Insights of the Year – Our Top 10 Blogs of 2017

2017 was a busy year for Equiteq, closing deals and advising consulting firm owners on their growth and exit strategies across Europe, the US, Australia and Asia. Within our market there are unique takeaways and insights for owners to consider when thinking about a sale.

As owners and acquirers set their 2018 priorities, we recap the learnings from Equiteq’s most read blogs of 2017.

  1. Should I sell my consulting firm to an overseas buyer?

Here we discuss the opportunities overseas buyers present, how to attract them and how to deal with the challenges these approaches can bring.

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Margin presentation is crucial to maximize equity realization

Margin presentation - money buckets cropped

Having previously given a general overview of consultancy financials and then having a closer look at revenue, our series now brings us to margins, which can make a big difference in how appealing your business is to a potential buyer.

There are different types of margins, but the two that consulting firm buyers focus most on are the gross margin and the EBITDA (Earnings before Interest, Tax, Depreciation and Amortization) margin. It is very important to note that in the context of a sale process, both of these critical statistics can be “adjusted”, or modified from your normal accounting practice for managing the business, or paying tax. These adjustments are never intended to mislead a buyer, in fact the opposite is true. By moving some expenses to different categories, or eliminating some altogether, a seller is actually showing the buyer a financial statement that more accurately reflects how the buyer would view the financial performance of the business once integrated into their organization. The proper presentation can have a material positive impact upon value realized in a deal.

Gross margin is simply gross revenue minus the direct costs required to deliver services or engagements that generated the revenue. Direct costs always include the salaries and benefits of the consultants and independent contractors that delivered the work to the client; think of them as a fully loaded staff cost.

Direct costs should also include the time spent by partners in delivering client work, but not the time spent selling, developing intellectual property (IP), administering the business or writing blogs or other marketing activity. When we are preparing a client for sale, we will often analyze and adjust the direct costs for these items to ensure that the gross margin statistic accurately reflects the cost of delivering the company’s services, rather than also including the costs of running or growing the business.

This is important to a sale process because a buyer might make a judgement about a selling firm based on the gross margin percentage – if it is low they might think “perhaps there is a utilization issue!” However, if in reality there is significant partner compensation in direct expenses that should be in selling expenses, then the buyer is coming to a wrong conclusion based upon incorrect information. By way of example, let’s say a shareholder/partner makes $500,000 salary, and this normally appears in direct costs (thus reducing gross margin by $500,000). If, in fact, this partner only spends 40% of their time on client engagements, then 60% of their salary ($300,000) should be moved to the admin bucket (more on admin shortly). Therefore, gross margin is $300,000 higher.

EBITDA margin refers to the profit generated by the business after subtracting administrative expenses from the gross margin. Some administrative expenses are obvious, such as rent, the salary of administrative professionals and IT expenses.

A critical adjustment when calculating the real EBITDA statistic is related to allocating the shareholder bonus properly between compensation related to running the business and profit sharing (which would not be included in administrative expenses required to run the business). This can have a significant impact on a sale transaction: A seller might want to reduce his or her implied salary in order to present a higher EBITDA statistic to a potential buyer. However, in reality what they are saying in this case is that they are willing to work for that reduced salary after the transaction.

The final piece of the puzzle when calculating the correct EBITDA statistic in the context of a sale process is to remove any non-recurring charges that a buyer wouldn’t expect to incur under their ownership. For example, if you spent $25,000 last year on legal fees related to installing a share bonus plan for junior partners we would expect to remove that expense from the administrative bucket when showing a buyer what our “true” EBITDA is. As opposed to the adjustments discussed above, this actually increases margin by removing an expense from the income statement. A buyer will agree with the approach, however, as long as they would not have the same expense under their ownership.

Given the complexities of the various margin statistics, and the importance of getting it right first time when speaking to a buyer, it is critical that care and expert advice is taken to ensure the financials are correct.

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Financial profile of a healthy consulting business

Profile of a healthy consulting business

By David Jorgenson, CEO at Equiteq. 

Equiteq has analyzed thousands of consulting and professional services firms over the past decade. In fact we recently conducted research with the buyers of consulting firms to find out what they look for when buying consultancy firms. Although there is a wide range of buyer requirements, the most popular criteria for buyers was found to be consulting firms with revenues between $15m and $40m, stable financials, deep domain expertise and leverageable intellectual property.

Through our work and research we have gained a unique perspective on the financial metrics of consulting firms. These are important for firm owners to understand while they are growing their businesses and when it’s time to sell. This series will look at the important metrics, with the first exploring what a healthy consulting business looks like.

Below is a chart showing our view of the financial profile of a successful consulting firm. This is a general view and individual consultancies may vary.

Equiteq’s model profile

model graph

The first bar of 100% represents total revenue. The key thing to note is that not all revenue is created equal. We’re sure you have your own views on what types of engagements are better for your business, such as being more profitable or helping to add a more strategic string to your bow. Buyers will have their own views on the most valuable engagements and these can be a key driver of price in a sale process. We’ll go into more detail on revenue in the next blog of this series.

The 50% bar in this chart can either represent delivery cost, or its exact inverse – gross margin. This means that healthy consulting businesses have at least 50% margin after all the costs of delivering services are paid. Importantly, this does not mean that all partner costs need to be paid as part of this 50%, because often we find consulting businesses aren’t allocating partner time appropriately to the next category of expenses.

The next category of expenses is admin or overhead costs, which are the costs of running the business. This segment should come in at around 30% of costs. As mentioned above, it is important to make sure that the accounting is accurate. For example, if a partner spends 40% of her time selling, then 40% of her salary needs to be in the overhead bucket. If not, analyzing the resulting metrics won’t provide the correct answer! We have found that allowing 30% to be spent on admin and overhead costs provides a reasonable balance between investing in growth while not overspending on central infrastructure.

The remainder is EBIT, or Earnings Before Interest and Tax. EBIT (or EBITDA) is the accounting profit that is available for distribution to the owners of the business. Accurately positioning the true profit of a business is the most important numerical topic when entering a sale process or negotiation, so we will dive into much more detail on the topic in a subsequent blog.

While we will go into further details about each of these factors in future blogs, it is important to have an overall view of what kind of balance there should be in a healthy consulting business. If revenue growth is high but gross margin is low, questions need to be asked about pricing, or utilization, or the accuracy of the management tools used to run the business. Equally important, if overheads are too low a consultancy may be missing out on growth opportunities which could impact its sale price in the future. By having an understanding of what the profile in a consultancy should look like, owners can take steps to remedy problems and set their business up for future success.