the contractual obligation to continue issuing payments. For instance, Amazon Web Services (AWS) charges based on the computing resources consumed.
• Utilities ➝ Electricity and water companies charge based on the amount used by the customer, which varies each month.

8. Retainer Agreement (Fixed Fee-Based System)

Retainer agreements require clients to pay a recurring fee for periodic access to readily available services.

• Legal Services ➝ Law firms often have clients on retainer for ongoing legal disputes and counsel at a moment’s notice.
• Consulting Services ➝ Consultants often charge a monthly retainer for continuous oversight and advisory services on behalf of past or current clients to ensure a positive outcome post-engagement.
• Maintenance Contracts ➝ For a temporary period, customers can purchase coverage for their products (one-time, upfront fee), where any issues are fixed at a discounted price (e.g. AppleCare).
• IT Services and Equipment Maintenance ➝ Companies pay for ongoing support and maintenance for IT support, as well as the regular servicing of machinery and equipment.

9. Advertising Revenue (Ad Model)

Advertisements are one of the main mediums for selling a product or service by reaching a certain segment of potential customers. Site owners, app developers, or content producers (e.g., YouTube channels) are thus frequently paid to display a company’s ads to their audience, which usually aligns with their target customer base.

• Ad Revenue ➝ Advertising revenue, or “ad revenue”, refers to the income generated in exchange for displaying promotional ads to certain users, such as subscribers, within an app, newsletter, website, or digital platform.
• Affiliate Partnerships ➝ Affiliate programs, or referral partnerships, involve the issuance of commissions to those that actively promote the products or services on behalf of a company (e.g. Amazon Associates, Udemy Affiliate Program).

10. Lending Agreement

The lending agreement revenue model produces a steady, predictable stream of continuous payments until maturity (or an agreed-upon deadline) — most often with a long-term lending agreement to ensure a constant stream of revenue (and profit).

• Capital Lending Model ➝ Borrowers can access funds issued by lenders in exchange for the contractual obligation to meet interest payments and the return of the original principal at maturity. The borrower obtains ownership of the borrowed capital for a set period.
• Rental Agreement ➝ The asset lending model generates revenue by charging fees to customers for temporary access to property assets, such as apartment rentals and access to self-storage units.

What is the Importance of Revenue Streams?

A company’s revenue streams are integral to its long-term sustainability. The following are the main reasons supporting the notion that revenue streams are of utmost importance to internal and external stakeholders.

• Financial Stability and Growth ➝ Revenue streams provide the necessary funds to cover operational expenses, invest in growth opportunities, and foster innovation. A diversified set of revenue streams can mitigate risks and create a more stable financial foundation for the business.
• Business Viability ➝ The long-term survival of a business requires at least one truly reliable source of revenue, and multiple revenue streams ensure that the company can further sustain its operations, continue to deliver value to customers, and remain competitive in the market.
• Adaptability ➝ If one revenue stream is negatively affected by unforeseeable circumstances, the other revenue streams can support the overall business and serve as a buffer against unfavorable market developments.
• Competitive Advantage ➝ The unique revenue streams of a company can contribute toward a company establishing an economic moat (i.e. long-term, durable competitive edge) by differentiating its product offerings from competitors, resulting in the protection of its long-term profits and market share.
• Customer-Centric Approach ➝ Multiple revenue streams offer businesses the optionality to cater to different customer segments (and end markets), enhancing customer satisfaction based on their specific needs and preferences.
• Revenue Optimization ➝ The historical performance of revenue streams offer insights into the strengths and weaknesses of business models, enabling management teams to identify opportunities to optimize their prices, enhance their distribution, and improve upon their go-to-market strategies — contributing toward more efficient revenue generation and profitability.
• Long-Term Sustainability ➝ Businesses with established revenue streams are better positioned to thrive long-term, even amid increased pressure from market competition. Business models that were honed over time can sustain unexpected headwinds and weather challenges to maintain steady growth.
• Revenue Diversification ➝ Companies that actively engage in diversifying revenue streams, where the operating performance is not overly reliant on one channel, can be perceived positively by risk-averse investors (and thereby, an influx of capital). The possession of multiple revenue streams, rather than merely one, can attract investors and stakeholders since that attribute is indicative of a robust, resilient business model. A diversified revenue model is far more appealing to risk-averse investors, including lenders, because that improves the credit profile and mitigates risk.
• Fund Research and Development (R&D) ➝ Given sufficient time, a company’s revenue streams can provide the necessary discretionary capital to fund R&D spending, enabling the company to be at the forefront of innovation and stay ahead of the curve.

How to Analyze the Revenue Stream of a Business

The revenue streams attributable to a company include not only the revenue sources but also the customer acquisition strategies and growth tactics inherent to the company’s business model.

Therefore, revenue streams are, first and foremost, the core drivers of a company’s growth and also the determinant of the long-term viability of the business model with regard to profitability and unit economics.

The most straightforward method of analyzing a business’s revenue stream is to calculate the gross margin on a per-segment level, assuming the data is readily accessible.

Publicly traded companies seldom report their operating performance beyond the gross profit metric in their filings (10-K, 10-Q).

However, the segment’s growth and gross margin can often be sufficient to distinguish between outperforming and underperforming revenue streams.

A company’s long-term objective must be to optimize its revenue-getting methods, bringing in each dollar of revenue at a lower cost. More specifically, the customer lifetime value must exceed the cost of acquiring customers, which is measured by the LTV/CAC ratio.

The LTV/CAC ratio is most commonly cited to measure the operating performance of SaaS companies, but from a high-level perspective, the concept applies to companies operating in all sorts of industries instead of only SaaS and subscription-based companies.

Suppose the revenue model and customer acquisition strategies are robust. In that case, the company’s likelihood of establishing an economic moat is much higher and ensures financial stability in terms of the long-term protection of its profits and market share.