Service Business Valuation
Web-based services businesses are any type of business that provides a virtual service through the internet, rather than in-person. These can range from SEO services, to web-design, copywriting, online coaching or tutoring, bookkeeping, and so on. The primary distinction for a services business is that there is a person, whether the owner or outsourced, that physcially performs the work or service that is being sold. If you run a services business where the service is automated through a software, then you have a SaaS business.
Service businesses are a great way for a sole-proprietor to make a living online, but they can also be lucrative investment opportunities when the service being provided is fully outsourced.
Web-based service businesses usually sell in the range of 1.50x to 2.75x earnings, or SDE.
The biggest factor to valuation for service businesses is who performs the services, whether it’s outsourced or in-house. However, there are numerous other important factors that we will touch on here, including niche, financial trends, customer base and concentration.
Top 5 Factors in Service Business Valuation
- Who performs the service?
- Customers and concentration
- Niche
- Financial trends & revenue consistency
- Customer acquisition
1. Who performs the service?
In our experience, services business are usually started by someone who is an expert in the field of service they are providing. They start out as a one-man show, until demand increases to the point at which they need to hire help. As the business continues to grow, the owner spends less time actually performing client work and more time managing the business.
Who performs the service is the most important valuation factor. Businesses that are one-man shows, where the owner does 100% of the work are very difficult to sell. Investors are looking for passive business opportunities, so having 100% of the work outsourced is super important for finding a buyer and getting a top dollar valuation.
Two things happen when the owner performs all of the client work: the potential buyer base shrinks drastically, and valuations get cut in half. The buyer base shrinks because we now need to find a buyer who is an expert in the niche, has enough time to dedicate to the existing client base, and has enough money to buy the business. Valuations get crushed because there is risk of clients leaving when the owner leaves, if the new buyer wants to outsource the service work he now has to hire someone which decreases profitability, and there are less buyers so the process is less competitive.
If you are looking to sell your service business, outsourcing the client work is the most important thing you can do. It increase “sell-ability” and value.
2. Customers and customer concentration
The second most important factor is who your clients are. There are a number of things a buyer will want to analyze regarding the customer base:
- Are customers businesses or consumers?
- How “sticky” is the relationship? Do clients leave for other service providers frequently?
- Is the service being provided one-time (ie. web-design) or recurring (ie. SEO services)?
- How much revenue do the top 5 customers represent?
The best client is one that needs your services on a recurring basis and has a sticky relationship that makes it difficult for them to switch to a competitor. When you look at your overall client base, you want a diversified client list with respect to revenues – you don’t want 1-3 customers generating 80% of revenues.
3. Niche
The niche is important because it impacts competition and the customer base. I’m going to compare to services/niches as an example: accounting/bookkeeping services, and web design.
With web design, there are thousands and thousands of freelancers, agencies, and providers on the market. The barrier to entry is very low. Most websites are built on easy-to-use softwares like WordPress now, so it’s easy for a one web developer to jump into your site and fix, improve, or upgrade things. Because of this, there are low switching costs so there is less customer stickiness. Additionally, most people just need their website designed once. They might come back for tweaks, refreshes, etc., but for the most part it is a one-time service.
On the otherhand, let’s look at an accounting service. Your customers are businesses, who need monthly financials tracked. They are recurring, because they need you to provide the service for them every month. There is a highier barrier to entry because the client is going to want a CPA compiling the financials, and becoming a CPA is way harder than learning how to build a wordpress website. There is customer stickiness because getting a new provider to step into your books, understand the way you account for things, etc. is more complicated than switching web-designers.
Which niche would you prefer to be in?
4. Financial trends and revenue consistency
Financial trends are important for selling any online business. Selling a business that has been consistently trending downwards is very difficult and hurts valuation as investors are looking to compensate themselves for the risk that the downward trend continues.
Buyers want to see year over year increases and the most recent 3-6 month trend be upwards. Additionally, revenue consistency is another factor. Volatile revenues are a risk for any business and tend to be more present in service sites that sell expensive one-time services. Revenues are probably pretty consistent from month to month for a bookkeeping business, but for a web-design business they can be very volatile if you have one month where you land and complete two big dollar projects.
Highest valuation = upward trends in revenue and profitability and consistent (not volatile) revenues.
5. Customer acquisition
Growing a services business is largely dependent on acquiring new customers. The methods for acquiring these customers can have an impact on valuation.
The best types of customer acquisition are: organic search, referral, word of mouth, and other free forms of customer acquisition that take zero time and cost zero dollars. Other less attractive forms are: paid advertising, paid lead gen, and anything else that requires paying money for customers.
This is going to be less impactful than the above factors, but it can also influence them. Businesses that get customers free are going to have higher margins and more growth opportunity as a new owner could choose to invest the cash flow in some paids marketing strategy like ads or lead gen.