When a business owner wants to scale, or attract investment or sell their company, one of the challenges they face is the lack of solid, financial information.
The purpose of financial information, and what potential investors or buyers want to know, is that your business model as advertised works.
There are five key pieces of financial information a business owner should have (I have used a B2B SaaS software company as an example, but these principles apply to companies in any industry).
WHAT DOES IT COST TO PRODUCE A PRODUCT?
The cost of sales should be fairly burdened. The gross margin will show whether there is pricing power.
WHAT DOES IT COST TO ACQUIRE A CUSTOMER?
With this information and the gross margin, the business owner will know the long-term value of a customer
The most important of these is the growth and composition of ARR and MRR.
RELIABLE GAAP FINANCIALS
For a SaaS company these mean that revenue is recognized according to US or international reporting standards and that main expense categories are classified in a way that allows comparison between companies in the same industry.
The business owner should ideally have three years of annual and monthly budgets, compared to actual results, with evidence of review.
Creative agencies have a problem in that they must constantly look for new projects. Project work can be very interesting, but relying solely on project work presents a number of challenges:
1. Revenue, profitability and cash flow can be volatile. Sometimes cash flow can be very good, while other times there can be a real cash crunch.
2. Obtaining new project-based work requires significant time and resource investments. It can be up to five times more expensive to obtain a new customer than to retain an existing one.
3. It can be difficult to plan long-term staffing—not only due to the unpredictability of the agency’s workload, but also because new clients have unfamiliar budgets.
Recurring revenue is revenue that is likely to return in the future. Developing sources of recurring revenue that cover at least some of your monthly fixed costs can have several benefits, including a more predictable cash flow. Doing so can also help you build longer-term customer relationships, which tend to be significantly more profitable over time.
The most common type of recurring revenue is subscriptions, with some of the most well-known examples being cloud storage solutions (like Dropbox) and software services (like Adobe Creative Cloud). But businesses across the board are increasingly utilizing subscription-based models, with other notable examples including rentals, home maintenance, and IT services and repair.
Subscriptions have also become increasingly important for digital marketing firms, which frequently offer monthly packages containing pre-defined bundles of services that are offered for a set, recurring fee. These bundles usually include an allocation of the agency’s normal suite of offerings, such as digital advertising, content marketing, social media management, graphic design and branding.
Almost every aspect of your business can be sold via subscription. One key for doing so is to ‘productize’ your service offerings, which is described in more detail later in this article.
In addition to (or instead of) ‘productizing’ your services, consider selling products. This approach is less common, but can be embraced by creative agencies for which offering monthly ‘packages’ is either unrealistic or something the owner simply doesn’t want to do.
If you are a design or marketing firm that sells to corporate clients, which in turn sells to consumers, you will not have direct knowledge of the consumer market. I have seen examples of marketing firms that have a side business selling select consumer products, which can be viewed as a firm spreading itself too thin. However, if done right, it can accomplish several things:
– It can show potential corporate clients that the firm really knows what clients are trying to accomplish. For example, the marketing firm can tell its potential clients, “we know how to sell to millennials, because we do it.”
– It can provide an additional, steady stream of revenue that’s not subject to the fluctuations of project revenue.
– It can increase brand awareness, which raises the value of the firm.
Some marketing firms specialize in one industry. For example, some only market to pharmaceutical companies, utility companies, or government entities. Whatever the industry is, it almost certainly holds events.
I have seen marketing firms hold conferences for the industries they target, or for their industries’ target audiences (or consumers). For example, a marketing firm with pharmaceutical clients might hold a conference for physicians, or a wellness summit aimed at patients with the types of conditions those companies’ products treat.
If an industry conference is already well established, there are ways to piggy-back on that conference. One example I have seen is for a design company to create a booklet, magazine or video for that conference.
Why turn services into products?
Turning your service offerings into standardized products increases the value of your business. When these standardized products are sold on a recurring basis, you can more easily train staff to both sell the products and perform the services required. This reduces the dependency of the company on you as an owner and allows your company to scale much more easily.
Furthermore, by offering products that can be sold on a recurring basis, you’re increasing the value of your business since recurring revenue streams are predictable and repeatable.
How to turn a service into a product
Identify recurring problems your customers have, and turn your solutions into standardized offerings—or, “products.” A few examples of recurring issues for which solutions can be turned into products by a typical creative agency include monthly content, digital or print marketing requirements; regular social media management; and branding and visual design updates.
What are the key considerations when turning services into products?
It’s worth addressing both your operational requirements and your client-facing features.
Specialize in repeatable, trainable tasks for which you have capable staff that can effectively and consistently deliver the product. If you plan to customize your solutions to each client’s specific requests, you risk being unable to deliver. Furthermore, when you anticipate and then try to accommodate all possible client requirements, you end up having people on your staff with skills that are very rarely used.
Consider offering fewer, but higher-quality products. It will be easier to train your staff, and they’ll become very proficient at what they do. A premium product can command a premium price.
