What are the most important factors investors look for when valuing an IT or digital services business? I’ve spent most of my career on that exact question — first in investment banking and now as a partner and investor at Tercera.
As an investment banker, my colleagues and I had the privilege of selling technology services firms to almost every global systems integrator, including Accenture, Cognizant, Capgemini, DXC, IBM and Wipro (just to name a few). In the process, I learned a lot about what they value — and what they don’t. Most, if not all, of the key value drivers for strategic acquirers hold true for financial investors as well.
At the risk of oversimplifying an incredibly complex topic, here are the top value drivers for strategic and financial investors (in no particular order):
- Revenue: mix, predictability, scale, concentration, and especially growth
- Independent Software Vendor (ISV) partnerships and market focus
- The team: management and employees
Revenue: Mix, Predictability, Scale, Concentration, and Growth
Revenue is the most important element in valuing a technology services business, and there are many different lenses through which to evaluate revenue.
When investors talk about revenue mix for a technology services firm they mean the breakdown of revenue between resell, professional services (time and material or fixed price engagements), or managed services. In general, professional services revenue is valued higher than resell revenue, and managed services revenue is valued higher than professional services.
The more predictable a firm’s revenue, the more valuable it is. A managed services revenue model (usually) has more revenue visibility than a professional services or resell-oriented business. So, in theory, an investor will value $1 of managed services revenue higher than $1 of professional services. Both will receive a higher value than $1 of resell revenue.
In practice though, it is more complicated. For example, professional services firms that have highly reoccurring revenue (i.e. revenue from the same clients year-after-year) with great margins will likely be valued at parity or even above a predominantly managed services revenue firm.
Strategic investors want to acquire firms that will ‘move the needle’ to compensate for the level of effort that goes into any M&A transaction. For this reason, the revenue sweet spot for strategic acquirers is usually around $30+ million in annual revenue.
Financial investors will target different revenue scales depending on their own strategy and target returns. For example, growth equity investors, like Tercera, typically look for a company with $10+ million in annual revenue.
Investors tend to be wary of companies with high client revenue concentration. The possibility of losing one key client and the revenue profile changing materially is, to put it mildly, suboptimal in the eyes of investors. Ideally, a technology services business has balanced diversification. It has enough large clients to demonstrate it can land and expand significant accounts, but enough diversification so that no single client represents a material risk.
Last, but certainly not least, is revenue growth. The single most important variable in predicting a technology service firm’s valuation multiple is revenue growth. As an investment banker I ran countless regressions on the businesses I sold, and time-and-time-again revenue growth was the most important variable in predicting valuation multiple.
The single most important variable in predicting a technology service firm’s valuation multiple is revenue growth.
A question we get all the time from founders is ‘how fast should I grow’? Answering that question in detail takes some explanation, so it will be the topic of a future article. In the interim, here are some book-ends:
- Growth floor: Grow at least as fast as your primary ISV partner
- Growth ceiling: Never grow so fast as to compromise client or employee satisfaction or – stating the obvious here – run out of money
ISV Partnerships and Market Focus
One of the most important strategic decisions a technology services firm can make is which ISVs to partner with. A firm that is a strategic partner to large, high growth ISVs with meaningful service intensity will be valued higher than a firm working with more mature, slow growth ISVs.
Partnering with the right ISVs is only the first step. What is even more important to investors is the depth of a firm’s ISV partnership. What is their partner tier designation? How many employees have certifications? How strong are the firm’s relationships up and down the ISV’s executive ranks? All of these elements matter (a lot) to investors.
Partnering with the right ISVs is only the first step. What is even more important to investors is the depth of a firm’s ISV partnership.
When it comes to market focus, I break this out into two areas — region and vertical.
First, the regional market where a firm has a delivery and client presence. There is no universal right or wrong answer to this piece of the puzzle. A firm’s ‘north star’ for which region to target clients in should be a function of where they have the most existing expertise and where the opportunity is the greatest. Similarly, there is no one-size fits all answer to an ideal delivery footprint. The ‘right’ delivery footprint should be determined based on what creates high quality outcomes for clients for the right price, plus access to a mix of talent, and proximity and convenience to clients and team members.
The second element of market focus relates to a firm’s end-client industry vertical specialization. Investors and acquirers understand that industry-specific skills and business insights are key to digital acceleration, and clients and ISVs are demanding this kind of expertise. For example, a firm with deep expertise serving large financial services companies will stand out from, and be valued higher, than a consultancy with broad but shallow experience across many industries. Focus, focus, focus.
The Team: Management & Employees
In a services business, the team is everything.
If a firm has nailed each of the different revenue lenses discussed above and has strong ISV partnerships and market focus, then there’s a good chance the management team is strong. But… smart investors look beyond the metrics and what’s been packaged up in an investor pitch.
Smart investors look beyond the metrics and what’s been packaged up in an investor pitch.
A world-class management team should have vision, and prioritize customers and employees, so before any first meeting, a good investor will spend 15 minutes looking at a firm’s online reputation and the pedigree of its management team. The first stop will likely be Google and Glassdoor, followed quickly by LinkedIn. The other factor is whether the founders have sold a business before. That experience is rare and highly valued.
Then, investors will look deeper. Is management recruiting and retaining the right people? Is the team deep, or is it just a handful of rockstars at the top? Is there enough bench talent so that as the business scales the next layer can continue to drive quality predictable growth?
If you’ve ever wondered whether investors really pay attention to analyst review sites like G2, Clutch, Gartner Peer Review and partner marketplaces for its key ISVs, here’s your answer. You bet they do. Most understand this is only one data point, but smart investors do look at all these sites. If customers look at them, why shouldn’t investors?
Depending on the revenue scale of a firm, investors will either focus on gross margins (revenue less direct costs associated with client delivery) or EBITDA margins (Earnings Before Interest Taxes Depreciation Amortization). Most investors use the EBITDA profitability metric as a proxy for operating cash flow, but all will look at both.
The faster a technology services firm is growing the more likely investors are to focus on gross margins over EBITDA margins.
The faster a technology services firm is growing the more likely investors are to focus on gross margins over EBITDA margins. The rationale for this distinction is that high growth firms do not have a ‘mature margin structure’ to fairly evaluate profitability at the EBITDA level. Said differently, high growth firms will invest in sales and marketing to capture share, and hire ahead of demand for key resources and administrative functions to support their growth. For this reason, they may not be profitable at the EBITDA level today, but could be in the near-to-medium term.
What Founders Can Do to Improve Valuation
What follows might sound a bit directional and simplistic, but without looking at the details of an individual business, here are a few pointers on how to turn the dials in your business to improve valuation.
If your challenge is:
- Weak revenue growth: You may need to revamp your GTM strategy. You may need a new sales leader and/or sales team members. Revisit your pricing to ensure you are competitive.
- Revenue concentration with 1-2 clients: Develop compelling case studies around these clients and focus on selling to clients with similar business problems.
- Out-of-favor ISV ecosystem: Think about carving this business unit out from the rest of your business, or reskill existing resources for a faster growing ecosystem.
- Lack of an industry vertical focus: Pick an industry — ideally one that is relatively underserved and does not yet have a dominant services company for your ISV.
- Weak gross margins: Lower costs by building out your delivery pyramid, bringing in lower-cost resources in emerging markets or areas with a lower-cost of living. You can also look at increasing prices, which is something that might be required (and acceptable to customers) given inflation.
One last thing: if you’re reading this and thinking, “wow, my services firm has all (or even many) of these value drivers nailed!”, we would love to talk to you. And if you don’t have it all figured out, let’s talk anyway. We might be able to help directly or connect you with one of our advisors.