Selling a small business is a major decision for any business owner, and the value they receive is rightfully a large focus as they start to explore the process. That value is typically derived from their financials: Sales, Net Profit, EBTIDA, etc. What’s often overlooked are the other factors that make their business marketable to potential buyers.
Service-based businesses have a unique set of challenges compared to other companies in this area. It’s not all about the financials. Often, when owners of these businesses start to prepare to sell, they’re disappointed in the value estimates on their business and the difficulty of identifying willing buyers.
The key to avoiding this disappointment is focusing on making your business marketable to a potential buyer. It goes beyond what your sales and profits are. According to the Exit Planning Institute, 80% of a company’s value comes from intangible assets. In other words, the majority of what makes your business valuable may not show up on your balance sheet. Let’s focus on a few key areas that often separate a business that sells for its full value from one that doesn’t.
Defining the Service Industry
At North Point, we consider a business service-based if it provides services rather than tangible goods. Some examples would be professional services like legal or accounting, IT support services, plumbing/electrical, consulting, etc. In some ways, it might be easier to think of what’s NOT a service-based company. This would be manufacturing, agriculture, pharmaceuticals, etc.
The Challenge
Let’s look at an example to illustrate how companies in different industries with similar financials have significant different value estimates:
Company A: Electric Company specializing in home construction & remodeling. It was founded 30 years ago by the owner in their garage.
- Revenue: $10 million
- Net Profit: $2 million
- Revenue Source: Long standing relationships with five general contractors making up 80%+of revenue
- Business Value Estimate: $8 million
Company B: Manufacturing Company producing widgets. It was founded 20 years ago with a 2 million dollar initial start-up cost and recently received a 10-year patent for the Widget.
- Revenue: $10 million
- Net Profit: $2 million
- Revenue Source: Diversified sales through multiple distributors and direct-to-consumer sales.
- Business Value Estimate: $16 million
Now imagine being the owner of these companies. You’re both doing the same amount of sales and have the same net profit, but the owner of company B is receiving 2x the price? Let’s dive into this by breaking down the four major challenges facing a seller of a service-based company by disclosing a key piece of information about each company.
Challenges Facing Service-Based Businesses
- Short-Term Client Relationships: Don’t take this the wrong way, we’re not talking about customer loyalty. What we’re talking about are contractual agreements that allow a buyer to confidently predict future sales. Multi-year customer contracts are rare in the service industry. They’re typically a transactional sale that may or may not be recurring.
- Relationship Dependence: Customer relationships are a critical component of any service-based business. You’re dealing directly with the client, and often those relationships fall on the owner or a few key employees to maintain. A buyer is going to consider the ability to maintain those relationships post-sale a risk.
- Low Barriers to Entry: Service-based companies typically don’t have a large start-up cost. That’s a great thing for the entrepreneur when they start, but it also allows for many competitors. The potential buyer could also consider starting a business themselves, thereby avoiding the risk of buying one.
- Commoditized Services: Many service-based companies offer services that are indistinguishable from the majority of their competitors. This magnifies the relationship dependence referenced above and can lead to competing on price as a differentiator. This can also give a buyer leverage if there are multiple companies for sale in your industry and your services are similar. They don’t necessarily want your specific company; they just want a company in your industry.
The Solution
- Minimized Owner or Key Employee Dependence: Create a structure where revenue generation and service delivery don’t hinge on specific individuals. This makes your business more appealing to buyers. Consider a scenario where you took a 6-month vacation from your business. What’s the impact? Your goal should be that there’s no impact on your sales, operations, or profitability.
- Transferable Brand Value: Strong brand recognition within your industry or region enhances marketability. Potential buyers will look for a reputable brand that can easily transition to new ownership. Building a brand name that contributes to the sales of a company, independent of having key salespeople (often the owner), is crucial.
- Accurate & Transparent Financials: Solid financial statements foster buyer confidence with any company. But I’d argue it’s even more important with a service business. There are enough challenges listed above that you don’t want to add an unnecessary potential deal breaker by not having financial reports that the buyer is confident in.
- Scalable Systems: The buyer is going to want to see organized systems that allow the company to maintain its operations under new ownership. They’ll also want to see how they can scale operations to support future growth. Make sure your operational systems are documented, followed by all, and continually monitored.
- Have a Niche or Expertise: Service companies can greatly increase their value by having a niche that separates them from the other companies in their industry. It’s the closest thing to a patent, in my opinion. If you can attract a category of clients based on your expertise, you’ll likely find a buyer willing to pay more for that niche.
Selling a service-based business isn’t just about revenue and profits. Much of its value comes from intangible factors, your brand, client relationships, systems, and areas of expertise, which often make the biggest difference to a buyer. The work you do now to identify and strengthen these assets, address weak spots, and set your business apart can pay off when it’s time to sell, helping you attract serious buyers and maximize both the value and legacy you’ve built.
