Last Christmas I read Peter Thiel’s book “Zero to One”. Anyone curious about, or actually in the world of startups should read it – it’s full of so many original and thought-provoking concepts.
These concepts range from ‘why companies should always aim to create something new (0 to 1) and not copy something else (1 to 0)’, to the concept of ‘don’t aim to disrupt’ but instead collaborate.
However, the most thought provoking topic for me personally was the idea that founders should aim to create monopolies. It provides you the emotional fuel to THINK BIG.
Because a business’ current value is the sum of its discounted future earnings, the businesses that maximise long-term profits are the most valuable. The problem is that competition increases costs. So, to maximize profits and minimize costs, a startup should inhibit competitors from developing. In other words, founders should aim to build monopolies.
Thiel argues there are four attributes that characterize monopolies.
- Proprietary technology.
- Network effects that enable the business to grow faster as it scales.
- Economies of scale which reduce the costs of growth over time.
- A brand.
All of these elements create barriers to entry that defend the future profits of the startup and reinforce monopoly power.
Now, this is all great in theory. But it got me thinking, how can service based businesses adopt some (or all) of the principles by Peter Thiel with the goal of creating real value in their business? I mean let’s face it, we aren’t all geniuses like Elon Musk or Steve Jobs – but we can aspire to be a bit better than the guy next door.
How to build value in a “body shop” business
Generally, these industries include accounting, medical practices, legal services, creative agencies, IT consulting…’knowledge industries’ as I like to call them.
Traditionally a highly personalised service, the greatest challenge body shop businesses face is that the goodwill or value of the business is intrinsically linked to the underlying people. Key man risk is the greatest challenge in these industries. An example of this is when a Director or Key person leaves an organisation, a handful of clients often go on to follow that individual due to their relationships. This means that the firm cops a double whammy of value loss – resources and goodwill (value).
Equally, traditional body shop businesses are time driven. That is revenue is limited by hours in the day and a rate at which that individual or team can charge per hour. “Value pricing” or productising services is a way to reduce this limitation, but ultimately it is still a far less scalable business model than a software business.
Valuations of “body shop” businesses
Let’s start with the fundamentals of how businesses are valued. There are a number of methodologies for how to value a business. The three most common are:
- Discounted Cashflow Approach (DCF);
- Net Tangible Assets (NTA); or
- Multiple of earnings approach.
Most accountants or valuation practitioners will adopt at least two of these methods when determining the enterprise value of a business – a primary method and a cross check. Whilst a DCF approach is the most ‘technically correct’, the most common approach is based on a comparable multiple of Future Maintainable Earnings (FME).
As a rule of thumb, body shop businesses are valued at an earnings multiple of between 2x – 4x FME, depending on a variety of ‘factors’. Business valuations are more of an art than science, however factors that influence the valuation multiple include:
- Customer contracts and quality of those customers
- External risks
- Key man reliance
- Future growth prospects
- Strategic position in the market.
My view on how to build real value in a body shop business
So the multi-million dollar question – how does a traditional service based business exit at a valuation greater than 4x FME?
Let’s refer back to the principles of Thiel.
1. Proprietary Technology
The challenge for service providers is that capability or the firm’s unique selling point (USP) is dependent on the people in the firm. For example, Management Consulting firms like Bain and Fahrenheit212 exist because they comprise highly intelligent people. The problem with highly intelligent people is that they don’t think like ‘normal people’ and their intellect is contained in their brain. Given the nature of consulting, that output is not an algorithm or product – it is the advice itself.
The best thing that consulting firms can strive to achieve is to systemise this IP by documenting it. That is, building unique processes and systems to reduce reliance on specific people and their unique talent, with the objective of reducing key man risk. This in itself is a challenge due to the specialised field of ‘consulting’ – and here we go full circle.
2. Network effects
The ‘network effect’ is an economic concept whereby a good or service becomes more valuable when more people use it. When the network effect is present, the value of the product or service is dependent on the number of others using it. Take Facebook for example – it would be pretty much useless if it was just you using it.
*On a side note – if you were a MySpace user (like I once was) you would at least have Tom
Body shop businesses typically only have one customer – the end customer. Besides referrals and partnerships with complementary service providers, I haven’t figured out a way how service businesses can even evolve into a network effect business model and retain their value proposition.
Open to ideas there guys.
3. Economies of scale
Body shop businesses still rely heavily on people to fulfill the work, however what businesses can strive to do is utilise software to make processes more scalable – increasing the revenue per head.
What separates ‘services’ from physical products and software is that people typically buy into the relationship. This hurdle can be overcome by building a brand.
The ‘Big 4’ aren’t termed that for no reason. They are an institution. Whilst the quality and output of the service may be consistent with their competitors, consumers and businesses will associate value to these brands due to their reputation and history.
Businesses and consumers will typically buy into large established brands, not the people – which is what makes them so valuable.
So in conclusion, whilst body shop businesses might seem ‘conservative’ compared to technology companies or startups as defined by Peter Thiel, organisations can strive to be better by focusing on one or all of the value drivers as outlined above.
Questions is, are you striving to be a Monopoly or just another business?