Valuation of a Services Company
Q1: How do you value a professional services company?
According to Suzanne Hooper at New Enterprise Associates [firstname.lastname@example.org],
"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
John B. Casey [email@example.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 [firstname.lastname@example.org] 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
"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, email@example.com; Sean Greene, firstname.lastname@example.org]
2) From HBS the "Method for Valuing Long-Term, High Risk Investments: The Venture
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
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, email@example.com]
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, firstname.lastname@example.org]
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, email@example.com]
Q2: What are the reasons that service companies don't garner the valuations that
product companies do?
Alex Nghiem [firstname.lastname@example.org] 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
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, email@example.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, firstname.lastname@example.org]
- 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, email@example.com]