By , Axial

September 14, 2016

Information technology consulting and services companies come in all sizes and have a broad range of capabilities, making them a very attractive segment of the market. While these companies may be getting a lot of attention from investors, many business owners struggle with communicating what makes their company uniquely valuable and poised for growth.

We talked with investment bankers and investors about how CEOs of tech-enabled business services companies should be thinking about their customers, products, and preparedness for a transaction.

Since many IT services and consulting businesses have varied product and services offerings ranging from managed services to hardware maintenance, it’s important for CEOs to have a firm grasp of which verticals are driving revenues.

“Buyers want to be able to understand very deep details on the business and cut revenue and gross profit in numerous ways,” says Arun Prakash, Managing Director at Carbon Arrow Advisors and Board Member of IT solutions company, Sayers. “Buyers and capital providers will categorize revenues by practice, products vs. services, vendor, customer, region, etc.”

Revenue attribution can also have an impact on valuation. “If some profits are driven from recurring revenue contracts, and some are driven from projects or less regular contracts, buyers might take a blended average of multiples to determine the value of the business,” says Andrew Heitner of Alcon Capital Partners.

While generally accepted accounting principles (GAAP) are important for any business, IT services and technology companies that do business in many states should pay special attention to sales tax nexus. “The rules vary from state to state and can be very confusing but my advice to a potential seller would be to make sure you do a thorough review on state tax issues well in advance of going to market,” says Ed Irwin, Founding Partner at Shore Points Capital. “It tends not to come up until full scale due diligence, but legal and accounting expenses associated with sorting it out can add up quickly.”

A seller who considers these matters in advance will save lots of time in due diligence and be properly positioned to market their business when it’s time to transact.

2. Acknowledge your concentration risks.

“Despite successful historic performance, which often inspires the seller’s confidence, many buyers will be uncomfortable with a high amount of customer concentration, especially if the top two or three clients provide the majority of the revenue,” says Jon Gordon, Co-Founder of Palladian Capital Partners and advisor to its IT Services portfolio company, Inergex. That’s why it’s important for CEOs to know the percentage of total revenue for each of their top ten customers.

While it’s not uncommon for tech-enabled services companies to have a high amount of customer and vendor concentration, having a single customer account for 20% of revenue, for example, will raise risk concerns for a buyer or investor.

Since any capital provider or buyer will eventually dig into the details of your customer and vendor mix, “It’s important to be ready to justify the level of entrenchment you have with that partner to keep buyers’ minds at ease,” says Prakash.

One added value of working with intermediaries is that they can help CEOs prepare for tough questions about concentration. Intermediaries with expertise in the market often assist in overcoming concentration concerns by providing a meaningful narrative around how secure the business is and ongoing plans to diversify revenue.

3. Know how leadership affects customers.

In tech-enabled services businesses, founders and CEOs often act as the top salespeople, especially in the early days. In fact, “Many small, entrepreneurial IT services companies have long-standing clients that followed the founder from a prior employer when he/she launched the new business,” says Gordon. If the owner sells or retires and doesn’t have the sales force to back it up, the business can really suffer.

Because the IT Services industry is so customer-centric, investors and buyers will want to be assured that significant customer churn won’t occur as a result of a change in leadership.

Even if a transaction is 5+ years away, it’s important for CEOs to have a plan for leadership changes post-transaction because it can influence the valuation of the business, structure of the deal as well as employee morale and company culture.

“Buyers don’t want to take on the risk of disruption to a customer relationship due to a transaction, or they propose a deal with a significant amount of the consideration in earnouts or seller notes,” says Prakash. “Planning for the transition could take months to years, but it is worth it as it could make the business much more valuable.”

4. Market the strengths of your employees.

“In services businesses, the main asset is your people,” says Jim McCabe, Senior Vice President at Outcome Capital, a software and information technology services boutique investment bank.

One way to drive premium value in a transaction is to accentuate the team’s certifications or  experience with various platforms. This also helps CEOs diversify the types of buyers or investors they can entertain (e.g. private equity vs. strategic buyer, etc.)

“Strategic buyers often view the acquisition of a services business as a way into a new set of capabilities,” continues McCabe. “These buyers will often pay a premium because they have not yet been able to develop the qualifications in-house, or they would otherwise take years to replicate through organic hiring.”

Since these capabilities often rely heavily on upkeep and development from key employees, it’s important to have a plan for retaining them when it’s time to sell.

5. Plan ahead.

No matter how far away from a sale your business is, it’s helpful to speak regularly with those who can help you uncover issues within your company.

“We’re big believers in the backward-planning sequence,” says Mark Sauter of Pickwick Capital, who’s served both as an investment banker for tech companies and a due-diligence advisor for private-equity groups that buy them. “Start with the end result you and your board want – say, an exit for a certain price by a certain time – and work backwards to identify the critical things to accomplish, in order. Then factor in market conditions, such as multiples and comps (with which your advisor can help), to determine if now or later is the right time to move forward.”

Knowing how your competitors and the markets are performing will help you develop benchmarks for growth so that when it’s time to sell, you’re truly ready.

 

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