15 Dec Building Value: Products or Services
It’s not surprising that most entrepreneurs of start-up companies focus on generating revenue from any viable source. Product revenue, services revenue, or both; whatever is easier to get and helps pay the bills.
Once the basics are covered and a company grows beyond startup mode, business executives can take a deep breath and consider the long-term direction and nature of the company when it “grows up.” Often these decisions are made opportunistically, based on near-term circumstances.
However, entrepreneurs should realize that the decision on whether to focus their strategy on products or services will have a dramatic impact on the longer-term value of their company. Both product and services companies can attract buyers, but there are key elements that influence the value those buyers will perceive in a mid-market business.
Industry segment plays a big role in both the desirability and the valuation of companies, even within the broad category of technology businesses. For example, valuation multiples of top line revenue and EBITDA vary greatly:
|IT Industry Segment||Low||High||Harmonic Mean||Low||High||Harmonic Mean|
|IT Hardware Manufacturer||0.3||12.4||0.7||11.4||15.8||13.2|
|IT Managed Services||0.4||8.7||1.0||4.5||35.1||10.6|
Data from Pratt’s Stats – companies with revenue from $5M to $100M, transactions completed from 2007 to 2017.
So why the huge difference? Firstly, the size of revenue and EBITDA have a substantial impact. In the ranges above, higher EBITDA will almost always produce a higher valuation multiple for a given amount of revenue. Companies with less than $5 million in revenue and/or less than $1 million in EBITDA will realize substantially reduced valuations and will find a significantly lower number of potential buyers.
For the relative valuation of products and services, it comes down to several key factors, including revenue/EBIDTA size, scalability, margin, and defensibility.
Scalability is a desirable characteristic of a business, meaning that its revenues can increase significantly without incurring massive additional costs. Technology product companies are often more scalable than service companies because they can leverage a relatively modest investment in human capital and infrastructure.
An acquirer will want to unlock the growth potential of the acquired business. Typically, the acquirer will need to make some type of investment to realize greater revenue growth than had been seen by the standalone business. That investment could include capital, staffing, sales and marketing, or a variety of other factors.
For the acquirer, the ratio of the growth potential to the investment required will have a great bearing on the perceived value of the acquisition.
If the acquirer can leverage their existing assets, such as sales and marketing resources or distribution capabilities, to achieve this growth, then the value of the potential acquisition is enhanced. On the other hand, if a substantial capital outlay is required, then the potential margin becomes critical.
Frequently acquirers can increase the margin of acquired businesses by consolidating overhead functions and/or by achieving greater economies of scale in the combined enterprise. While this margin improvement can contribute to the return on investment (ROI) calculation and can help justify a transaction, it may not be enough on its own.
Will the transaction have a material impact on the top line revenue of the combined organization? Even more importantly, will it have a material impact on the EBITDA for the combined organization?
If the top line revenue growth (or potential) is high, but the cost for achieving that growth makes a significant negative impact on the overall EBITDA margin then it could be a deal breaker.
Worse yet, if competitors could easily move into the market, putting margins at risk, then a potential acquirer will likely walk away.
How difficult would it be, in both time and money, for a competitor to replicate your products and services? Could they simply hire a couple of your key people?
Defensibility applies to both protection against potential competitors and protection of revenue and margin. If your sources of revenue and the margins you can command are relatively secure, then you will be in a much stronger negotiating position with potential acquirers.
If an acquirer can enter a new business area better, faster, and cheaper by acquiring you than by starting from scratch, then you are likely to have a positive outcome.
Bottom Line for the Entrepreneur
- Target a market with great growth potential.
- Be scalable with resources that are readily available to a potential acquirer.
- Differentiate value-added and overhead functions. Make the overhead functions easy to unplug.
- Ensure that you have an attractive margin on the price for your product/services vs. the cost of goods sold (COGS).
- Have defensible products/services that competitors cannot readily duplicate
In this series of articles, the Austin Dale Group will distill some of the lessons learned from our many years as M&A and Strategic Growth Advisors to emerging and mid-market technology companies. We will review what acquirers want and how these key factors can have a dramatic impact on the value of a company to shareholders and acquirers.