Valuation and Succession Strategies for Services Businesses

When talking with owners of consulting firms, I often get asked about valuation and the acquisition process. In my experience, many owners of small firms are uncertain about what their business is worth, what succession options look like, and how to explore these. There aren’t easy ways to learn about these things and yet they affect how owners think about their succession plans, retirement, and legacy and where they take their business longer term. Since most people have never bought or sold a firm—or have very limited experience doing so—there are naturally a lot of unknowns. To help people navigate these topics, I’ve organized some thoughts on valuation and succession strategies based on my experience.

These thoughts are purely my own—they are not academic or research based, but rather they’re informed by my 20-plus years of experience talking with dozens of consulting business owners about their business dynamics and financial interests. This includes the 19 companies that TiER1 Impact has acquired or invested in and dozens of others that we have evaluated over the years. This also includes insights from discussions with numerous business owners who have sold to private equity firms or other strategic buyers, as well as various conversations with investment bankers and private equity firms. First, I’ll offer up general points about valuation and succession strategies and their pros and cons. Then, I’ll share more tangible examples and how TiER1 has traditionally approached acquisitions both in terms of valuation and structure.

How to value a services business

My first caveat is that a business is worth whatever someone will pay for it. So, while there are many valuation heuristics that hold—and generally good logic as to why those heuristics hold—there will always be exceptions. However, exceptions tend to be rare, especially with small services businesses; when they do occur, it’s primarily because the acquiring entity sees unique potential from the business to be acquired and it typically is a result of something else that they (as the buyer) bring to the relationship. I’m going to ignore these exceptions and simply acknowledge that they exist.

Keeping that caveat in mind, here is my general guidance on valuation:

Common valuation multiples

Note: The terms EBITDA (earnings before interest, taxes, depreciation, and amortization), profit, cash flow, and SDE (seller’s discretionary earnings) are used synonymously. In a services business, while not identical, they are very close approximations of each other.

Services businesses are generally valued on a multiple of profit, because the cash generated by the business is what allows the buyer to make the investment/acquisition work. The buyer(s) will use the future cash flow to pay back the purchase price and generate their return. For example, if the multiple being paid is “4X EBITDA” and the business stays consistent for four years, the buyer will have paid off the investment in a four-year period. Of course, no business remains perfectly consistent, but this is a simple way to think about profit multiples. If there is little to no consistent profit, it’s very difficult to value the business. One thing to note is that if the owner is active in the business, this cash flow/profit number must be calculated after the owner’s normal compensation has been accounted for, because even if the owner leaves (and their compensation is theoretically saved), someone must be hired to take their place. That’s why the profit number used in small businesses is sometimes referred to as seller’s discretionary earnings (SDE), discretionary meaning “beyond” the earnings required to employ the individual.

I start here because people sometimes ask whether it makes sense to use a multiple of revenue as is done in some industries. Revenue multiples make more sense for some industries, including heavy intellectual property (IP)–based businesses (e.g., software businesses), which sometimes don’t generate any positive cash flow. This is because the potential scale of profit on those businesses is large and, in theory, profit can grow significantly with limited additional cost investment. Those businesses also tend to be less tied to individual people—that is, the IP is theoretically more transferable—and their value is tied to the momentum and scale of the revenue generated from the underlying asset. However, it’s worth noting that the most common strategy for buyers to make money from those businesses is to flip them and sell them again (versus paying for them from the cash flow of the business). Those businesses have value because of the potential of the cash flow they can generate and the possibility of someone else realizing that potential. That’s the primary way large revenue multiples can make sense, and so, if you have that type of business, you should be prepared for the future changes that are likely implied from subsequent sales.

From my experience, small services businesses, which I’ll define as those that have $1–5 million in revenue and 5–30 people, sell for multiples of 2X to 6X profit (or EBITDA) depending on these variables. (Services businesses that have around $1.5M in revenue and fewer than five people are what I’ll refer to as micro-firms. Micro-firms are very difficult to purchase and should have a different financial strategy.) As a business grows larger and exceeds $5M in revenue, the multiple starts to increase. Fairly large established businesses of $30–40M or more might trade at 5X to 8X EBITDA. Small services businesses have a lot of risk as they are heavily dependent upon people and their knowledge and relationships. In my experience, without active continued investments, the value of an individual’s relationships decays rapidly within three years, so we are very cautious about buying any businesses where it might take longer than three years to realize our return.

