Question: I am considering the purchase of a service business and find it difficult to find a bank that knows how to value the good will of its customer base. What can you suggest?
Answer: A retail hardware or furniture store has inventory, display cases, office equipment, etc. These are hard assets on which one can place a value; not so with a service business. Examples of service businesses include insurance agencies, law firms, and medical practices. These are businesses whose value is determined primarily by its customer base.
In valuing a service business, there is no one-size-fits-all formula. Banks have a hard time placing a value on service businesses. They are more comfortable with ones who own buildings, machinery, equipment and inventory which you can see, touch and establish a resale value.
If you are considering the purchase or sale of a service business, valuation is normally based on several criteria. Let’s examine a few:
- Growth & retention of customers – Can the business demonstrate consistent year over year growth and retention of its customer base?
- Profitability – Is the business earning a profit after expenses, including interest on debt, depreciation of assets, and taxes (EBITDA)?
- Cash flow – Are collections current and cash flow sufficient to cover current and near term obligations?
- Customer base – Is company dependent on a single or few big customers as opposed to a diversified customer base?
- Employee base – Is there little employee turnover and are key employees happy in their relationship with the company?
- Impending litigation – Are there any legal issues pending or on the horizon? If so, is the company adequately insured?
Other considerations may include a consistent monthly income stream. An example would be an insurance agency that bills its customer monthly and whose policies renew automatically each year.
Another measure of value may include the amount of market share. Companies that provide a niche service with little competition will command a higher multiple of value.
Then there is the issue of reputation and quality of the leadership team. Is the company well regarded within its industry group and can it survive and retain its competitive edge if the owner or a key employee leaves? And will the seller agree to stay on for a period of time to ensure an orderly transition to the new ownership?
In summary, of all the considerations mentioned, cash flow is the most critical. Banks focus heavily on liquidity. You should seek out lenders who have carved out a niche underwriting service businesses. Trade associations representing various service industries can refer you to these resources.
Gray Poehler is a volunteer with SCORE Naples and can be reached at www.Gray.Poehler@scorevolunteer.org. Business counseling is available, without charge, from the Naples Chapter of SCORE. Call (239) 430-0081 or visit https://naples.score.org/content/find-mentor-165 The SCORE business office is located at 900 Goodlette Road North, in the Fifth Third branch bank building. Office hours are 9 a.m. to noon, Monday through Friday.