The main character in my book owns a marketing agency. I picked a service business intentionally because, with so much of the value tied up in the owner’s relationships, service businesses are notoriously difficult to sell. The founders leave and so do the clients, making service businesses next to worthless unless you can figure out how to make the clients stay when the owner(s) want to go.

David C. Baker is one of four people in the United States that knows this better than anyone. In addition to being an author, David has made his living over the last few years selling agencies. He’s done 140 deals and along with two or three other M&A professionals, David is considered the guru of building and selling a successful agency.

I’ve been doing some research in preparation for my Creating a Sellable Service Business Workshop and I had a chance to interview David. I thought you might like to read our exchange:

John: What are the unique challenges of selling a marketing agency?

David: Mainly it’s the fact that there are no outside non-participating investors for smaller firms. I can’t think of one, actually. And that’s typically because the firm trying to find a buyer has grown up around the principal and his or her desires and hasn’t been viewed primarily as a business.

John: What attributes are buyers looking for in the agencies they are buying these days?

David: Specialized focus is always first. Second is financial performance. Third is client list that they will have access to. Gone are the days when someone buys a firm just to have a presence in some market. And very few transactions are initiated simply to add capacity instead of building it.

John: How are agencies being valued?

David: The more typical agency is being valued at 3-5 times EBITDA after normalizing principal compensation. Interactive firms are going at significantly higher multiples.

John: What proportion of the overall deal is “at risk” in some form of earn-out? (I’ve heard big agency holdcos are now paying 3 times upfront cash with up to 7 available in an earn-out; can you verify or refute?)

David: Usually one-third is paid upfront at closing; about one-third is paid in a longer-term note (not tied to any type of performance) over 3-5 years; and the remaining one-third is tied to earn-out goals.

John: What is the biggest mistake you see agency principals making when it comes to selling their firm?

David: Thinking it has value just because they’ve worked hard for many years, even though the financial performance has been meager; along with thinking that their company name has some sort of tangible value.

John: What proportion of the agency principals who sell last the full length of their earn-out? Why or why not? And do you have some survival tips?

David: The answer to that depends quite a lot on the terms of the sale. If most of the transaction value is in the earn-out, they are likely to stay. The typical scenario is that the principal DOES remain for the entire earn-out, especially since the typical earn-out has now dropped from 5 years to 2-3 years.

John: What other things do agency owners need to know about selling a service business?

David: They shouldn’t expect any money from it. I’ve participated in 140 deals, but the four of us who are active in that space for smaller marketing firms still find deals for a small percentage. The value of the firm is primarily in the cash it throws off to the owner on an ongoing basis, and not in a pot of gold at the end of the rainbow, unless all the stars align properly.

If you’d like to meet David in person, he runs a New Business Summit every January in Nashville.

I had dinner last night with a guy who trains dogs. He used to train dogs for an hourly fee but decided to shift his model from selling time to selling a product. Now he markets a set of pre-recorded dog training videos through his web site and earns more than a million dollars a year selling something people buy while he sleeps.

Selling a product, rather than your time, offers a fantastic leap in lifestyle benefits and makes your company more sellable. When I recently surveyed merger and acquisition (M&A) professionals about what makes a business attractive to a strategic acquirer, virtually all of them agreed that a company’s potential growth is second only to profitability among the factors that make the company a must-buy in the eyes of an acquirer.

But the term “growth potential” is a little nebulous, so I asked the M&A guys to go a layer deeper and explain how buyers assess a company’s scalability. The most important question they ask themselves is: “Could your business be five times bigger without adding five times the cost or complexity?”

Customization is the five times killer

If you customize what you sell, it means people are involved, which makes it impossible to scale quickly.

In my research business, we started out offering to customize the reports we sold, but it robbed our business of its leverage. Once we standardized and stopped offering to tailor reports, we were able to scale up.

Yes, we lost a few customers who were used to the custom reports, but we added many more new subscribers because we weren’t wasting our time and money customizing and could invest those resources in hiring sales people.

Often the need to customize comes from ten percent of your pickiest clients. If it is time for you to say goodbye to the customers who want their Big Mac without the pickles, follow these three steps:

1. Narrow your target market. Part of the reason you have to customize may be that your audience is too wide. Decrease the diameter of your bull’s eye until you can identify a group of people who like what you sell off-the-shelf and develop a discrete offer for your ideal customer.

2. Productize. When customers buy services or time, they are accustomed to being able to provide input. At the same time, everyone is used to buying products off-the-shelf. The trick is to brand your stuff consistently so customers start to see it as a tangible product instead of a squishy service.

3. Say no. When customers ask for special tweaks, explain that your offering has been time-tested for X number of years to render the best results. Explain that you’ve honed your formula and – just like the twelve herbs and spices or the secret for getting the caramel inside the chocolaty pockets – you’re not willing to change something that has been proven to work. I have found that most people respect your intellectual integrity and go along with your standard offering. The one or two who insist on special favours are not worth the hit your valuation will take when you’re ready to sell.

