A key to attracting a buyer to purchase your firm is your ability to prove you have healthy client relationships. Learn how to convert client relationships into appreciating assets on a balance sheet.
Sean Magennis [00:00:15] Welcome to the Boutique with Capital 54, a podcast for owners of professional services firms. My goal with this show is to help you grow scale and sell your firm at the right time for the right price and on the right terms. I'm Sean Magennis, CEO of Capital 54 and your host. On this episode, I will make the case that a key to attracting a buyer to purchase your firm is your ability to prove that you have healthy client relationships. I'll try to prove this theory by interviewing Greg Alexander, Capital 54’s chief investment officer. Greg has helped many firm and their leaders convert client relationships into appreciating assets on a balance sheet. Greg, great to have you today. How would you frame up this critical topic?
Greg Alexander [00:01:18] Yeah. You know, the key here is the balance sheet. So if you're if you're an owner of a professional services firm right now, you probably get your monthly reports from your accounting firm and the one you pay most attention to is cash flow and the next one you probably pay most attention to is income and maybe you look at the balance sheet once in a while. However, as an owner, not an employee, as an owner the balance sheet is the most important of all the financial reports and the client relationships are actually assets on the balance sheet. So that's my advice. First, as a way to frame this up, is that, I would you know, think about your balance sheet first, focus on that. So the balance sheet calculates the net worth of a firm, you know, i.e. what a firm is worth and it does so by listing the firm's assets and then it subtracts its liabilities. So for those of you who are not financial wizards out there, let me just give you a real simple quick analogy to illustrate and maybe I'll use your your home as my example here of your balance sheet. So let's say the assets of your home are the land it sits on in the house itself and let's say these two assets, the land and the structure worth half a million dollars and the liabilities of your home are primarily the mortgage and for this, let's assume your mortgage is 300 grand. So by simply subtracting the liabilities from the assets in this example, I can see that your net worth of your home is two hundred thousand of the equity of your home is two and a thousand. So a firm's client relationships are its assets and like all assets, they should be proactively managed and cared for so that they appreciate in value. And unfortunately, many firms turn their clients into depreciating assets and this happens when they treat their clients as transactions. Clients are viewed as deals. So the framing of this conversation today, Sean, is to think of your clients as balance sheet assets, much like your home. You know, you get a new roof...
Sean Magennis [00:03:23] Yes.
Greg Alexander [00:03:23] ...Install a new air conditioner, you paint the house, you take care of it so it goes up in value. And the same thing has to happen with the client relationships.
Sean Magennis [00:03:31] That's a beautiful analogy and and very understandable. So, Greg, when you when you are considering a firm to invest in, how do you go about assessing the health of their client relationships? Because this is this is key.
Greg Alexander [00:03:45] If it is so, there are many ways. Where do I get started? Here, let me let me try to share maybe a few simple ones for the audience. So one area that will be placed under the microscope is revenue concentration. So many boutiques have really sexy looking financial statements. But when you peel the cover off, you can see that they really are house of cards. They generate most of their revenue profits from a very small number of clients and if one of these clients was to leave, the financials completely fall apart. And unfortunately, this is very common, especially with project based boutiques. These firms live and die by the big deal in their operating model is very unreliable and therefore not sellable. So be sure not to have a single client equal to more than, let's say, 10 percent of your billings so that would be kind of one thing to consider, revenue concentration.
Sean Magennis [00:04:37] Yes.
Greg Alexander [00:04:38] Another simple one to get started with is the tenure of relationships. So firms that generate billings from clients for years are very attractive. This suggests that the client relationships are very strong. If the firm did not deliver value than the clients would go elsewhere. So as it relates to tenure of relationships, a rule of thumb is that the average client tenure should be three years or more. Okay, another one to consider as it relates to client relationships and whether or not they're appreciating or depreciating assets on your balance sheet could be client quality as a measure of the strength of relationship. So, for instance, let's say your firm generates billings from startups. That's going to discourage buyers. Startups have a very high failure rate in revenue from this segment can be unreliable. In contrast, if your boutique generates its billings from the Fortune 500. This will encourage buyers. Large enterprises are unlikely to disappear overnight. So revenue from this segment is going to be really valuable. So those are some ways to think about measuring the strength of your client relationships.
