by Eric Furlow

I get asked every day about the valuation of hosting companies and related entities. Here is my take on the market. Since everyone in the hosting space is not a pure play hosting company, I will review several combination business models.

• Pure Play Web Hosting Companies, without an IDC
• Pure Play Web Hosting Companies, with an IDC
• Web Hosting Companies, which offer web site design services
• Web Site Design Shops, which can also host their client’s site
• Web Hosting Company, which also offers IT related, one time and recurring services

Pure Play Web Hosting Companies, without an IDC:

Of these five business models, this scenario is by far the most liquid, and is what the greatest number of buyers are presently looking for. While this model is the easiest to value and has the least variation in valuation perception between buyers and sellers, it is not necessarily the most valuable of the five. These companies are valued around 11-13 times monthly recurring revenue. If a company is growing rapidly, it is common to add the trailing six months and annualize the amount. In some cases, with all of these business models, the valuation can easily be less due to variables such as annual billing, no contracts, commodity pricing, high customer churn, reliability problems, bad reputation, poor support, a lack of organization and a few other reasons. In other cases, the valuation can be slightly greater due to the opposite status in all of the aforementioned variables. In addition, with every model, the company can be worth a greater amount to a specific buyer because of his post-closing synergies and strategy. This happens quite frequently.

The reason there are more buyers for this business model is because most of the time these buyers have their own IDC and want to increase the capacity utilization by migrating the seller’s servers/customers. In addition, there is no data center to acquire, manage and sell post-closing. In almost every case, if the seller co-locates their servers or leases servers from a Tier 1 facility, the risk to the buyer is less than if the seller has their own IDC. The buyer simply takes over the server leases.

Pure Play Web Hosting Companies, with an IDC:

When growing a web hosting company, the benefits of control and leverage of owning an IDC can be notable. When evolving into the divestiture phase, it can be a negative to many buyers. (On a side more, I have seen many very successful business models where the company co-locates and/or leases servers with no intention of ever owning the IDC.)

Here is an example of when the IDC can be a problem:
A web hosting company billing out $1,000,000/year, invests $500,000 in a small IDC which they anticipate using 30% of with the existing servers. Six months later the IDC is built, the servers have been migrated, and the company has grown to $1,200,000 in annual sales. Now let’s say, for whatever reason, the owner wants/has to sell the entire company. There are two basic groups of assets.

Est. Value
1. Recurring Revenue (and associated equipment): $1,200,000 +-
2. IDC: (with associated, and now slightly obsolete equip) $450,000 +-

Scenario A: To most buyers the company is worth $1,200,000 +-, because they have their own IDC and do not want or need additional capacity.

Scenario B: To a few buyers it’s worth $1,650,000 because they want to acquire an IDC either because they need more capacity, want an IDC in that geographic area, or simply because they are currently co-located or lease their servers and want to finally own their own. The number of buyers pursuing Scenario B is far less than in Scenario A. However, this buyer is much more motivated to do a deal.

So the seller has a decision to make. Sell the customer base, and then try to sell the IDC to another buyer at a later date, or hold out for a buyer who wants both. The greater the recurring revenue a company has as a multiple of the amount invested in the IDC, the less this is a detriment to the divestiture process.

Web Hosting Companies, which offer web site design services:

One day earlier this year someone presented an argument to me that one time web site design revenue is actually recurring revenue and should be valued as such. His logic was that customers continually ask his firm for updates and changes, and that is recurring revenue. The truth is, it is not recurring revenue and the market agrees, hence one-time design revenue valued less than recurring revenue. It is no more recurring than an accountant or attorney whom provide regular professional services to their clients.

One approach to valuing the one time design revenue is applying a multiple of the gross profit … design income per hour, minus real employee cost per hour. Some hosting and design companies are in reality breaking even on the design work. Their goal is to provide inexpensive web design to keep the customers from leaving. In this scenario, the one time design revenue is worth almost nothing other than its positive affect on decreased customer churn.

Side Note: The Valuation and liquidity with any design revenue stream.
This applies to the business model in this section as well as to the next section. The greater design revenue is as a percent of the total revenue, the less the valuation of the company. In addition, the company is less liquid. Another correlation, the more design revenue is a part of the total revenue, the more the company is valued using metrics such as EBITDA multiples, growth rates, gross profit, and the committed client work pipeline, and less on the recurring revenue multiple. The reason there is such a focus on the recurring revenue with regular hosting company valuations is because the buyer’s cost structure post-closing is in many cases going to be notably different than the seller’s cost structure.

Let me illustrate two scenarios of web hosting and design companies for sale.

Scenario A: (the good one): This company has 8 employees and 80% of their revenue is recurring web hosting revenue. The owner is passive and is not involved with day-to-day operations. In addition, the design clients are not local. … This company is not only “very sellable”, it can be moved out of that market.

Scenario B: (the bad one): This company has 8 employees and 80% of their revenue is one-time web design. This owner, who designs himself, is very active in the business and knows most of the web design clients himself. Most of the design clients are all in the local market. This company is close to being “un-sellable”.

Web Site Design Shops, which can also host their client’s site:

This business model looks a lot like Scenario B. This is really a web site design shop, which can just happen to host their client’s web sites. They no doubt co-locate or lease a couple of servers somewhere. This is the least valued of all the business models. Having said that, it doesn’t mean it’s not a profitable and rewarding business to own. These shops are typically sold to a senior employee or an in-market or adjacent-market similar web design shop.

Web Hosting Company/ASP, which also offers IT related, one time and recurring services:

This is the most unique of all of the business model categories and where some very interesting deals are happening these days. These recurring revenue streams come from managed services in addition to regular hosting. Each of these entities has to be analyzed individually and the focus is more on EBITDA, assets, client list, developmental stage, and all of the other typical valuation metrics. The premium valuation is apparent both with private and publicly traded Internet companies. It is important to note these businesses are worth notably different amounts to different buyers.

The benefits of these types of entities are that customer churn is less and there are typically higher revenues associated with each customer. In many cases the customer would have to go to great lengths to leave the company. While design services can be picked up by a new web design shop fairly easily, in many cases, IT managed services cannot.

Side Note: Carve-Outs
With any of these models, even pure play hosting, occasionally companies decide to carve-out a specific line of the business. In some cases it might be a carve-out of the shared line of the hosting business, or in others, the dedicated line. All else being equal, what I have seen is a decreased valuation on the carved-out assets. If a company is carving out a line of business, they typically have not focused on it for a period of time so it’s operating less productively than what the company as a whole is operating. In addition, the documentation of the assets is typically sub-par. Having said that, carving out a business line is usually a logical and profitable course of action. What I recommend to sellers is to treat the sale of the carved out assets with the same level of professionalism you would if you were selling the entire company.

About the author

Presently, Eric Furlow assists small and medium sized companies both acquire and divest technology companies. He has experience in over 60 transactions in the paging, SMR, cellular, tower, ISP and web hosting industries. He has a Masters in Finance from Bentley Graduate School of Business in Waltham, MA. Before heading up Furlow Consulting Corporation , he was the Mergers and Acquisition Manager for A+ Network, Inc. which was sold to Metrocall, “MCLL”.