PS. One available spot at my “Sellability” workshop

One of the 16 attendees at my upcoming Sellability Workshop in Chicago on September 28 & 29 just cancelled. This session is not for everyone (attendees must have between $500,000 — $7,000,000 in annual sales), but if you want his spot, this is your opportunity. First come, first serve, and I have no plans to repeat the session. What you’ll learn is the “inside baseball” on selling your company for a premium from people who have actually done it. Apply here.

(photo courtesy of Flickr/pamhule)

I’m starting a new business and have decided to build it from the start to be attractive to a strategic acquirer. My most important operating metrics will be Net Promoter Score, cost per account acquired and number of users, and my financial statement of choice will be a cash flow statement, not my P&L.

If I get it wrong, I’ll most likely walk away with nothing.

One of the most important decisions we all need to make is whether to position our business for a financial acquisition or a strategic one. It’s a high-stakes call that can end in disaster.

The safe route

The safer – but potentially less rewarding – route is to build your business for a financial acquisition. Financial buyers will base their offer on all of the core operating metrics taught in grade nine economics: How much profit do you make? How fast are you growing? How much recurring revenue do you have? How dependent is your business on you? The basics.

Swinging for the fences

A strategic acquirer will look past your financial metrics and dream about what your business could be worth in their hands. They’ll model the impact on their business if a small percentage of their customers buy your product – or if your customers buy their product. They might see your little business as a Trojan horse that will allow them to enter a brand-new world of buyers. That’s why, for example, Herman Miller announced plans to buy Hong Kong-based POSH Office Systems. It bought the company not for its $50 million in revenue but for POSH’s relationships with Chinese furniture dealers and the corresponding billion-dollar opportunity of selling office furniture to Chinese companies.

Because strategic acquirers have much more to gain, they also pay a higher price. Nowhere was that more evident than Microsoft’s recent acquisition of money-losing Skype for $8.5 billion. My guess is that Ballmer wants to convince more Windows users to upgrade to a new version (half are still running XP) – and a slick Skype integration could be the killer app. If Skype was valued by a financial buyer, it’d be worthless. But if Microsoft can use Skype to get a good chunk of a billion Windows users to upgrade, it might be well worth $8.5 billion to Microsoft shareholders.

The curse of the high school dropout

A strategic acquisition sounds great, right? So why wouldn’t everyone prepare their business to be attractive to a strategic?

For the same reason most right-thinking people don’t buy lottery tickets. If you pour all of your money into building a company for a strategic acquisition, you’re playing high-stakes poker. If it works, you get rich. If it doesn’t – and you end up with an unprofitable company – your business might just be worthless in the eyes of a financial buyer (fives times zero is still zero).

It’s like the promising high school athlete who forgoes education to focus on making the big leagues. If he is more talented and determined than a million other kids with the same dream, he is set for life. If he misses, he will probably end up pumping gas.

So why can’t you position yourself for both a strategic and a financial?

Well, you can, but you’ll probably end up with a business that is sucking and blowing at the same time. Just like Newton taught us, every action is accompanied by a reaction of equal magnitude but in the opposite direction.

When you’re optimizing for a financial, you’re not optimizing for a strategic and vice versa. For example, the company positioning itself for a strategic acquirer will pour all of its cash into product development. If the same company was positioning for a financial exit, it would limit its R&D spending to the bare minimum to protect its market position and maximize its EBITDA.

If POSH had been looking for a financial exit, it might have focused on directly serving a small number of very profitable Hong Kong-based investment banks instead of undertaking the cumbersome job of building a mainland dealer network that an acquirer like Herman Miller could leverage to enter China.

How to decide

Imagine who would want to buy your business and try to quantify the impact acquiring you would have on their business. If the financial upside for an acquirer is substantial (1,000% + return on their investment in the near term), then perhaps it makes sense to roll the dice and build for a strategic acquirer, assuming your lifestyle needs do not require you to draw much cash out of your business while you build it.

If, in your most sober analysis, a buyer’s upside will be more modest (less than 100% in the near term), it may be better to hedge your bets and build a good business with real profits any financial buyer would love to acquire. A profitable business will still be attractive to a strategic, but a financial will rarely be interested in an unprofitable business.

One final note on the subject of strategic acquisitions: I still have three spots left for The Sellability Workshop. I’m not planning to repeat it, so please fill out the application here if you want to join us.

Drive your first shot into the woods and most friendly golfers will give you a “Mulligan” which allows you a second chance to start out right. Lately I feel like I’ve been handed The Entrepreneur’s Mulligan.

Don’t get me wrong, my last business wasn’t a disaster, but there were things I would have changed:

• Over the years, I had painted myself into a corner by having employees on a hodgepodge of bonus plans which reflected my latest thinking on incentives at the time of hiring them. Hire enough people over a long enough period and you have a labyrinth of employee agreements to juggle.
• I had longstanding suppliers we stuck with out of inertia, not because they offered the best of what we needed.
• I had given one-time favours to some customers, only to have them taken for granted as long term elements of our relationship.

And because all of those things involved people and emotions and drama, they weren’t as easy to change as it was to write them just now. Over time, my business began to feel like how I imagine an artist feels mid-way through a painting when she realizes she selected the wrong-sized canvass: it’s too late to turn back, but it will forever be a flawed piece of work in the artist’s mind.