Sean Magennis [00:05:54] Outstanding, Greg and resonates strongly with me because in my experience, particularly when I was running my boutique for 14 years, I had many clients for the entire 14 year duration. In fact, some of my strongest relationships were those that we sold in the early days and went with us and through the cycle and we learned so much from that and that was a key to us unlocking the value that we received when we sold that business. So really important. So revenue concentration, client tenure and client quality. These are really fantastic, Greg. So there are three easy to understand items and hopefully you are audience members will absolutely spend time making sure you get these three right. So, Greg, an additional item is what should a professional services firm leader do to improve these three, these three areas?
Greg Alexander [00:06:52] So investors are going to steer away from boutiques that do not institutionalize their relationships. So evidence of this can be found in kind of well documented client account plans. Buyers will want to see that these critical client relationships are housed inside of a customer relationship management system that's used by all.
Sean Magennis [00:07:13] Yes.
Greg Alexander [00:07:13] A risk that a buyer takes from buying a boutique is key employee turnover and sometimes these key client relationships sit with key employees, and when the key employee leaves, they take the clients with them. And buyers are not going to acquire your firm if that potential potential exists, even even if it's a slight potential of happening, they're going to run away. The acquire will want to know that these relationships are with the firm, the institution, not with the employee. So that if the employee quits the billings, don't go away and this requires the institutionalization of your client relationship. So that's the key thing. So make sure that your clients are clients of the firm. They're not clients of a single person and if you can prove that by having tools like this, CRM systems, account plans, et cetera, that'll give great confidence to a potential buyer that these clients are likely to stay with you over time.
Sean Magennis [00:08:13] Wonderful point, Greg and again, resonates with me because as an owner of a professional services firm, institutionalizing the ownership of your key clients, in fact all your clients has got to be one of the top five priorities.
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Sean Magennis [00:10:19] So, again, in an effort to provide you immediate takeaway value, I have again prepared a ten question, yes or no checklist. Please ask yourself these 10 questions. And if you answer yes to eight or more of these questions, you can prove you have a healthy client relationship.
Sean Magennis [00:10:40] Number one, Are your client relationships an asset on your balance sheet?
Greg Alexander [00:10:43] So let me dove in here a minute.
Sean Magennis [00:10:45] Please.
Greg Alexander [00:10:46] So when you get your balance sheet, this is an easy question and I love the fact that you set it up as yes, no. When you look at your balance sheet, are your clients on the balance sheet? Probably not. Right. So right away...
Sean Magennis [00:10:56] Great point redo your your balance sheet.
Greg Alexander [00:10:59] Redo your balance sheet, right and then when you read through your balance sheet and you're going to place a client relationship on the balance sheet, what do you have to do? You have to value it.
Sean Magennis [00:11:06] Yes.
Sean Magennis [00:11:06] What's that relationship worth?
Sean Magennis [00:11:08] Yes.
Greg Alexander [00:11:08] Well, you can do a simple understanding as to what the profitability of that client is. How much EBITDA does that client produce? You probably have a good feel for what your multiple of EBITDA is between five and ten, let's say. So if a client is generating one hundred thousand dollars in annual profits, you know, that client's worth 500000 to a million.
Sean Magennis [00:11:29] At exit.
Greg Alexander [00:11:30] You can value it right on your balance sheet. Right. So that's a that's a very easy thing for an owner to do, is just to take out your balance sheet. Yes. No, my clients on their if they're not, I got to get them on there. And how do I value them?
Sean Magennis [00:11:43] Excellent. Number two, is this client asset appreciating in value?
Greg Alexander [00:11:50] Yes. So here's an easy way to do that, right? Put multiple annual balance sheets next to each other and maybe maybe you can project into the future, even go back in time. So, for example, if I'm doing business with X, Y, Z company when they first become a client four years ago. OK. So each year for the last four years. What were they worth? Were they going up in value or not? Yes. And if they weren't going up in value, how come?
