CoreConnex | Business Systems for IT Service Companies

Perhaps this is a walk on the “wild” side for those who are more comfortable with technology and less comfortable with finance. For many owners of VAR, MSP, and outsourced IT service companies, it’s the technical challenges that they thrive on. Lock them in a room with their own P&Ls and cash flow statements and the keen edge fades.

Business owners and senior managers know they must do a good job managing company finances if they want a business that has value, but they often miss a few key steps along the way. The problem is generally not a lack of effort or commitment. Most owners do a lot of things well and make honorable efforts to manage their finances, but they often fight a loosing the battle and don’t know that they are just a few steps away from winning.

In the business courses I teach at the University of Washington and in the nation-wide research I have conducted, I am continuously surprised at the level of disconnect that exists between seasoned business owners and the financial processes they manage. They are generally well aware of revenues and the costs of doing business. Most owners generally understand “accounting” and are well versed in billing, tracking expenses and reading the P&L at the end of the month. But achieving a positive bottom line is only a small part of financial management.

One very popular misconception is: “If I make a profit and have a solid net worth on my balance sheet, I have achieved success.”  Important, yes, but these are mere entry points and certainly do not ensure a good end game.  Reality sets in years down the road when the proud business owner is shocked to learn that no one is willing to buy his company for anything near what he expected. This can be a very sad day, but at that point it is too late for corrective action.

So let’s start at the end and work backwards. For most business owners, the goal is to eventually sell their company and cash-in on the rewards of years of hard work. Granted there are some business owners that only see their companies as a “life-style” choice and really don’t care if they ever build a future financial value - they just don’t want to work for someone else. But for everyone else, there are kids to put through college, mortgages to pay, and a desire to enjoy some of the finer things in life - not to mention a desire to avoid poverty in their later years.

For owners who would like to get a good return for their efforts, it is important to build the business and manage the finances early on with this end in mind. Rarely does a valuable company just happen by accident. And you don’t need to wait until it’s time to sell the company to reap the benefits of smart planning. A company that is built with equity value in mind can also;

• get better bank credit lines
• attract investment and give up less stock
• acquire other companies and expend less capital stock in doing so
• take a stronger position in a merger…

… and the list goes on.

So what do we mean when we say “equity value.” First, this is not just about profitability and net worth.  You won’t find this on the balance sheet. The real value of a company is a function of the market. It’s just like selling a home. It doesn’t matter how much you have invested nor how well it was maintained. The real answer shows up when the broker does the analysis of comparables: “what else is available, what has sold, what did someone pay and how does it compare?”

Another way that price gets defined is when an expert is brought in for this purpose. Most buyers hire a financial expert to perform “due diligence” and they will probably conduct a “company valuation” (note that “valuation” and “evaluation” are two different things). They will look at “comps” (comparable companies and recent purchase prices), they will look at market trends and they will take a close look at the company’s business trend lines. When the trends and basic numbers come out well, the value of a company can be multiple times its earnings and often way beyond balance sheet equity or asset value. And of course the opposite can be true: a company that has a strong P&L and solid book value can be worth very little in the real-world market if it has irregular trend lines and an uncertain future.

A competent financial expert performing due diligence will raise questions such as:

• 1. What is the overall rate of growth over the last 2 to 3 years? Is it sustainable and consistent or is it erratic?
• 2. What is the company’s ability to generate “disposable cash?” This is a slightly different way of looking at profit and typically includes owner bonuses and equity distributions.
• 3. Is the expense structure in line with industry norms?
• 4. Is the company a low-cost commodity play or does it get premium prices for high-quality results?
• 5. Does the company have a balanced client portfolio or is the portfolio “top-heavy” “bottom heavy” or “all over the map.”
• 6. Is the company’s revenue coming from recurring service contracts or does revenue come from one-time projects or the sale of products?
• 7. Does the company have high or low client turnover (churn)?

In other more established markets, business owners understand these issues and what it takes to get predictable valuations. The IT services market is a very young niche and it has a long way to go before it becomes more predictable how the market will value the typical IT service company and how that will translate into a purchase price.

But even with this uncertainty, there is a lot a business owner can do to build value. Here are 7 important actions that can maximize the future value of your company.

1. Have good financial “instrumentation” (graphic reporting) so that trends and patterns are visual - not just piles of numbers. Work toward steady growth and increasing margin over time.
2. Get industry statistics and benchmarks to compare against. Without market data there is no way to know how your business compares to others. And then, stay on top of market data because it changes and you must respond.
3. Set business growth goals and track progress against goals. Include goals for basic financial ratios and translate these goals into actions that your whole team is accountable for.
4. Smooth out your revenue growth line. A lumpy line will get discounted.
5. Balance your client portfolio with a good distribution of sizes and types of client companies.
6. Move toward monthly retainers and away from business that must be constantly resold.
7. Avoid simplistic fee-per-unit pricing for your services. This will make you look like a commodity player and force you to continuously lower your prices to compete. The high-road to higher margins includes a combination of Service Level Agreements for a defined list of assets with an adjustment for systems complexity. The end result is a fixed monthly fee that gets adjusted periodically or as new hardware and software is added. This is not simple and is not a commodity. This is, however, part of why you are their long-term trusted IT partner.

Without a deliberate process of setting financial direction and measuring progress, the best you can hope for is accidentally having a happy surprise in the end. This is about the same as Los Vegas odds.