Each company’s costs to create an RMR customer and the length of time each customer remains performing is critical to determining the value of any customer base. A company’s attrition performance speaks to the strengths of the respective management team and the level of customer care that each base has experienced over time. The rate at which customers cancel or become non-performing (attrition) speaks directly to the longevity of a recurring revenue stream and in turn, the value that is placed on it by the market.

While attrition does not measure the rate of growth of a company, it certainly impacts the net growth rate that the organization is able to maintain. As the saying goes, “It is cheaper to keep a current customer than invest in creating a new one.”

In concert with understanding the attrition dynamics of a target company, it is important to understand the reasons for attrition — what causes customers to cancel or not remain paying? While a number of companies still do not maintain records (monthly or annually) of their customers’ cancellations and associated reasons, each business operator will have an opinion as to what attrition level his or her company has experienced. With due respect, after all of our work looking “under the hood” of companies, we usually find the actual attrition rate is higher than their estimate.

When an offer is being considered and you are fashioning your letter of intent (LOI) to purchase the target, always rely on the seller’s attrition representation in valuing the company, but leave a mechanism to adjust “subject to due diligence” when the facts are in and irrefutable for the seller to gain perspective. This process makes for an equally informed buyer and seller to confirm or adjust pricing or deal terms.

As to valuation considerations, while there are always extenuating circumstances to explain high or low attrition rates, the buyer will initially value the company based, in large part, upon size, type of RMR and geographic density of the customer base. Therefore, a $50,000 RMR company may be valued in a market range of a 28 to 35 multiple of RMR, but which end of that range the buyer chooses will be dramatically driven by the “historical attrition rate” of the customer base.

Industry wide, net annual attrition (gross customer losses plus resigns and increased RMR for added services or price increase of like customers) will range from a low of 4 percent (smaller companies) to a high of 11 percent for companies with more than $500,000 of RMR. Readers can reference the TRG Annual Attrition Study for results by varying size of company. Below are some excerpts from the company size data over the last three years:

Much as customer service expectations cannot be turned around overnight after an acquisition, neither can very high attrition experience. A buyer must adjust the valuation of a target company or, at the least, adjust the LOI terms related to a holdback (dollars or tenure, or both) to protect himself for the time it will take to bring the attrition down to a respectable level. The security industry offers the opportunity to structure a deal with an economic look back performance guarantee (holdback) for the benefit of the buyer. So, a company with $50,000 of RMR and a historical net attrition rate of, say, 13 percent, should be valued at the low end of the market range or a holdback of more than the traditional 10 percent/one year should be negotiated.

On the flip side, if the attrition rate was in the 4 percent range, expect to be at the higher end of the market range and to receive a good deal of push back from the seller when trying to negotiate any holdback protection, especially if that company creates new customers at less than a 10 multiple of RMR.

Another aspect of attrition that is often misrepresented is controllable versus uncontrollable; higher levels of attrition are often explained away as uncontrollable. Based upon our work with a number of companies across the country, the single largest cause of high attrition (gross and net) is the company itself. While the reasons may be varied, one usually can translate the losses into some aspect of management’s performance or lack thereof. Some of the best management teams in the industry have gross attrition of 12 percent, but they manage their net attrition down to 9 percent or as low as 7 percent because of their focus on resigns, service add-ons, price reductions to save customers, smaller but consistent price increases, and more. They manage their customer losses by first measuring their performance and then addressing the varied causes of attrition as an organization as a whole.

The market rewards companies with impressive sales organizations (growth machines) that control their cost to create. It also rewards companies that manage their customer losses with similar management analysis, focus, and concerted efforts to retain each customer or protected site. n

Editor’s Note:  Part 3 in “The Art of the Deal” series will focus on cash and the necessity of investigating the cash that is received from a customer base. This most important metric, when substantiated by third-party records (bank statements) is very telling about the quality of the base and the sustainability of the revenue stream under consideration. Look for it in the March 2014 issue.

About the Author:

John Brady is principal of TRG Associates Inc., Old Saybrook, Conn. (www.trgassociates.com). Since its inception in 1991, TRG has been successfully assisting a wide range of security and fire alarm companies, entrepreneurs, lenders and investors in due diligence and acquisition planning.

The Art of the Deal

With the security and fire industries still very fragmented and continuing to grow, the acquisition opportunities within the United States and Canadian markets continue to be very active. As importantly, the capital markets continue to be very supportive of both industries when they identify capable management teams to back.

The predictable cash flows associated with the recurring monthly revenue (RMR) in these industries are the “crown jewel” that drives impressive operating margins. Author John Brady, principal of TRG Associates Inc., Old Saybrook, Conn., has been privileged to perform a vast number of valuations and due diligence efforts on behalf of buyers and sellers over the past 20 years and identifies what he has found to be the important aspects in the “art of the deal” in this six-part article series.

While maintaining a disciplined approach to evaluating a seller’s business is critical, there is an art to buying a selected group of RMR customers. This article series explores the important aspects of that art:

1. What should go into any acquisition valuation of RMR and the company as a whole? What revenue has value?
2. How does the attrition history of the seller impact the level of due diligence and ultimate valuation?
3. In performing due diligence, cash is your key indicator as to the health of the  target company and the associated RMR. How do you analyze that important asset?
4. How does the buyer assess the installed technologies and signal platforms of the seller’s customers and what effect do those have on valuation?
5. How does the buyer assess the service expectations (obligations) and economics of a customer base? You won’t change those expectations overnight so assess carefully.
6. The letter of intent: how to fashion the art of the deal in a “hot market” versus practicing prudent investment principals.