Pricing and terms are equally important when it comes to successfully transforming services into products. Consider establishing a recurring monthly fee for your products. This price may initially need to be estimated. For example, if you’re offering an unlimited number of support calls, you’ll need to estimate the number of calls you’ll receive and the number of staff you’ll need to manage those calls. You should ensure the price is high enough to cover your expected costs, and also high enough to attract quality clients. For example, it’s preferable to serve 10 clients who pay $297 per month, compared to 30 clients who only pay $97 per month. You’ll be able to provide these 10 clients a higher level of personal attention.
Always err on the side of charging too much. If you’re looking to attract people to your products, but are concerned that the cost might be off-putting, you can always consider offering a ‘freemium’ package that entices clients with basic offerings but requires them to upgrade to receive premium service.
Also, it’s crucial to establish clear and reasonable service standards. These might include clearly-delineated hours of service, or specific turnaround times. For example, an IT services company may choose to receive calls only during business hours and the early evening. Clients requiring 24/7 support might need to invest in a premium package priced accordingly. Likewise, bookkeeping companies can establish guaranteed turnaround times for filings, based on the number of days required upon receipt of complete supporting documentation.
Where possible, implement client contracts. This is a good way to establish recurring revenues and create operational effectiveness. A good approach can be to have a relatively short up-front contract period, in which you invest in the onboarding process and then move to a month-to-month arrangement.
It goes without saying that it’s important to ensure the services you turn into products are of the highest calibre and are packaged neatly. All the standardization and quality customer service in the world will not help you if your product isn’t optimal.
Standardized service offerings that offer solutions to recurring, pressing problems faced by your customers can be turned into products.
How can this be done?
Consider establishing a monthly price. This price may need to be adjusted through trial and error. For example, if you’re offering an unlimited number of phone calls, you’ll have to estimate the likely number of incoming calls, and the number of staff necessary to handle those calls. You should set the initial price high enough to cover your expected costs, and also high enough that not everyone will pay it. (Otherwise, you might end up deluged and unable to deliver your service obligations).
If you must err on the price, err on charging too much. Then, offer a ‘freemium’ option where something is offered for free. (But no actual phone or e-mail support.)
Terms are just as important as price.
If you charge premium pricing, you have to offer very high value while still outlining reasonable expectations. Some examples of how you can do this are as follows:
Timing: Restrict the number of hours
If you offer technical support, only offer it during certain hours—or offer a premium package that provides service outside those hours. Similarly, you could make it clear that you only work through one issue at a time, although you promise to solve the issue within a reasonable timeframe. (What is reasonable depends on the service.)
If you provide a marketing service, you might guarantee to provide the collateral a certain number of days after you receive all the necessary specifications.
These can work both ways. With a contract, you have guaranteed income for a certain period of time. But if your customer is not happy, insisting on a long contract may not be optimal. A good approach is often to have a relatively short up-front contract period, and then transition to month-to-month.
The financial requirements of recurring revenues are important.
For project-based revenue, the cost of acquiring a customer must be amortized over the first project. With recurring revenue, the customer acquisition cost (CAC) will likely have to be amortized over a longer period. CAC is defined as the total direct marketing expenses, plus the salaries of your sales and marketing personnel, divided by the number of customers acquired. If your marketing costs in a month are $10,000, salaries are $20,000, and you acquired five new customers, the CAC would be $6,000. ($10,000 plus $20,000/5.)
The Lifetime Value of a customer (LTV) is defined as the gross profit per customer divided by the churn. (Churn is the opposite of customer retention; it’s the percentage of your customers you lose on a monthly basis.)
Now, assume these customers will pay $2,500 per month, and that your cost of sales is $1,000 which the gross profit per customer $1,500. If your churn is 4 percent per month, the lifetime value of a customer (LTV) is gross profit per month/churn, or $1,500 ($2,500 less $1,000)/4 percent equals $37,500.
The LTV/CAC here is $37,500/$6,000, which equals 6.25. That’s a good ratio. Anything over 3 is acceptable.
The key is to measure and manage the key numbers: Customer acquisition costs, gross profit per customer, and churn.
It’s a good idea for marketing firms and other creative agencies to develop streams of recurring revenue. The two main reasons for this are, first, because recurring revenue can more easily free up the owner’s time for day-to-day business development, and second, because it will increase the business’s value.
How can you outsmart your competition and grow your company? Let’s say you are the owner of a small company. It is profitable, because bills are paid and money is in the bank. However, the company is not growing or becoming more profitable. Many companies devise corporate strategies to achieve these goals and some include very specific interim goals. But a great number of strategies are poorly executed and goals are not achieved. One factor that distinguishes great companies from many ‘also-rans’ is that they are very analytical; they have detailed, actionable information, and a deep knowledge of their entire value chain whereas many companies are data-rich, but information-poor. Key Performance Indicators (KPIs) measure factors that are crucial to the success of your company. KPIs are a way of measuring how the company is achieving its interim goals and therefore executing its strategy. These KPIs should be informative and specific to the decision maker that uses them and be ‘drillable’, i.e. a decision-maker should be able to drill down and see the various components that make up a single number. General Motors has the following six main KPIs: Market share, revenue, operating profit, cash flow, quality and customer support. Each one of these can be subdivided. Market share, for example, can comprise submarket models and analysis. A Balanced Scorecard is one common way to look at KPIs. This assesses the achievement of goals from a number of different perspectives; those of the Customer, Internal Business Processes, Financial Performance and Innovation and Learning.
