Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How Non-Discretionary Spend Drives Business Sale Prices
Transcript
- Lucas: There is a specific kind of fear that haunts every serious business buyer, and it has nothing to do with the quality of the product or the strength of the brand. It is the fear that once they take the keys, the customers will simply stop paying. We see this play out constantly in lower middle market deals, where a seller relies on relationships built over decades but fails to lock those relationships into enforceable, non-discretionary contracts. Luna: Right, and most people think they have recurring revenue because they invoice monthly, but if that revenue is based on optional services like marketing campaigns, it vanishes the moment the budget gets cut. Lucas: Exactly. And today we are looking at a recent transaction involving a mid-sized HVAC distribution firm in the Midwest that sold for eight times earnings before interest, taxes, depreciation, and amortization. That is a very healthy multiple for that sector, especially given the current interest rate environment. The deal didn’t close at that price because they had the best margins in the industry; it closed there because their customers were legally obligated to keep buying. Luna: So you are talking about service agreements that cover mandatory maintenance rather than optional upgrades? Lucas: Precisely. The company provided parts and installation for commercial buildings, but the real value driver was their facility management contracts. These weren't just repair calls; they were scheduled preventative maintenance agreements tied to building codes and insurance requirements. If a building owner skipped those checks, they risked voiding their insurance policy or violating local safety regulations. That creates a floor under the revenue that is incredibly hard to break. Luna: That makes sense because the cost of not doing the work is higher than the cost of doing it, so the spending becomes non-discretionary. Lucas: It does, and that distinction is what separates an eight-time multiple from a four-time multiple. When we look at previous episodes on this show, we discussed how owner dependence sinks sales. Here, the owner wasn't the reason the clients stayed; the regulatory framework was. The buyer saw a cash flow stream that would continue regardless of who managed the day-to-day operations. It effectively removed the key person risk entirely. Luna: But isn't it hard to prove that these contracts are truly sticky when you are trying to sell the business? Buyers are usually skeptical of any contract terms. Lucas: They are, which is why documentation is everything in this scenario. In this specific case, the seller had spent eighteen months pre-deal cleaning up their contract portfolio. They replaced handshake renewals with three-year master service agreements with automatic renewal clauses. More importantly, they included early termination penalties that were steep enough to deter casual walking away. When the due diligence team reviewed the books, they saw a ninety-two percent retention rate on those specific contracts over the last five years. Luna: Ninety-two percent is really high, especially in the service industry where labor shortages often disrupt service delivery. Lucas: It is high, and that stability allowed the buyer to model their future cash flows with much less discounting. Usually, buyers apply a heavy risk premium to businesses where revenue can fluctuate month to month. By locking in non-discretionary spend, the seller reduced that risk premium. The buyer could confidently project that the revenue would hold even if the economy tightened, which is exactly what we are seeing happen as we move through the third quarter of twenty twenty-six. Luna: I wonder if this dynamic changes depending on the size of the buyer. Would a private equity firm care more about this than a strategic competitor? Lucas: Actually, private equity firms care about it intensely, but for a slightly different reason. A strategic competitor might buy the business to eliminate competition or gain access to the client list. A financial sponsor, like a PE fund, buys it to leverage that stable cash flow to pay down debt. That stable cash flow acts as collateral for the acquisition loan. So, non-discretionary contracts aren't just nice to have; they are often the primary asset that finances the deal itself. Luna: So the contracts essentially become part of the collateral package for the leveraged buyout. Lucas: That is a fair way to put it. Without those predictable payments, the bank wouldn't lend as much money, which means the seller might get a lower offer or have to provide more seller financing to bridge the gap. We have seen many deals fall apart at the closing table because the buyer couldn't secure financing without proof of that recurring revenue base. The seller thought their goodwill was enough, but the bank only cared about the signed contracts. Luna: It sounds like sellers need to be very intentional about how they structure their client agreements long before they decide to sell. Lucas: