Operating and Investment Risk Profiles Effect on Enterprise Values (EV)

Ephor Newsletter Q3 2024

We at Ephor trust the first half of the operating year 2024 has met or exceeded the early-year expectations. Sector-wide, despite all the political disruption, both labor and general cost inflation, and general economic uncertainty, coupled with the positive increase in demand for outsourcing services: Ephor’s benchmarking process, suggests that 8%-10% revenue growth YOY is very common with ratable increases in gross profits (GP) and the coterminous EBITDA.

Unfortunately, enterprise valuations (EV) have lagged materially behind due to the high interest rate environment for buyout financing and the "increasing risk profiles” of the sector operating companies. As such below we have outlined a few of the risk profile factors that institutional investors have become very risk averse to.

It's logical that the “more risk” in the business model and its processes, the lower the resulting EV and vice versa: Those companies that command the highest EV illustrate the below Risk Profile attributes:

  1. A Portfolio of Revenue Sources: Service businesses that produce consistent and profitable new client acquisition & revenue growth illustrate multiple venues of revenue sources, as such, they are not solely dependent on “Direct Sales" initiatives. Ideally, Direct Sales should not exceed more than 35% of the new revenue production. The target new revenue & new client mix that investors most appreciate illustrate revenue sources from Channel Partners (35%), Other Strategic Relationships (15%), and the remainder from “Raving Fan” Referrals (15%). For additional guidance see Ephor’s publication: Portfolio of Revenue Sources.

    • Over the past 4 quarters, our database includes 7 successful transactions where an effective Portfolio of Revenue Sources exclusively added an average ~12%+ premium to the exit EV value.

  2. Specialization & Productization of Services: One of the most effective discriminators in the marketplace for all outsourcing companies is the ability and skill to package its services into “Products”. Those products are then supported and distributed through effective product marketing to very specific niche markets. Institutional investors have rewarded “operators” handsomely for their expertise & proven success in this area.

    • Over the past 5 quarters, our database includes 5 transactions that illustrate Productization has commanded a 7%-10% premium to the exit EV value.

  3. Low Customer Concentration Risk: It’s only logical that a “dependence on a few customers” is risky business. Specifically in the outsourcing sector the institutional guidelines on “concentration” include:

    • No individual customer should represent more than 15% of the total revenue of the company

    • No 3 customers should represent more than 35% of the total revenue.

    • No 2 customers should represent more than 40% of the GP generation.

  4. Often, we hear from the CEO Entrepreneur that despite the risk: “we need and will take the cash flow”. At Ephor we can provide numerous examples where the cash flow has been offset by EV discounting due to this risk factor.

    • In fact: our database indicates that over the past 3 years, it's been common for “the discount for high customer concentration risk” to be as high as 50% of the Cash EV: with the remaining 50% of the EV potentially being realized through challenging 3–5 year earnout structures.

  5. Insulated or Contractually Obligated Revenue Streams: while difficult to achieve in the outsourcing business it always adds to the EV when the customers are contractually obligated to the company through term length of contracts, minimum volume of service volumes, revenue sharing, and liquidated damages clauses upon termination, etc. This is an area where productization and specialization have illustrated great returns.

    • Of recent, 2 transactions in 1H 2024 illustrated “customer contractual glue” resulted in an average of a 10+% EV premium.

In closing, no discussion on Enterprise Value (EV) drivers would be prudent and complete, if we did not mention a few additional attributes that can negatively impact EV values:

  • High Fixed Cost to Variable Cost Ratios are generally a result of too much capacity, lack of scalability in the SG&A business processes coupled with excessive executive compensation, etc.

  • Benevolent Dictatorships & CEO Centric Organizational Structures where the CEO Entrepreneur is the “Hub” of all decisions & outcomes. A talented, results-proven, and empowered leadership “teams” always command an uplift in EV value.

  • High Executive and Leadership Turnover: have “outside executive hires” been successful or not? This is an area of evaluation that we at Ephor focus on as we evaluate the value of the company. This provides us with great insight into the culture, its ability to change, and the existing leadership effectiveness.

Finally, at Ephor, we fully realize the Enterprise Value (EV) of your business likely represents a high majority of your net worth. Each month on behalf of our ~30 institutional investment partners, and/or your peers, we average evaluating and generating Enterprise Value input for 2-3 operating companies.

As such, we are happy to provide a few minutes to answer additional questions or provide further clarity on how valuation mechanics are deployed. Simply email us at meier@ephorgroupinc.com, or visit the website at Ephor Group, Inc.

In any event, we wish you well in Q3!

All the Best,

Garry E. Meier

Managing Partner and Strategic Practice Lead

Ephor Group, Inc.