My experience in buying and selling businesses have been entirely in the digital agency space, but for the most part, all companies look at buying service businesses the same. Below is a non-sequential random list of thoughts and facts you should think about before selling your service business.
Getting an LOI is the first step, but the items below will ensure that the original offer price stays somewhere in the realm of the offer, as well, set you up for success in obtaining your earn out.
- 1. Earn Outs – The dreaded earn out. 95% of the time, when selling a service business, you are going to have an earn out a good portion of the selling price. I would anticipate receiving 20-30% up front, 30% when a year hits, and then maybe a final 35% when you hit the 2-3 year mark or a specific revenue objective. I have asked around and for the most part only 50% of people hit their earn out as planned.
The most important part to negotiate is that you are in control of meeting the earn out terms. As an example, if you have an earn out that is tied to the company achieving a specific profit %, yet the acquiring company is in charge of hiring/firing, you could without any control miss your earn out.
So while I would not be afraid of the earn out, make sure you are in the drivers seat.
- 2. Client Concentration – You don’t want 1 client representing more than 20% of your overall revenue. If you have that, the fear is that once the company is acquired, the client could leave, and the entire acquisition will have failed. So often times if you have one client that represents more than 20% of your revenue, they may discount any revenue/profit for that client. This will affect your overall value.
And while its always difficult to decide how big a single client will be, try to spread out the revenue and sales/marketing focus whenever you can.
- 3. Earnings Multiple – 9 times out of 10, you will sell on a multiple of EBITDA. Basically, Net Income less interest, depreciation and taxes. Depending on how big you are when you sale will greatly impact what you sell for. If you are a $2m a year in revenue company, you might get 2-4x EBITDA. If you are a $10m a year in revenue company, you could get 10-12x EBITDA. The main differences being that if you are a bigger company, you probably have less likelihood that a few bad employees or clients could hurt the acquisition, and the business is probably more scalable in general.
- 4. Ad backs – If you are like most service-based businesses, you probably use your business for all types of expenses that if you sold the company, they would stop. An example might be that you put your car payment through the company, or you inflated your salary. Often times you have expenses that wont exist once the company buys you. These are called ad backs, and as long as you can explain them, you can put them back into your EBITDA calculation and give you an higher exit valuation.
- 5. Net Revenue – Too many times I have seen service-based businesses show their revenue with an inclusion of outside costs like pass through media. In the agency world, a lot of companies count clients spend (Google Adwords for example) in their net revenue calculation. This is not only poor accounting practice, but it will grossly hamper your EBITDA %, which could show you to be a more risky acquisition. A higher or industry average EBITDA percentage implies health and scale. Low EBITDA percentages implies risk. The top line is not as important as fitting into a proper ratio of Net Revenue / Ebitda in accordance with your industry. There is no set percentage, but if you are in the 15-25% EBITDA area you are doing well.
- 6. Vertically specific – If you can appear to be more vertically concentrated, you can often times get a slightly higher value. This is something you need to plan out ahead of time, but usually if half of your revenue is in a specific vertical that the buyer cares about or wants, you can usually justify a 20% premium.
- 7. Accurate Forecasting – This is a huge point that needs real thought put into it. As I stated in #10 below, where you are going is going to be important. They will want to see this in a forecast. The issue is, they are going to likely tie you to this forecast for the earn out. If you miss it, you will drastically reduce what you end up seeing in terms of cash. But you cannot go too light on it as then your buyout will be greatly reduced up front. So put some real time into it and come up with a realistic expectation of where you can be. Don’t put in a stretch goal, you will lose!
- 8. Executive Contracts – This is one of the stickiest topics in any service business acquisition. Even non-equity holding execs that are important to the business must sign an employment agreement or your entire deal could fall apart. One of mine almost did. The good news is that you and the acquiring company are in alignment on doing what’s fair to insure that your most important employees are motivated to make the deal happen. Be transparent to the top guys about a looming acquisition and start early on what reasonable requests might be from him/her.
- 9. Advisement Firms – Unless you know the acquiring company well, I would often times use a firm to help find a buyer and negotiate. Usually their connections will run deep with other advisement firms representing active buyers and they can get a bidding war going. Expect to pay a small monthly fee + 5% of the total proceeds of the sale. Select one with industry knowledge specific to you, it will be money well spent.
- 10. Revenue Acceleration – Buyers buy companies based off of where they think you could be in revenue/EBITDA 2-3 years out. So if you can sell while revenue is climbing, often times you can get a premium by justifying where the company is going to be. If you sell your company during a couple of years of flat (or worse, down) revenue, you just won’t be able to sell your way into a higher perceived value and most likely will only attract buyers looking for low-cost acquisitions.
If you are thinking of buying or selling an agency or service business, shoot me an email I would be happy to offer up any advice.