Sean Magennis [00:12:13] Right. Great question to ask and ensure to the extent you can, an appreciating client value.
Sean Magennis [00:12:20] So question number three, do you have a diversified client base with no one client worth more than 10 percent of your total revenue? Number four, does the tenure of your client relationship exceed three years? Number five, are your client businesses stable? Number six, are your clients and relationships stable? What is that, Greg?
Greg Alexander [00:12:56] Yes. So here's what that means. So you can be doing business with a company and at that moment in time, that company is doing well. But when you peer into your client's customers, those are end customers. How are they doing? So, for example, for many, many years we thought General Electric was the very definition of a rock solid customer and all of us would be honored if they were on our client roster. Not anymore. Why? They were overexposed to the oil industry, the oil industry became very unstable and took G, GE right into the tank. I don't even think they're part of the Dow Industrial Average anymore. So peek into...
Sean Magennis [00:13:40] Yes.
Greg Alexander [00:13:41] ...The customers of your clients and try to get a feel for how stable is their business.
Sean Magennis [00:13:46] Outstanding, and that goes to truly knowing your customer. It's not a trite it's not a trite saying, is it?
Greg Alexander [00:13:52] Right.
Sean Magennis [00:13:54] So question number seven, do you have account plans? Number eight, have you institutionalize your client relationships into a customer relationship management system. Isn't that key, Greg?
Greg Alexander [00:14:11] It is, a couple of things on seven and eight, account plans and CRM. So if I'm doing due diligence, OK, and part of my due diligence is understanding healthy client relationships and in my information request, I asked for log in credentials to your CRM system. You tell me we don't have one. The conversation doesn't proceed.
Greg Alexander [00:14:30] If I ask...
Sean Magennis [00:14:31] No doubt.
Greg Alexander [00:14:31] Right. If I ask you for access to your account plants, which ideally would be in your CRM system, but if they're not and I say, hey, here you you tell me that your top 10 clients are these and I ask you for acount plans for each and you don't have them and your answer is, well, all that we have all in information, but it's in the salesperson's head. That's a major red flag because again, if that key employee walked out the front door, is all that tribal knowledge goes with him or her. So these have to be documented and that's a sign of institutionalizing the relationships.
Sean Magennis [00:15:03] Outstanding, and a follow on number nine. Very, very important is are the client relationships with the firm and not with your key employees?
Greg Alexander [00:15:13] Yes and one quick trick there that we look for when we're doing diligence is executive sponsored program. So most professional services firms have partners and they're the highest up in the organizational chart and to all of those partners make, you know, fairly regular client visits with the key clients.
Sean Magennis [00:15:33] Yes.
Greg Alexander [00:15:33] And do they own those? So that, again, because partners are less likely to leave the firm because they have ownership. So if the relationships are held by the partners, at least partially, then that's an indication that the client relationships have been institutionalized.
Sean Magennis [00:15:49] Outstanding, and then finally, question number ten, will the billings from your client relationships stay when the key employee quits?
Greg Alexander [00:15:58] Yes. Obviously, that's what this is all about.
Sean Magennis [00:16:00] Yep. And if you follow our sponsor, Collective 54, we have a concept called the strategy defense, which is all part and parcel of maintaining and ensuring that you have your revenue concentration, your client tenure and most importantly, your client quality. So if you answered yes to eight or more of these questions, you have excellent client relationships. This will make you very attractive to potential buyers. Client relationships are an asset. Like other assets, some relationships appreciate in value and others depreciate, appreciating client relationships will increase the value of your firm. Depreciating client relationships will decrease the value of your firm.
Sean Magennis [00:16:49] When trying to exit for a great price, bullet proof your client relationships. If you enjoyed the show and want to learn more, please pick up a copy of Greg Alexander's book titled The Boutique How to Start Scale and Sell the Professional Services Firm.
Sean Magennis [00:17:08] I'm Sean Magennis. Thank you for listening.