Key factors that drive the specific multiple that might fit a service business include:

• Size—the larger it is, the more predictable and stable it is.
• Repeatability of clients—demonstrated recurring revenue (particularly renewable contracts) is worth more than sporadic one-off projects.
• Diversity of client base—a large, diversified client base is more resilient than a concentrated one.
• Strength of business development—a demonstrated system for creating and expanding clients increases value.
• Growth rate—this is an indicator of the strength of business development.
• Project size—this has to do with efficiency of business development and the ability to win large chunks of revenue versus many small ones.
• Overall gross margin of the services is an important consideration.

How intellectual property impacts valuation

Many small services businesses have also invested in IP creation, including training courses, proprietary content or methods, and/or software. People can often overestimate their IP’s market value, so it’s worth exploring this.

There are two primary ways IP can have value for a firm. The first is by increasing the efficiency of delivery and effectively increasing the productivity of the work—that is, not having to custom create things every time and/or being able to streamline work through reusable IP. In this case, the value of the IP will be reflected in higher gross margins and net margins and the valuation described above generally will account for it. Perhaps the multiple will be higher because of higher margin in the work.

The second way IP can be valuable is if there’s a significant existing user or subscription base where the IP is directly licensed by others and not simply used by individuals within the firm. When the IP has real licensing with dollars flowing from subscriptions, it becomes valuable at a different multiple because it tends to have greater scale. However, I can’t overstate how difficult it is to reach that point. Creating IP is only a fraction of the challenge. Marketing and scaling the sale of IP requires significant investment. Those who have traversed this challenge likely have something of value under a different valuation structure, but many who have simply created IP that’s useful to them, the business, and in its application to clients experience limited external financial value.

Prospective buyers to consider during succession

With that as a backdrop for valuation, here are my general thoughts on prospective buyers and who is a fit in certain situations:

Generally speaking, there are six primary paths of succession that I group into three categories. These do not include the default path of holding the company indefinitely nor the path of family succession. The three categories and six paths include:

• Financial buyers, including private equity and family offices
• Employee buyers, including ESOPs and sale to one or more key employees
• Strategic buyers, including larger firms as well as other practitioners

Financial buyers

The most typical private equity (PE) transaction involves a fund that purchases controlling interest in a services firm, either to be integrated into a larger firm they’ve already purchased or to serve as a platform for continued growth. To be a candidate for a PE purchase, a services firm generally needs to be of substantive size—$10M in revenue is the minimum but $20M or more is typical—and growing at a substantive rate. The factors cited above (client diversity, recurring revenue, unique value proposition, and a strong sales model) are critical for this to be a relevant option. And even when it is a viable option, there is still some significant risk. Specifically, most PE firms ultimately realize their financial value through a resale of the organization in a three- to five-year period. This is because of the nature of the funds that must return capital to the original investors.

My view on PE has always been that it’s not necessarily the first sale of the business that is problematic, but rather it’s the second sale—the one you have little to no control over. PE has other downsides, including substantial pressure placed upon the business, a loss of control of culture and strategy, and difficultly in retaining an inspired and engaged workforce. PE firms tend to be very transactionally driven and very good at financial engineering and optimization. While this can help a business operate better, it also can present substantive risk to an organization’s culture and relationships. The upside of PE is that, for the right businesses, the valuation can be attractive and the payment to the sellers can largely occur up front at the time of closing, so it represents less financial risk than other transactions. PE can also sometimes help fuel additional growth.

Family offices are a variant of PE that generally operate the same way, except many family offices have more of a buy-and-hold strategy. Because the funding source is one ultra-high net worth family, there is no artificial timeline placed on the return of capital and thus, the buyer can be more patient with the longer-term growth strategy. For this reason, family offices can often be the more attractive version of PE.

In general, those who care about any kind of long-term legacy or the continuation of a healthy environment for employees need to be cautious about PE options.

