Several  times my partners and I have played around with the idea of acquiring a smaller hosting company that was for sale on the open market.  We have the infrastructure to accommodate several times over the number of clients we currently have and purchasing a smaller company seems like a logical choice for us to quickly grow our client base. 

One of the concerns we have about purchasing another hosting company is that our operation is completely different than that of most hosting operations, for instance GoDaddy, they do bargain basement hosting and offer annual renewals on their hosting customers.  Several other large bargain basement, barebones hosting operations out there are setup the same way or similar as well. 

The vast majority of our clients are billed on a monthly basis.  The reasoning for this is because we actually bring a few other products and services to the table and also have a retainer agreement that certain clients take advantage of.  We also offer other services outside the realm of hosting such as development. 

I ran across this article today, and I actually have an email into this guy to discuss some of this but haven’t heard back from him yet.  This is great information if you are in the hosting industry and I recommend you check out Furlow Consulting’s website.

If you are acquiring web hosting companies and a specific target primarily has annual customer accounts, don’t run for the hills, quantify it.  Some buyers are immediately concerned about the increased risk of customer renewals for annual accounts which are 6-12 months out.  At the same time they do not want to provide service and support each month for free for many of the customers for that period of time.  There is a solution.

The two main value drivers in this equation are customer renewal rates and the “Total Customer Support Months” figure, (or “TCSM”).  The later is as follows.  If a customer signed up or renewed their annual contract 2 months ago, then this customer counts as 10 Customer Support Months.  If a customer signed up or renewed 5 months ago then the contributing Customer Support Months is 7.  Add this for every customer and you get a Total Customer Support Months.  Multiply the total, times the average monthly cost to provide service and support to the average customer and you get the TCSMs figure in dollars.  This needs to be subtracted from the valuation of the company if all of the customer accounts were monthly.

For example, if you are analyzing a customer base of 1,200 accounts and they are all billed annually and spread evenly throughout the year so each month 100 are up for renewal, then the TCSM is 7,800 for all of the accounts and the average monthly cost to provide service and support to the average customer is $8, then the value of this issue is $62,400.  This figure is of special relevance if the renewals are not spread evenly across the 12 months of the year.  It is common for companies to do “marketing blitz’s” from time to time and sign up a lot of annual accounts in a 1-3 month period.

Click here to see the example chart provided in his article…

Customer renewal rates is the other value driver.  I will use two examples.

Higher Renewal Rates:  The target company has 1,200 customer accounts which pay $240/year ($288,000/year), and they are evenly spread throughout the year so 100 are up for renewal in each of the next 12 months.  In looking at the trailing 12 months, on average each month 95% of the customers renewed for another year, so the initial forecast for the next 12 months is that 1,140 will renew and pay $273,600, not counting new customers.

Lower Renewal Rates:  The target company has 1,200 customer accounts which pay $240/year ($288,000/year), and they are evenly spread throughout the year so 100 are up for renewal in each of the next 12 months.  In looking at the trailing  12 months, on average each month 50% of the customers renewed for another year, so the initial forecast for the next 12 months is that 600 will renew and pay $144,000, not counting new customers.

Forecasting Renewal Rates:  I wish forecasting annual customer renewals would be as easy as taking the seller’s historical rates and forecasting it out 12 months, but it’s not. 

• It is important to realize at first the target company’s renewal rates will be par for the course, but over time the buyer’s renewal rate will be the correct rate to forecast. If the buyer’s rate of renewal is 60% and the seller’s rate is 90%, it goes without saying the buyer needs to think hard and fast about why and DO NOT forecast the acquired base at 90% renewal for a long period of time.
• Some of the factors which will affect a change in the renewal rates of the acquired base are the acquirer’s billing methods, pricing, service, support etc.  Changes in each of these will affect renewal rates and should be factored in to the forecast.
• Look at the quarterly changes in customer renewal rates prior to closing.  Look at the trailing 4 quarters renewal rates.  Are they getting better or worse? … take into consideration the trend as opposed to using just last years total renewal rate.
• Figure out why did the renewal rate change?  Did the seller keep lowering prices faster than others in the industry, hence the renewal rates increased a bit quarter over quarter?  Or, did the renewal rates fall slightly because a year ago there were 300 accounts per support employee, six months ago there were 500 and for the last quarter there were 700 accounts per support employee. 

In conclusion, yes, there is a reduction in the value of a web hosting company which has primarily annual customer accounts, but it has a lot more to do with Total Customer Support Months “TCSM’s”than it does renewal rates, because even monthly customer accounts have renewal rates.

Furlow Consulting – Valuation of Annually Billed Customer Accounts