What makes an IT services business valuable from a

shareholder perspective?

Excerpt from article published at Dataquest by Rajul Garg, Director, Sunstone Business

School | Jun 25, 2014

The mega successes of IT services businesses like Infosys, Wipro and HCL among many

others have inspired a whole generation of entrepreneurs to starting services businesses.

Right from the mid-90s, services businesses have continued to proliferate and pepper

the streets of nearly all tier 1 cities and increasingly a large number of tier 2 cities. The

sector generated nearly Rs. 220,000 crore in 2011 turnover and continues to clock

impressive growth – it grew 21% in 2011 over 2010 and at a compounded annual

growth rate (CAGR) of 27% since 2005.

The market continues to be fragmented internationally as well as in India. There are a

few large players – top 5 players control over 50% market share, top 10 control 60% –

and a much longer tail of small ones. Just driving around Noida towards Sector 62, once

can spot scores of such companies typically staffing anywhere between 10 to 250

people. Out of the total estimated workforce of 1.5 million, nearly a million belongs to

the top 10 players. The remaining workforce – over half a million young men and women

– are spread across thousands of companies.

Lot of such small businesses make for great lifestyle businesses. In a company with a

couple of steady customers being served by 50 odd engineers, there’s a lot of margin to

be made on a month-to-month basis. Assuming negligible investments towards growth,

low attrition and, engineer margins at ~Rs. 15,000-25,000/engineer/month. an owner

can take home a cool Rs. 7.5-10 lacs/month. A lot more money than most employed

professionals in any sector would make. And it’s your own business with further potential

for growth. If you are one of these entrepreneurs, great for you. Keep at it ! This is not

very different from a boutique business owner owning a standalone store at a great

location.

The problem starts when such entrepreneurs want to grow these businesses. Sometimes

driven by necessity (existing customers may not be stable), and sometimes by ambition,

entrepreneurs want to invest sales money to scale these businesses. That’s where

prospect of external (investor) money come in, and you start hearing things like

shareholder value, valuation and all the related terms. All of a sudden, this highly cash

flow positive boutique business doesn’t seem that valuable any more. When compared

on a revenue-to-revenue basis with say, an E-commerce company, it would turn up

about 10x shy.

The reason lies in that thing – scalability. The ability of a business to grow. Services

businesses are like 2-headed monsters. On one hand they need a perpetual supply of

great engineers and on the other hand (and in perfect synchronization) a set of matching

customer orders. You have to bell the cat at least on one of these two issues and hence

the holy grail of services business scalability is the ability to forecast business. If your

customer can tell you their needs 6 months in advance, you will be able to most likely

plan for it. Hell, even 2 months would be good!

Thus, a services business with better forecasting will be more scalable over a period of

time. Even better if this forecast keeps growing in a predictable way. Shareholders value

future – the promise of a better tomorrow. So what kind of customers provide long term

visibility that can be forecasted and has the ability to grow predictably – its not recently

funded startups in the Bay Area or the constantly changing “social media” companies.

It’s the large companies with their fixed budgets. Think American Express, Boeing,

BMW… you get the drift. These are the companies who make these decisions at the

beginning of the year and stick to these allocations all year – more or less. These are the

companies you can walk the corridors of and get more business by developing more BU

relationships. Obviously it’s hard to get into these companies (more on this later in this

series), but if you can get in, they provide the endless stream of predictable business

that a services company strives for. They result in scalability. And hence shareholder

value. If you are a Rs. 50 crore service business, your best valuation case is that you

have 4-5 customers, each giving Rs.10-15 crores in business and which is but a small

percent of their technology spend – hence a potential for a lot of growth. Your worst is

100 customers, all maxed out and, wavering.

Shareholder value for services businesses gets created by long-term large customer

relationships. Everything else is just a way to get there.