Starting fresh

And that’s one of the things you can look forward to after selling your business: you will get a blank sheet of paper and some time to design your next company. I think we entrepreneurs are creative souls and every artist is striving to create their masterpiece.  Can you name a song writer who wrote only one tune? How about a legendary architect who designed just one building or a photographer who took just one picture?

So why would an entrepreneur want one business as their legacy?

Scribbling on my blank sheet

I for one have started to jot down some ideas about my next business. My first few baby steps have been to:

• Develop a long terms vision and a set of values for my company which I personally find motivating and I think will resonate with people who come to work with me.
• Write an analogy for my new business which will quickly communicate the business idea to people who want to get involved.
• Quantify a 10-year goal and a basic strategy.

I’m sure I won’t get this business completely right either. And nor does the golfer who gets a second chance at their tee shot hit a hole-in-one. But that’s not the point. I’m just savouring that sense of excitement you get when someone gives you another chance to do it all over again.

So, have you taken your Mulligan?

It was my wife’s birthday yesterday. She’d kill me if I told you how old she turned but suffice it to say, it was a biggie (there is a zero on the end).

In an effort to preempt melancholy, I made my wife her favourite breakfast of all time: an egg McMuffin complete with a happy face made of HP sauce:

Kicking off a milestone birthday right

Finding English Muffins in this part of France is no easy task but I was determined to get this milestone birthday off to a good start. Which got me thinking, about milestones. Why is it that we celebrate birthdays or the start of a new year? On paper, it’s just another day, right? But milestones give us an excuse to hit the pause button and remind us of what we have accomplished, all the things we have to be grateful for and gives us permission to dream a little about the future.

So what are the milestones that you’re celebrating on your journey to building a valuable, sellable company?

If I may, here are a couple I think you should consider commemorating.

1. The day you go “all in”

Most of us start businesses while doing something else. You plan your business, maybe make a couple of sales but, as long as you have a job or a few credits left to get, you’re still on the fence. Then one day you decide to quit everything else and commit 100% to getting your business off the ground. Now that’s a day worth celebrating –  not for what you have accomplished, but for the courage it takes to jump off the fence and the adventure that lies ahead.

2. First time someone (or something) makes a sale

Making a sale as a business owner is a bitter sweet feeling. The sense of triumph is tainted by the realization that your business is dependent on you showing up. But the day that your salesperson walks into your office with a signed contract or someone hits the “buy” button on your website without you having to nudge them is a glorious moment in time.

3. A New home for your company

There is something special about moving into new space. A lot of business owners are creative souls at their core and a new environment to work in usually means you’re growing and investing in the future. Definitely a time to throw a party.

4. The million dollar mark

Hitting a million dollars in revenue is a significant achievement. Of the 27 million businesses in the United States, roughly 3%  do more than a million dollars in sales. You’re in an elite group – celebrate.

5. The first shot over the bow from an acquirer

The first time someone approaches you about buying your business is a special milestone. It’s usually an informal advance, maybe over lunch or at a trade show. I remember the first time I was approached by a big company who wanted to buy my marketing agency. The partner in charge of business development asked me to lunch and, once the plates had been cleared,  asked me if I would ever consider selling my company. I asked him what he was offering and he made a vague reference to “ten times”. I thought ten times was a very generous offer for a service business until he revealed he was referring to ten times net income after tax and that most of it would be made available on a five year earn out. While I passed on the offer, a little part of me was flattered to have been approached.

6. One million dollars of EBITDA

While you don’t need to have a million dollars of pre tax profit to sell your business, it is an important milestone to shoot for because it opens the door to a wider range of buyers. Some strategic acquirers won’t consider a business will less than a million dollars of Earnings Before Interest Taxes, Depreciation and Amortization (EBITDA). Also, financial buyers (e.g. private equity companies) have started to come “down market” and some will now consider businesses with a million dollars in EBITDA. You may not want to sell to a financial buyer, but having another offer at the table creates competition for your business.

7. First management team meeting

Cobbling together a senior team is a slow process but eventually you realize that your business is no longer all in your head and that other people have (and want) a say in things. Sitting down with your management team for the first time is a moment to savour – you’ve built a business capable of attracting senior talent and you have taken a giant step towards being sellable.

8. LOI / term sheet / Expression of Interest

Another big milestone is the first time you get a written offer to buy your business. More than empty chatter over lunch, this is a formal document where someone validates – in writing – that your life’s work has value to someone other than you. There’s still a long road ahead before closing day, but you deserve to celebrate.

9. Closing day

You need to down an entire bottle of your favourite bubbly for surviving the due diligence period which is a little bit like how I imagine a stoning to feel.

10. Your last day

In my last company, I remember the final day like it was yesterday. I had ridden my bike to work so when it was time to go, I put on my biking clothes, said my goodbyes, and road off down the street. The spring air has never felt so fresh, my bike had never felt so light. Freedom is a feeling to behold.

Out of interest, what milestones are you celebrating?