Employee buyers

An ESOP is a great tax-advantaged ownership transition strategy for organizations that want to continue building on the existing structure, culture, and brand by transitioning ownership to the employee base. This is done through the creation of an ESOP trust, which borrows money to buy the business and then issues shares to employees over time. It can work well for services companies, but in general it requires a few things, including:

• A stable cash flow. Positive cash flows are needed to support debt servicing that allows the seller to get paid. Since there is no other “outside source” of funding as there is in other transactions, if an ESOP starts to lose money or doesn’t generate sufficient cash flows, it can create substantive challenges.
• A stable (and ideally growing) revenue. An ESOP has an annual valuation. For employees to fully understand it and appreciate it as a benefit, it generally needs to be growing. If an ESOP declines in value, it can cause more turnover, which can create greater repurchase challenges. That is, while the company is generating less profit, it is faced with more repurchase obligations for employees who have exited, and the convergence of these two things can create issues.
• A substantive size. An ESOP transaction isn’t cheap. ESOPs also contain annual fees for administration, trustee, audit, and valuation, which can feel cost prohibitive for smaller firms. As an organization becomes larger and more profitable, these costs are offset by the considerable tax savings on profits. Most ESOP experts would say a minimum of about $1M of annual profit is needed for an ESOP to make sense, although smaller ESOPs have been created.

The three most cited downsides to ESOPs are complexity, cost, and capital. In a typical ESOP, the seller carries most of the financing and isn’t paid much up front. The ESOP trust borrows some amount from a traditional bank, but the rest of the financing often comes from the seller in the form of seller notes. (TiER1 Impact has created an alternative model to address these challenges, which I share below.)

The other more flexible approach to employee ownership is to sell the company to one or more key employees, which can help organizations avoid some of the fees and costs involved in an ESOP. However, it can be difficult to find employees who have the financial resources, risk tolerance, and/or leadership experience to take on the organization’s operation. It also often depends on some form of seller financing and can create strain among close relationships within the business.

Strategic buyers

Strategic buyers are generally larger firms that can create greater value from the underlying business either by expanding market access or by providing greater resources or cost efficiencies. (TiER1 would be considered a strategic buyer for most of the companies we have acquired.) Potential upsides to a strategic buyer include continued growth with even greater opportunities for employees and customers. A potential downside includes straining the new entity for everyone if cultural misalignment or significant operational misalignment already exist. That’s why clarity of values, shared vision, operational norms, client and employee management expectations, and anticipated changes in direction are all paramount to success.

Integrated strategic acquisitions can also be challenging for the individual seller. If they leave after closing, this can cause challenges to the organization’s continued success, including the transition of relationships. However, if they stay, it can be difficult to find the right role for an individual who has historically led all major business decisions. In my experience, those who love the sales side or the delivery side of services settle in the best. Those who love operations or leading the organization as a whole will struggle the most.

When considering a strategic buyer, I’d suggest finding out if the buyer has any experience with successful acquisitions. Integration of acquisitions can be difficult for everyone involved and not having experience with the process can result in significant challenges. Start by talking with someone who has been acquired by the purchasing entity. If they don’t have much/any history with acquisitions, make sure you’re dealing with someone who demonstrates a good deal of humility and inclusiveness, because things will inevitably go sideways, so stepping into a partnership with someone who will collaboratively navigate challenges that arise is important.

Most strategic buyers will, in some way, look to integrate businesses as there are operational efficiencies in doing so. In addition to exploring what your role will be, it’s critical to consider how important the brand is (to you and to the market) and how to best transition it. For many sellers, this can be an emotional thought process as some portion of their identity is tied to the brand. At TiER1, we typically integrate our acquisitions, but we also have a model that allows entities that have enough size and strength to operate independently while augmenting them with a scalable back-office infrastructure and providing other resources and partnership opportunities to spur growth. It’s worth noting that an acquisition by an existing ESOP like TiER1 provides the ESOP option without incurring the cost, complexity, and capital issues that a standalone ESOP can present.

A variant of a strategic purchase is a purchase by a practitioner—someone (or a small group of people) in a specific industry that understands the business and wants to own something in the industry and/or combine entities in the industry. An upside to this approach is that it supports continuation of the business on its current path. For this option to work well, you need to ensure that you’ve found an experienced leader with sophisticated business management experience, as well as someone who has adequate outside financing either through personal resources or another investment partner.

Most strategic purchases require some form of earnout where a portion of the purchase price is paid up front with the remainder paid upon some type of key success milestones, often over a one- to three-year window. (Our model for this is described in the TiER1 acquisition example below.)

