My favorite app on my phone is Waze. It gives directions based on crowd-sourced, real time data. It will find alternate routes to guide you around traffic jams, seems to always know the shortest route, and has fun things like special guest voices. (If you don’t have this app, go download it. You can thank me later.) One thing about Waze is that it doesn’t always take the most conventional path. But, it gets you there quickly - as long as you commit to the route. It may seem counterintuitive—I swear it took me through a guy’s backyard one time in LA—but it will get you to your destination. We started this blog series by asking you to understand exactly what your current business model is. (In “map speak”, what is your “current location”?) In this post, we are going to think about where you want to go.
Ideally, transforming your business would be as easy as summoning an Uber and having them take you to where you want to go. Unfortunately, getting to your destination is more like the trust you must have when you use Waze. (It might feel weird, but you trust its constant recalculation of the best route, consideration of all options, seeing how things are going for others, etc.)
For most service provider business owners, there are just a handful of potential destinations that are in play. They typically fall roughly into one of these categories:
- Liquidity event- you have worked very hard to build this business and you are looking for an exit. Maybe you sell to a larger Service Provider, typically called a “strategic”, or you sell to a private equity firm. Most of these deals will allow you to “take some chips off the table”, roll some stock forward, and get a second bite of the apple in a future event. (For any of you that have been through this, you know I just hit Buzzword Bingo in this paragraph!!) But, there are cases where you simply monetize your asset and go travel the world.
- Build for the future- perhaps you have partners or family involved in the business. You helped create the business and have grown it handsomely, but now you are ready for a new challenge. You want to create a long term business that can be handed off to your partners or family. Sustainability is the key here.
- Lifestyle business- maybe you don’t really want to do anything else, but you want to do less of what you are doing now and build some financial security. There is nothing wrong with this either. You can build a valuable business, create a great place for people to work, and enjoy success without the pressure cooker of trying to transact your business.
Whichever destination you punch into your app, the routes will be a little different, but there are some common waypoints with all of them. First and foremost, as we mentioned in the first blog, you want to create what is called “enterprise value". You want to create a valuable company, irrespective of what destination you have chosen. Running your business like you want to sell it is rarely the best option because that lends itself to too many short term decisions without building for the long term. How then do you create enterprise value?
The easiest way to think about this is from a contribution margin perspective. You need to take your top line revenue and categorize it by type of revenue. A typical categorization might be “resale”, “professional services”, and “recurring revenue”. Then, you need to allocate your costs effectively across these lines of business. (Your accounting team can help you allocate these correctly if you don’t look at this way already.) Then, where possible, you need to allocate your G&A expenses by line of business. What you want to get to is contribution margin to EBITDA by line of business.
Once you know what portion of your profits are tied to each line of business, you can assign an exit multiple to that type of revenue. For estimating purposes, you can use the below exit multiples for EBITDA:
- Resale: 2-3x
- Professional Services: 4-8x
- Recurring revenue: 8-12x
You will arrive at a blended multiple that is a weighted average based on your actuals. Typically, the average IT service provider can see a blended exit multiple around six times EBITDA. Very well run IT service providers that have clean accounting and nice profit margins can see 7-9 times EBITDA exit multiples. You will always hear about the company that sold for some kind of crazy exit multiple, I know of one that sold for 13.4 times Last Quarter Annualized (LQA) EBITDA, but those companies typically have VERY high profit margins and 90% or more of their revenue is recurring.
When you run these numbers, you’ll probably discover what people in our industry call the “valuation gap”. That’s the gap between what you thought your business was worth and what it probably is actually worth. (Note: people experience this personally all the time with their homes. They think it is worth one thing, but when they put it on the market, they find something entirely different.) Your job is to fine tune your business to bridge that valuation gap. You’ll need to tilt your revenues more towards a recurring one and build efficiency into your service delivery model to maximize contribution margins. (A good blended EBITDA target is between 7-12%. Very high performing service providers are in the 15-20% range.)
As you consider this journey from where you are to where you want to be, you’ll have to traverse congested roads, back roads, traffic jams, and take some routes that are unfamiliar. But, the view at the end is worth it. Now that you better understand your business (current location) and your desired outcome (destination), we’ll begin to explore the turn by turn instructions that will help you get from here to there. We’ll look at sales transformation, operational leverage, productization, service delivery models, marketing, and other topics that will be essential for you to navigate to your desired goals. So, click “Let’s Go” on Waze and let’s get started!
Previous - #1 of 10, Service Provider Transformation Series: What is your Location?
Next - #3 of 10, Service Provider Transformation Series: Know Your Strengths
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