Value of service contracts for ICT businesses
The value of service contracts: are longer term contracts worth more than short term, 30 day notice, contracts ?
In this E-tutorial we deal with the value of support contracts for ICT businesses. The revenues of an ICT business are typically divided into the following revenue streams: support contracts, management services, ad-hoc projects and hardware/software re-sales.
As we saw in the edition on multiple of revenue valuations the main driver of value for an ICT company is the support contracts. Support contracts bring in regular revenue and provide the business with stability and the ability to forecast income and activity.
All support contracts are based around a certain "statement of work" document. Whilst the statements of work do vary, there is a huge variation in the duration or notice period that clients are contracted for, from 30 days, to 3 months, 12 months or 2 to 5 years.
From our experience the one of the first questions buyers of ICT businesses ask is "what are the company's contract terms for duration and/or notice period?"
Depending on the answer many buyers rule themselves in or out of the sale process at this stage. Longer contract terms certainly attract more buyers and higher valuations, however there are pro's and con's for each strategy.
So does the duration of the contract really matter?
Short term contracts
If there is a contract in place at all, the minimum notice period will be 30 days. So in theory the client could cancel their contract, pay one further month's retainer and walk away effectively overnight. Therefore for a prospective buyer, short term contracts represent a significant risk that they will acquire a client base which is able contractually to walk away without allowing time for the new ownership to build their own relationship with the client base.
On the flip side, because of the nature of the industry and the perceived complexity of the ICT systems that are in place, the clients of ICT businesses tend to be very "sticky". With many of the ICT businesses that we talk to, who have short term contracts in place, many of the clients have been with the business for several years and whilst the good quality of service is maintained and pricing remains at the level they signed up to, there is no real reason for them to change their IT supplier. Short term contracts also represent a smaller hurdle for signing up new clients for ICT contracts and so many ICT businesses use short notice periods as their Unique Selling Point to win more business.
Long term contracts
For the purposes of this article we will assume that a long term contract is for a period of 12 months or longer, with at least a 3 month notice period before the contract renewal date. (Note that this is different from a rolling 3 month notice period once the initial contract period has ended).
Contracts of 2 to 5 years duration are typically seen with ICT businesses which service the financial sector where security of information and sustainability of ICT support is very important.
Long term contracts provide the ICT business with stability and the ability to forecast income and activity. The company is therefore able to plan their future resources and growth in the knowledge that their current client base will remain under contract for a reasonable period of time.
The client base will also tend to be more committed to the ICT business having in many cases carried out a certain amount of due diligence to make sure that the ICT company will meet their requirements and offer a good quality service, before signing up to a long term contract.
For a prospective buyer, longer contract terms reduce the risk of the acquisition, and allow the new ownership time to build their own relationship with the client base well before the contract renewal date.
The counter argument to this of course is that if the ICT business is not providing a quality service, it would be in a weak position to enforce the contract agreement should the client decide to stop using and paying for the service. Long term contracts at low / unsustainable prices will also be more of a liability than of value.
In conclusion, as long as the IT business provides a good service at good market prices, both short and long terms can generate favourable revenues and long term clients.
However when it comes to the sale of the ICT business, from the buyer's point of view, the perceived security of long term contracts and the inherent commitment of the client base is highly desirable and will drive up the value of offers made.
Would you like advice on preparing your IT support and telecoms business for sale?
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Please contact us on 020 8090 9380, email [email protected], or complete the form below to arrange an appropriate time to review your exit strategy and the value of your business in confidence and without obligation.
This article originally appeared as part of our series of e-Tutorials for the Sale of IT Support & Telecoms Companies.