Pros and cons of succession strategies:

A note on micro-firms

Micro-firms (those that range from a sole proprietor to up to five full-time employees, often augmented by a contracting network) can be tough to purchase. Their cash flows are typically tied very closely to the owner-operator who leads them and aren’t easily transferable to others. These firms generally don’t have a scalable service delivery organization or a scalable sales model to create ongoing financial value that’s independent of the individual owner-operator. None of that is necessarily bad; it’s just something worth acknowledging.

Oftentimes, the best financial strategy for the owner-operator of a micro-firm is to operate in a lean model with limited long-term investment. Dabbling in long-term investment without committing to it can frankly be a waste of resources. In a lean model, the focus would be on building strong client relationships where services are personally delivered at a high hourly/daily margin or through a trusted contractor network where additional margin is created. This can create a financially lucrative operation. When it comes time to sell or exit the business, the best strategy I’ve seen is to transition that business to a strategic buyer/partner. There is little value up front in that type of sale, but you can create a model with a two- or three-year runway where the acquirer pays you the profits you would have otherwise received and also shares any growth they’re able to create from the client base you’ve generated. This monetizes the business, creates a graceful transition, and can lead to growth. And, if structured right, you can be paid much of this at a capital gains rate instead of an ordinary income rate, thereby saving a significant amount in taxes.

The most valuable salable assets that micro-firms typically create are the client base and/or relationship base generated by the brand. It’s worth reiterating that while micro-firms often generate IP, without a large established market of licensing, that IP often has limited transferable value.

TiER1’s acquisition approach and structures

To provide concrete examples of how this can work, I’ll share how TiER1 fits within these options and how we find which organizations might be a good fit for acquisition.

TiER1 Impact is the parent company of TiER1 Performance (and other investments). TiER1 Impact is where our ESOP resides, meaning it’s the company owned by all TiER1 employees. We have designed TiER1 Impact to be a catalyst for the development of healthy, high-performing services organizations, which are sometimes integrated together and other times exist in a standalone fashion.

Over the past 15 years, we’ve had great success with acquiring companies that range from one-person micro-firms to 30-people firms. Not all of our acquisitions have been successful (and we’ve learned from the challenging ones), but we’ve had a very high percentage of success, which we measure by client and employee retention, growth, realization of financial goals, and seller satisfaction. We’ve learned that the more explicit the buyer is in outlining payout structures, roles, expected timelines, drivers of success, strategy for integration, and how potential challenges might be addressed, the higher the likelihood of success will be. Additionally, creating a structure and role that aligns with earnout incentives or financial goals (and doesn’t create conflicts in it) is essential. In general, alignment of goals and personal values and full engagement of employees are paramount to success. If people don’t want to stay in a services acquisition, then it’s not worth the time or money for either party.

When exploring acquisition candidates, we always start with the alignment of values. We seek to work with people who are human centered, show concern for their clients and employees, love to collaborate with others, and have a humble, servant-leader orientation. They must either operate or be willing to operate in a high-trust culture with limited structure. Those who are more individually competitive in nature, prefer highly controllable environments, or are significantly financially driven are often not a great fit for TiER1. Although the values and personalities of the owners are a decent proxy for the culture of the organization, pure alignment on values and desired impact doesn’t imply alignment on operational culture, which makes understanding the cultural similarities and differences even more imperative. Discussing in advance what will happen if things don’t go as planned is also crucial.

Acquisition Structures

There are three structures we use to facilitate acquisitions or investments: integrated acquisitions, independent companies, and sponsored ESOPs.

Integrated acquisitions are companies we acquire and fully integrate into TiER1 Performance (T1P), our largest operating entity (in this model we are a strategic buyer). Beyond the intangible qualities of organizations described above, the firms that best fit with T1P tend to be in the broad human performance space providing culture, leadership or strategy services, custom learning and development, organizational change management, and communications, or sometimes specialty process, design, or technical capabilities. They generally have one or more large-scale clients along with many past clients or dormant relationships. Our general model involves integrating the brand, sales, and delivery teams with T1P, usually over a six- to 12-month period, and then jointly grow by expanding the services delivered to their relationships and, in some cases, leveraging their unique services to expand existing T1P relationships. We integrate sales efforts and provide additional sales support resources to the organization to fuel further growth. The delivery teams are integrated with T1P’s teams, providing additional career growth opportunities and expanding the capabilities that can be delivered. We create a financial model (which I explain below) where everyone shares in the growth, keeping our collective goals aligned. The process of integrating sales and services takes work, but again, it’s in our best interest to create an environment that retains, engages, and develops employees as they are essential to future growth. Ultimately, in this model we end up with a fully integrated team. This is reflected in T1P’s leadership, which includes many people who joined by acquisition.