In the GM example, four of the top six KPIs are related to financial performance, one is related to the customer and one is related to internal business processes. This is fairly typical of an owner or top executive perspective. Others, such as a VP of sales, would require different KPIs related to customer satisfaction, retention, acquisition and support. Now let look at the five KPIs a business owner needs to follow and which are crucial to the success of his business. These indicators need to be strategic. I have chosen five indicators which are all related to financial performance as they are important from a top-level point of view:
1. Sales growth. What are your sales and how much are they growing. For example, if you want to double your sales in five years, they need to increase by 15% by year.
2. Gross Profit. What is gross profit and the gross profit margin as a percentage of sales?
3. Net Profit. What is the net profit and what is net profit as a percentage of sales?
4. Return on investment. What is the net profit divided by the amount of capital you have invested in the business? Ultimately, running your business has to be more profitable than putting your invested money in the bank or buying publicly traded dividend paying stocks.
5. Cash Conversion Cycle. What is the time it takes to spend cash (on inventory, materials etc.) from the time it is collected through customer sales? Even if very profitable, a business must keep a keen eye on its cash to ensure that there is not a sudden cash crunch.
To improve your business, you need to review these 5 numbers on a regular basis.
Have you ever wondered what determines the value of your business?
Perhaps you’ve heard an industry rule of thumb and assumed that your company will be worth about the same as a similar size company in your industry. We have found there are eight aspects that drive the value of your business, and they are all usually more important than the industry you’re in.
Not convinced? Let’s look at Jill Nelson, who recently sold a majority of her $11 million telephone answering service, Ruby Receptionists, for $38 million.
That’s a lot of money for answering the phone on behalf of independent lawyers, contractors and plumbers across America.
To give you a sense of how high that valuation is, let’s look at some comparison data. The Value Builder system has studied over 30,000 businesses in the last five years. The average value for companies looked at was 3.6 times pre-tax profit.
When they isolated the administrative support industry that Ruby Receptionists operates in, the average multiple offered for these companies over the last five years was just 1.8 times pre-tax profit.
Jill Nelson, by contrast, sold her interest in Ruby Receptionists for more than 3 times revenue.
There were three factors that made Nelson’s business much more valuable than her industry peers, and they are the same things you can focus on to drive up the value of your company:
- Cultivate Your Point of Differentiation
Buyers of companies do not buy what they could easily build themselves. If your main competitive advantage is price, an acquirer will rightly conclude they can simply set up shop as a competitor and win most of your price sensitive customers away by offering a temporary discount.
Ruby Receptionists invested significantly in technologies that ensured that no matter when a client received a phone call, that call would be routed to an available receptionist. Nelson’s competitors were mostly low-tech mom and pop businesses who often missed calls when there was a sudden surge of callers. The technology at Ruby Receptionists could handle spikes in phone calls because of the unique routing technology Nelson had built that transferred calls efficiently across her network of receptionists.
Nelson’s acquirer, a private equity company called Updata Partners, saw the potential of applying Nelson’s call-routing technology to other businesses they owned and were considering investing in.
- Recurring Revenue
Acquirers want to know how your business will perform after they buy it. Nothing gives them more confidence that your business will continue to thrive post sale than recurring revenue from subscriptions or service contracts.
In Nelson’s case, Ruby Receptionists billed its customers through recurring contracts—which made buyers confident that the company was there to stay.
- Customer Diversification
In addition to having customers pay on recurring contracts, the most valuable businesses have lots of little customers rather than one or two biggies. Most acquirers do not want any customer to represent more than 15% of revenue.
At the time of the acquisition, Ruby Receptionists had 6,000 customers paying an average of just a few hundred dollars per month. Nelson could lose a client or two each month without skipping a beat, which is ideal for reassuring a hesitant buyer that your company’s revenue stream is bulletproof.
Nelson built a valuable company in a relatively unexciting, low-tech industry, proving that how you run your business is more important than the industry you’re in.
How does the blender manufacturer Vitamix get away with charging $700 for a blender when reputable companies such as KitchenAid make blenders for less than half of that?
It is because Vitamix specializes in one thing, and they do it better than anyone else.
WhatsApp was just a messaging platform before Facebook acquired them for $19 billion US. Go Pro produces the best helmet mounted video cameras in the world. These companies stand out because they poured all of their limited resources into one big bet.
The term “goodwill” is often used in conversation as a subjective description of how much your customers like your business.
However, in valuing a business, there is nothing subjective about the definition of goodwill. It is the difference between what someone is willing to pay for your company minus the value of your hard assets.
Are you trying to time the sale of your business so that you exit when both your business and the economy are peaking?
While your goal to build the value of your company is admirable, here are five reasons why you may want to sell sooner than you might have planned: