Acquisition Valuation of a Service Business: Risks and Rewards of Intangible Assets

Written for Valorem Principia

This article provides an understanding of the valuation factors to consider when acquiring a service business. Please note that the information herein is solely for discussion purposes and does not constitute valuation advice and would not apply verbatim to any specific business. We recommend that all acquirers consult with legal counsel and valuation professionals.

Intangible Assets

During a recent meeting a client asked: “...this is a service business...the company’s only assets are its people and its clients...it is doing very well and sales exceed $8 million per year...but I truly can’t tell whether any of this amounts to much money...where do I go from here?” Such analysis is common. Often times, in service businesses the vast majority of assets are intangibles such as client lists; trained, effective employees who are difficult to replace; systems, procedures and know-how; name recognition, image and reputation; leases in preferred locations; long-term contracts with credit-worthy customers; patents, licenses and recipes; ability to charge above-market prices; etc. The existence of such intangibles results in going-concern value and goodwill above and beyond the aggregate value of the business’ tangible assets. The aggregate value of the tangible assets of a service business, such as a language school, is minimal. Tangible assets may include computers, a photocopy machine, a language laboratory, a few textbooks, and furniture. These tangibles, once depreciated to their current fair market value in use, may not amount to more than two to three hundred thousand dollars for a business that generates annual revenues of $8 million and cash flows of $1.5 million. The true value in such a service business lies in the intangibles: the assembled and carefully selected personnel of teachers and administrators; contracts with clients; teaching methods; and systems and processes. These intangibles create going-concern value.

The determination of value and risk for service businesses is complicated and time consuming because the most valuable and irreplaceable assets are intangibles. Typically, the acquisition of intangibles represents the most risk for buyers and investors.

Valuation Process

A business valuation assignment is a two-step process: 1) determining sustainable (projected) profit levels for the business; and 2) assessing the level of risk associated with projected profits (reflected in the multiplier or the capitalization rate). Once these two items have been selected, the formula is simple: business value is equal to profits multiplied by a multiplier or divided by a capitalization rate. For example, if a restaurant generates earnings before interest and taxes (EBIT) of $200,000 per year, and recently restaurants have been selling for multiples of 4.0x EBIT (or a capitalization rate of 25%), then that restaurant will be worth $800,000.

The problem is that projected profits or EBIT are difficult to develop. EBIT multipliers or capitalization rates, when available, vary substantially from business to business, industry to industry, region to region, year to year, and, some times, for no apparent reason. It is not unusual to see an EBIT multiplier range of 3x to 7x for a specific business type. For the restaurant above, that would mean a valuation range of $600,000 to $1,400,000, or the possibility of overpaying by 133%.

Projecting Earnings

To develop projected earnings, we must determine revenues and expenses. Since revenues come from customers, it is important to carefully review all customer facts and trends. These include, but are not limited to, payment history, account sizes (% of revenues), change in account size over time, and potential for new accounts. One essential aspect of customer trend analysis is to understand how customers are generated and the factors that can affect the sources of client generation. For example, if a business has an excellent location, then street construction activity and changing traffic flows for an extended period, can seriously affect revenues and profits. Alternatively, if the sole owner’s excellent reputation as a world-class seismologist is the primary source of business, then “key-person” risks (e.g., old age and extra curricular activities such as bungee cord jumping) must be thoroughly examined. For the seismologist, a condition of the acquisition must include a succession analysis that answers the question: can the buyer preserve the business?

When the business has several long-term contracts with clients, the buyer must study the likelihood of contract renewal. An example, the towing business that has a long history of profitable and sole-source contracts with several police departments. It is very likely that various regulatory agencies would investigate this company for monopolistic and antitrust behavior, corruption, price-fixing and even racketeering. The legal costs to defend such challenges could easily wipe out all of the business’ earnings.

The ability to sell to customers, i.e., the product offered by the business, depends on the product. For the language school, the product consists of the multi-lingual teaching staff, the teaching methods and the curriculum, the language tapes, the quality of the facilities, the schedule of classes, the price structure, the registration process, and the reputation of the school. All of these must be organized and assembled in a format that is appealing to the customer.

Capitalization Rates

The capitalization rate or the valuation multiple reflects the risks associated with the earnings stream projected above. The relationship between capitalization rate and multiplier is as follows: Cap Rate = 1 / multiplier. The lower the risk, the lower the capitalization rate; and the higher the risk, the higher the capitalization rate. For multipliers, the inverse is true: the higher the risk, the lower the multiplier; and the lower the risk, the higher the multiplier. Capitalization rates and multipliers can be derived from existing transactions, if available, or can be calculated by using recognized methods. The Capital Asset Pricing Model (CAPM) is the most common model relied upon to develop capitalization rates. Another method is the build-up method. Most authoritative textbooks on business valuation provide in-depth explanations of these methods. Remember, capitalization rates and multipliers have a significant impact on value. Proper research and due diligence are required to select the appropriate capitalization rate and multiplier.

Conclusion

When acquiring a service business, the buyer must consider numerous factors before setting a purchase price. The intangible assets, which typically comprise a significant portion of the value of a service business, must carefully analyzed. The risks and rewards are reflected in the capitalization rate and the projected earnings, which are key components for determining value. Proper research and due diligence are necessary to avoid costly mistakes.

About the Author

Mr. Nevin Sanli is President and co-founder of Sanli Pastore & Hill, Inc. (“SP&H”), a specialist business valuation and litigation consulting firm employing 15 to 20 individuals. SP&H has offices in Los Angeles, San Diego, Sacramento and San Francisco.

SP&H specializes in business valuations for mergers and acquisitions; business litigation; condemnation (valuing goodwill and leasehold); privatization; financing including private placements, venture capital and IPO’s; ESOP’s; partnership and corporate dissolutions; and estate and gift tax planning.

Mr. Sanli has been engaged in business valuations since 1986 and has performed over five hundred consulting assignments. He has testified as an expert witness on numerous occasions. Mr. Sanli speaks frequently on the subject of business valuations to audiences ranging from 15 to 250 people. In addition, Mr. Sanli is the official trainer of the Redevelopment Institute of the California Redevelopment Association. Mr. Sanli also designs customized training courses on business valuations.

Mr. Sanli is an Accredited Senior Appraiser (ASA) of the American Society of Appraisers, business valuation discipline. He has been elected a “Global Business Leader” by Who’s Who Worldwide and is a member of Marquis’ “Who’s Who in Finance and Industry” and of “Who’s Who in the World”.

For additional information on business valuations or services offered by Sanli Pastore & Hill, Inc., feel free to contact Mr. Nevin Sanli at (310) 571-3400, or e-mail your inquiries to nsanli@sphvalue.com.