How to Value a Service Business

Colorado is a service-based economy - there are more service businesses in the state than any other type of business. While the Rust Belt, Great Lakes regions, and both coasts have access to rails and waterways, Colorado is landlocked, lending itself to services, rather than heavy manufacturing. When it's time to buy a service business, there will be many options. 

Service businesses run the gamut, from accounting firms, to drycleaners, to janitorial services, engineering, public relations firms, and many other options. Despite their disparity, they all have one thing in common: offering a service to clients. (Although restaurants, hotels, and hospitals also offer services, we would classify those separately for industry segmentation purposes.)

In our March newsletter, we discussed the importance of tangible assets when valuing a manufacturing business. By their nature, however, service businesses don't have much in the way of tangible assets, making EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), for larger businesses, or SDE (Seller's Discretionary Earnings), for smaller businesses, multiples typically lower than manufacturing businesses. Generally, the smaller the service business, the lower the SDE multiple. 

Valuing a service business involves many factors - a tidy, one-size-fits-all formula doesn't exist. That being said, sellers should recognize that buyers will be particularly interested in certain characteristics for most service businesses.

Normally, valuation is based on several criteria, including: history of profitability, cash flow, overhead, intellectual property, company reputation, number of years in business, opportunities for further growth and added profits, stability of key employees/management team, and customer diversification.

Further consideration goes to whether the company can add more services. Value increases when a service business offers something unique, especially in a growing industry or market. These industries include rapidly growing service sectors, such as: internet/web-based or cloud-computing services and information technology. Relocatable, internet-based businesses with low overhead are particularly attractive due to scalability. Also, the ability for a business to be operated from anywhere increases the number of prospective purchasers - which increases the business value due to higher demand.

In addition, companies with a large recurring monthly revenue stream (for example, when a high percentage of clients are signed up for automatic bill pay each month) will command more value. Examples include alarm companies or website/email-hosting companies that have monthly auto bill pay from clients. Such a consistent revenue stream impresses both buyers and lenders alike.

Other crucial areas for valuation include intellectual property, ongoing relationships with clients, and having a good team in place - ensuring the company will retain its competitive edge, even when the seller (who typically drives new and repeat business) leaves. 

Without significant capital assets, key customers and employees are critical. A strong management team adds to the value of a service business (often more so than in manufacturing) and, conversely, it can detract from value when there's a poor or inexperienced team.

Another measure of value may include the amount of market share. Companies that provide a niche service and don't have much, if any, competition will command higher multiples of value. 

Within the industry, B2B (business-to-business) companies generally command more value than B2C (business-to-consumer). For both, however, client-base diversity commands value - more medium- or small-sized clients being preferable to a few large clients. With low customer concentration, financial risk is reduced. If one client, for instance, cancels a contract or goes out of business, the service business remains financially viable.

Although contrary to an owner's instinct, businesses command higher value when they're not dependent on the owner's personal relationship with clients. If the owner generates a substantial amount of revenue versus the other employees in total, the business could be at risk after the sale. Service businesses are more valuable when customer relationships are readily transferrable: as customers of a drinking-water delivery or HVAC service business don't usually care who the company's owner is, for example. Also, keep in mind that seasonal businesses, due to their cyclical nature, have lower value.

Cash flow is "king," so the primary consideration for bankers is a buyer's ability to stay current on loans for acquisitions and working capital. Banks focus heavily on reliable cash flow for service businesses, given that there is little, to no, collateral within the service business itself. 

Whether you're in the market to buy or sell, understanding the various considerations of valuation for a service business will make the process smoother and increase the probability of a more successful transaction.

(originally published in the June 2013 eNewsletter)