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Why are service businesses often less valuable than companies that sell products?
The answer comes down to how well your company can run without you (SOPs can help, grab your copy of The Definitive Guide to Standard Operating Procedures). You may be decades away from wanting to sell, but understanding an acquirer’s point of view now will help you build a more valuable company in the future.
So why do acquirers put such a low value on most service businesses? As a service business, you are selling your employees’ time. You may dress that up as hourly billing, day rates, project fees, value-based pricing, or any number of other models, but they all come back to the same problem. Most people only have around two thousand productive hours per year, and your job is to sell them for the highest rate possible.
However, your people are mobile, and if a competitor wants your employees, they can pay them a premium to leave you and work for them.
Nothing is stopping an employee from leaving you and selling their time to someone else, which is why most acquirees have a build versus buy conversation when they are evaluating your business. Acquirers will calculate the cost of recruiting and training your team (or one similar) and then make you an acquisition offer substantially less than that. That’s why most service businesses sell for a low single-digit multiple of their annual profit.
Suppose you try to drive a harder bargain. In that case, you’re likely to turn your would-be acquirer into a competitor because there are few barriers to entering a people business, and no matter how much we hate to admit it and no matter how you care for your employees, most people will leave their current job for a 25% pay bump.
How Kristin Khale Went From 2 to 8 Times EBITDA
The secret to maximizing the value of your service business is to offer something proprietary. Build out a unique offering that is difficult for other companies to match. For example, look at the story of Dr. Kristin Khale, who helps businesses pick a benefits program for their employees.
She has started three insurance agencies, and the first two were people businesses that sold for a modest 1.5 to 2 times EBITDA.
With her third business, Khale wanted to attract a higher multiple, so she decided to transform it into a technology company. She built in-house software that enabled her benefits consultancy to eliminate much of the paperwork and many of the tasks associated with administering a benefits program.
She didn’t white-label someone else’s product. She hired coders to build a proprietary platform.
Thanks mainly to her exclusive technology, Khale built Navigate HCR up to more than 40 employees before she decided to sell. She got three offers and ended up agreeing to be acquired for around 8 times EBITDA plus a five-year contract that guarantees her employment.
That’s a whole lot better than 1.5 to 2 times EBITDA and don’t let the door hit you on the way out.
If you want to transform your service business into a valuable company, develop something you do that nobody else offers. Take your proprietary process, standardize it, and then codify it through technology. You’ll be building a more predictable business and a much more valuable company in the long run.