10 Characteristics of Professional Services Firms that Influence Their Valuations
Hinge specializes in providing marketing and related services for professional services firms. I use a slightly different term to describe the same kinds of companies – specialty services firms. As a business appraiser, I focus on the special characteristics of specialty services firms that can make them a bit more valuable than other kinds of companies. If you run or are in a specialty services firm, these insights may be informative to you.
What kinds of companies are we talking about? The list is long, but here is a representative sample:
- Consulting firms (variety of stripes)
- Architectural/engineering firms
- Accounting firms
- Business appraisal firms
- Some brokerage firms (like insurance brokerage)
- Specialty IT consulting firms
- Asset or wealth management firms
- Trust companies
- Other types of professional services firms
As you can see, there are a wide variety of specialty services firms. What, you might ask, do these various kinds of companies have in common? After observation and reflection over the years, I’d offer the following list of characteristics that specialty services firms tend to have in common. Eight of them tend to contribute to higher valuations than firms that lack these characteristics. And the other two can detract from value. By focusing on these characteristics at your firm, you and your team can build the value of your specialty services firms.
- Good margins and profitability. Profit margins for well-run specialty services firms can be 10% to 20% or better. To be sure, I’m talking about profitability after market compensation for professionals, so there is a clear distinction between the returns for labor and the returns to ownership.
- Low capital intensity and low capital expenditures. Specialty services firms are not capital intensive.We need to buy furniture and computers and software and services. For instance, in our business appraisal and financial advisory firm there are very few machines in our offices. We do have a couple of copy machines (they really do more than that these days) and binding equipment, and that’s about it. We don’t have to buy buildings, heavy equipment, manufacturing equipment, rolling stock, airplanes or other capital items. Reinvestment requirements are relatively nominal for most specialty services firms.
- Low working capital requirements. Like all companies, specialty services firms must finance their accounts receivable and payrolls, but most firms have very good payment terms with their customers. For example, we ask for a 50% retainer on all set-fee engagements, and a retainer on other projects that are performed on an hourly basis.
- High cash flow. The combination of good margins, low capital intensity and low working capital requirements tends to yield relatively high enterprise cash flows.
- Recurring revenue. Many professional services firms have some or lots of clients that do business with them on a recurring or continuous basis. We’ve all heard the saying that it is cheaper to keep an existing customer than it is to find a new one. Recurring customers are beneficial in many ways, including 1) marketing costs for retention are minimal, 2) recurring business is more predictable than periodic or spasmodic business and tends to reduce riskiness of cash flows, and 3) it is easier to grow if you have to replace a smaller portion of your customer base that you lose to attrition, competition or for any other reason.
- Borrowing capacity based on cash flow. Many specialty services firms have no debt; however, their steady and predictable profitability is viewed favorably by bankers and other capital providers. This borrowing capacity can come in handy for leveraged dividends, leveraged share repurchases, other ownership transition transactions or for financing an attractive acquisition.
- Brand recognition. Brand recognition for specialized firms tends to be greater than for those that are less specialized. There are two kinds of brand recognition here: enterprise and personal brands. Here we refer to the enterprise brand which, if good or excellent, tends to promote business development and growth.
- Pricing ability and profitability. The specialized nature of services offered by specialty service firms helps them to avoid commodity pricing, or pricing at the lowest ends of various service lines. Customers tend to be willing to pay more for experts that are recognized in their fields than for generalists who purport to be able to do anything for anyone. The pricing power of specialty services firms tends to facilitate profitability and margins, which takes us back to the first characteristic above.
Note that all of the above characteristics tend to promote profitability, growth and value while reducing risk. But all is not always rosy. Specialty services firms often have a couple of characteristics that can increase risk and reduce value.
- Key person risk. If a specialty services firm is too heavily dependent on one or a couple of rainmakers, there is a risk to the expected future cash flows if any of them were to leave. This is often true for smaller firms in their early growth years, since many specialty services firms are started by one or two professionals.
- Personal brand versus enterprise brand and goodwill. We alluded to this above, but if all of the goodwill of a specialty services firm resides in one or two key persons, there is little basis for growth or significant value. That is why it is important to build your firm’s enterprise brand. Individual professionals often have their own personal brands, but these professionals tend to do better when they can benefit from an enterprise brand.
At this point, you might ask, ‘So what?’ Why are these characteristics important for specialty services firms or, more important, why do they matter to your professional services firm? A very short valuation lesson will help address the questions.
The value of any business is the present value of all expected benefits (i.e., cash flows, or #4 above), discounted to the present at a discount rate that reflects the risks associated with achieving those cash flows. The expected cash flows have two components, the base level of cash flow, say your last twelve months EBITDA (earnings before interest, taxes, depreciation and amortization), and the growth expected from that level into the distant future. On the positive side of the valuation equation:
- A higher base level of profitability enhances value relative to a lower base. Obvious, but true (#1, #4 and #8 above).
- Low capital intensity and low working capital requirements suggest that for every dollar of earnings (say before interest and taxes) there are more dollars available for reinvestment for growth or for distributions (#2 and #3 above).
- Recurring revenue tends to diminish risk and to promote growth, as well as minimize marketing costs, all of which enhance value.
- Brand recognition can enhance pricing power and profitability and helps avoid the competitive jungle of the lower end of clients in your field.
- Finally, on the positive side, the borrowing capacity of strong and growing cash flows tends to facilitate transactions that can enhance shareholder returns and shareholder value.
Few things are free, and specialty services firms have risks. Key-person risks must be considered carefully in the context of specialty service firm valuations (#9 above). What are you doing to reduce that risk in your company? Personal brands are great, but limited. What are you doing to grow your enterprise brand (#10 above)? One of the benefits of sustained enterprise marketing is an umbrella enterprise brand under which individual professionals can prosper.
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