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Valuation of a Services Company

Q1: How do you value a professional services company?

According to Suzanne Hooper at New Enterprise Associates [shooper@nea.com], "There's no easy answer. The bottom line is that every valuation exercise is different and there are many factors that affect it - including qualitative ones that you may not think about. For example: competition for the deal, applicable market growth potential, strong management and so on. Anything that reduces the risk increases the valuation. The less things you have in place to reduce the risk, the lower your valuation. Entrepreneurs need to remember that investors expect a certain return for the amount of risk they are taking, so potential future value and exit timing will affect today's value."

John B. Casey [jcasey@cais.com] believes that, "For all intents and purposes, [valuation] is like any other sales process. Valuation is negotiation. Valuation can either be viewed as a black art or as a negotiation process. I've found it more useful to adopt the "it's just another negotiation" perspective. The negotiating talents of the participants are a very significant factor, along with (of course) participants' ego and emotion. So my recommendation is to do a lot of pre-game preparation by looking at comps, case studies, and anecdotal advice you get from others, but to treat the negotiation process itself as the real playing field."

Roger W. Davis [rogerdavis@cc-link.com] has an even more pragmatic approach. "Valuing a service company is tough. There are no hard and fast rules. One way to look at it is this: imagine that in two years, you get run over by a truck. Your wife is now the major shareholder, but she wants nothing to do with the company. Do you want her to try to figure the value of the company so she can sell it to your partner? On the flip side: imagine your partner gets hit by a truck and you have to pay off his widow. How much? Those two extremes should help you find a comfortable number.

"Look at it another way: Say you are so successful Computer Associates tries to buy you out. How will you arrive at a purchase price? You might want to think about that now. You don't need a number so much as you need a process.

"You can hire a lawyer, accountant, or professional appraiser. Hell, hire all three. Pay them each $3,000. They'll each give you a value loosely based on your answer to the following question: "Just give me a ball park figure for what YOU THINK this company is worth." One will tell you it is worth about 75% of that number, one will say roughly that number, and one will say about 25% higher.

"On the other hand, save your money and read a few books: Valuing Small Businesses and Professional Practices by Shannon P., Dba Pratt, Robert F., Cfa Reilly, Robert P., a Schweihs.

"Here are a couple of resources on the Web:

There are a number of methods used to determine valuation, but as discussed above, "it depends". It is probably best to use two or more methods. If several of the methods derive similar answers, this might lend credence to your valuation.

1) The comparable transactions method:

One recommendation in using the "comparable transactions" method is to put together a spreadsheet showing mean, median, high, low for revenue, EBIT, and net income of last twelve months for two dozen comparable software transactions. It's not rocket science, but when you've pulled the comparables together into a single spreadsheet you can really learn a lot about where you might fit into the spectrum. Check for these figures by looking at EDGAR filings. Comparables are a key to an analysts' valuation in any industry, and so are an important part of a netpreneur's homework for the negotiation. [John B. Casey, jcasey@cais.com; Sean Greene, sean@greentravel.com]

2) From HBS the "Method for Valuing Long-Term, High Risk Investments: The Venture Capital Method":

The formula looks at projected net income several years out and an investment amount. You plug in the assumptions and out pops the final ownership percentage required by the investors. The variable assumptions are:

  • Required IRR
  • Investment Amount
  • Term (years)
  • Income in the terminal year
  • P/E ratio (what the stock would sell for, compared to the terminal year's earnings per share)

The formula, in essence, takes a projected exit point, projected earnings and assumed P/E ratio and works forward to the current year to determine what % of the company they will need today. Aside from arguing that your sales and profit projections are achievable, you need to argue the P/E - which is where the comparison shopping really ought to be focused. If your business is internet-related, P/E's for comparable companies can be all over the map. This is where doing your own research and being a good salesperson is so valuable. [Ben Cruz, ben_cruz@earthlink.net]

3) Another method is to value your company at 1x sales. But this method may only be appropriate if you're not very profitable and don't expect that to change much in the future. Mature, low growth companies with slim margins might warrant such a valuation but in the Internet industry, the reverse is probably true. Instead, look at future sales and earnings - not current figures. [Ben Cruz, ben_cruz@earthlink.net]

4) Another valuation method including fixing the exit point, taking a multiple of earnings, and discounting the value back to today's dollars using the appropriate IRR. [Sean Greene, sean@greentravel.com]


Q2: What are the reasons that service companies don't garner the valuations that product companies do?

Alex Nghiem [alexdn@globalobjects.com] points out that although some of the major product companies (Oracle, SAP, Peoplesoft) have a high percentage of revenue in services, a service company is not as attractive to a VC as a product company is.

If you're contemplating starting a services vs. a product firm, here are some of the thoughts on how services firms measure up:

  • We all understand the leverage upside of product -- you make money while the lights are out; and with the right product and right channels you can get phenomenal leverage on your investment in development. But outside of that, product gives you two huge advantages - 1) customers who you can sell other things to - including services, and 2) market discriminators for services. Hence the magnificent service revenue/profit numbers for Oracle, SAP, etc.

    As product vendor, when people need the technology turned into a solution (services) you get premium prices for your consultants because you're seen as *the* expert. Of course your service revenue is directly proportional to the number of warm qualified bodies you can put in the field at any given time, limiting growth, but typically services start as a small "side" business for a product company adding margin gravy.

    In pure service, your product is your people. People come and go, and good ones are always hard to find. So again there are sort of natural limits on how fast you can grow. And even if you're a "solutions" vendor, you're often competing against internal resources and all the firms pushing bodies. Conversely, product companies have a perceived value-add to clients – and their consultants can charge a premium fee.

    A service business is just a more "touchy feely" business which lacks the leverage opportunity that product offers. And products provide a natural lead to build a service business; hence the attraction of product. [Howard B. Freidman, howard@e-cerv.com]

  • According to Jeff Bellin, America Online executive, "In my opinion, it is very difficult to attract investment in a services company. Two ways of changing that are to have a strategy of getting very big pretty quick, most likely through acquisitions, or to develop a strategy to "productize" some of the firm's intellectual property, thereby creating a future revenue base that would be more attractive."
  • Recently I've gotten the impression that the VC community is more open to funding services firms than in the past. Maybe one reason is that in a softer IPO market, a services firm that can attract great staff with expertise in the right technologies (and grow rapidly) can command a premium in an M&A scenario. A hot services company may do as well or better than a warm product company these days -- and maybe with the amount of capital backed up these days BOTH will get financing. Thus, CEOs of services firms should acknowledge the "tilt" but proceed on the assumption that a good services business plan/team can compete for those VC dollars. [John B. Casey, jcasey@cais.com]
  • While services are "hot" at the moment, the ghosts of technology past haven't left the minds of investors and analysts. When we went from Mainframe to PC many years ago, there was a huge services boom. That boom turned into minimal returns once ready made software became widely available for the corporate box. The same, I fear, will happen to this boom. Once the software companies catch up with customer needs, services will once again take the back seat to shrinkwrap. Gartner, in its technology forecast this past fall, predicted a significant drop in the percentage of IT dollars spent on services by 2001. The moral is to enjoy it while you can. [David J. Simonetti, djs@projix.com]

 

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