The second less common model for us is investment in standalone independent companies. While the same intangibles are necessary, standalone investments that work well include firms that have a well-established financial foundation (e.g., they are consistently profitable), have a very different customer focus than T1P (e.g., they have small clients, niche industries, and/or niche geographies), or have an adjacent or different service focus (e.g., innovation, specialized digital design services, marketing, etc.) where the retention of a distinct brand and customer value proposition has value. In this model, the value from TiER1 is to provide a graceful long-term transition of ownership and/or strengthen leadership while providing efficient back-office operations and scale and creating front-end partnerships and growth strategies. This model also offers companies an instant employee ownership model to support transition without the cost and complexity challenges that come with establishing an ESOP.

In both models, we generally value businesses around 3X to 4X EBITDA, with the potential to earn an additional 1X to 2X through a shared growth model. We typically base this on the past three years of operation as businesses’ financial performance often fluctuates. In fact, many companies don’t have consistent profit levels; so, to create a “fair” value, we sometimes develop a conservative approximation of the profit we believe we can generate given the organization’s current revenue base.

Our payment structure is typically 40–50% up front in cash with the remainder being paid over a three-year period where organizations must exceed a revenue “floor” to earn these payments. The revenue floor is usually 80–90% of recent years’ revenues—a target that’s almost always very achievable but also mitigates the risk of the unknown as it is impossible, in small services businesses, to accurately assess the quality of the relationships and the momentum of those relationships. There is significant asymmetric information where the seller knows much more about the business than we do. The revenue floor earnout model aligns our interests. Again, the final 1X to 2X is achieved through a shared growth model where the seller may get 10–25% (depending on other financial structures) of the growth in the client base, including active clients and past relationships. For example, if you had a $2M revenue business with $200,000 of profit each of the last three years, our model might look like: $700,000 (3.5X) purchase price, with half paid at closing and half tied to a revenue floor of $1.7M. A shared growth model might include another 20% of revenue growth, so if the client base grows to $3.5M over a three-year period, an additional 20% of the $1.5M in revenue growth is paid to the seller. In this case, that would be $300,000, or effectively another 1.5X the original profit for a total payout of 5X.

This model has worked very well for businesses that have a strong foundation of clients and leadership has the opportunity to expand on that through new services and capabilities and greater resources. Businesses that have a less stable foundation of clients have had less financial success. A key success criteria in the integrated model is jointly identifying the seller’s role. Our goal is to integrate leadership as part of our team, usually for a few years (or more). Doing so, though, requires thoughtfulness about the strengths and interests of the individual(s) and their effective placement inside the company.

The third model that we have been actively developing is the concept of a sponsored ESOP, where TiER1 takes on the challenges of cost, complexity, and capital to help an organization create its own ESOP. One of the biggest financial differences between this and an independent entity inside our ESOP is that the shareholders are separate from each other. With a sponsored ESOP, the entity has more brand and operational independence from TiER1’s ecosystem but also has more independent costs and risks. We provide the financing that allows the sellers to get paid largely up front and help them navigate the process, structure, administration, and management of the ESOP. As part of our financing, we take warrants in the company and have a vested interest in supporting its ongoing growth and aligning the interests of all involved. We also offer efficient fractional back-office support wherever needed. This model allows companies to develop an ESOP while mitigating many of the risks associated with the standard process.

In summary, succession is a tough topic to navigate. There are lots of personal motivators and concerns, and timing matters too. Understanding the various options and their pros and cons as you prepare for future possibilities is important. I hope these insights help you better understand what plans can exist and how the valuation process can work. If you have questions or are seeking more information on any part of this process, reach out to me directly at g.harmeyer@tier1impact.com.