Absolutely. Most small business owners don't think about this until they receive a term sheet. But if you want to maximize your exit multiple, you need to treat your client contracts like intellectual property. You should be reviewing them annually to ensure they include auto-renewal features, clear scope definitions, and penalties for early cancellation. It transforms your relationship from a friendship into a legal obligation, which is what buyers pay for. Luna: Does this approach work for service businesses that don't have obvious regulatory drivers, like maybe a software consulting firm? Lucas: It works anywhere you can create dependency. For a consulting firm, it might mean tying your fees to specific compliance deadlines or ongoing technical support mandates. If your client's internal team cannot function without your specialized knowledge or tools, you have created non-discretionary spend. The key is to identify what keeps your client awake at night and make sure your contract addresses that fear directly. Luna: That shifts the focus from selling hours to solving critical problems that can't be ignored. Lucas: Exactly. And this leads us to a common mistake sellers make. They try to bundle these essential services with nice to have items to increase the total contract value. But if the nice to haves are dropped during a recession, the entire contract looks risky to a buyer. It is better to have a smaller, fully protected core contract than a large one with volatile components. Buyers love simplicity and certainty. Luna: So clarity and protection trump volume in the eyes of the buyer. Lucas: Volume matters, but only if it is durable. In this HVAC case, the total revenue was modest compared to some tech companies, but the predictability was so high that it commanded a premium. The buyer knew exactly what they were getting year after year. That predictability allows for better operational planning and lower stress, which is something any new owner values highly. Luna: It seems like a lot of work to restructure contracts, but the payoff in valuation seems worth it. Lucas: It is significant work, and it often requires legal counsel. But remember that this preparation happens over two to three years before the sale. It is not something you do in the last ninety days. If you wait until you are ready to sell, it is too late to build that trust and structure. You have to embed these practices into your daily operations well in advance. Luna: Do you see a lot of sellers resisting this because they think it makes them look rigid to their clients? Lucas: They do worry about that, but the data shows that professional clients actually prefer formal agreements. It reduces ambiguity and ensures consistent service levels. When you frame it as protecting both parties, clients are usually receptive. The resistance comes from owners who are comfortable with chaos and think that flexibility is a virtue. In a sale, flexibility is often a liability. Luna: Chaos might feel like freedom to the owner, but it looks like risk to the buyer. Lucas: Precisely. And this brings us to the financial mechanics of the deal. Because the revenue was so stable, the seller was able to negotiate a higher percentage of upfront cash versus seller notes. Seller financing is common, but it carries risk for the seller if the buyer defaults. With strong non-discretionary contracts, the buyer can demonstrate they can service that debt easily, making the seller feel more confident leaving money on the table. Luna: So the contract quality directly influences the payment structure of the transaction. Lucas: It does. And it also affects the speed of the sale. Deals with clean, recurring revenue structures tend to close faster because there is less uncertainty to resolve during due diligence. The buyer doesn't need to run extensive sensitivity analyses or worry about churn rates. This efficiency saves everyone time and money, including the brokers involved. Luna: Which reminds me that we have listeners who support this show to keep these deep dives happening ad-free. Lucas: If these conversations have moved your work forward in some small way, consider supporting us directly. It helps us cover the research and legal consultations that go into these detailed breakdowns. You can find us at buy me a coffee dot com slash fexingo. Any amount helps us keep the lights on and the analysis sharp. Luna: Thank you to everyone who has already joined in. It truly makes a difference in the quality of what we can bring to you each week. Lucas: Back to the deal specifics. One final nuance on this HVAC case is how they handled the employee transition. Since the service contracts were the main asset, retaining the field technicians was critical. The buyer required that all lead engineers stay for at least twelve months post-close. Luna: That makes sense because the clients hired the company for the expertise, not just the parts. Lucas: Right, so the seller had to allocate a portion of the purchase price to earn-out bonuses for those key staff members. It was a clever way to align incentives. The employees got paid extra to stay, and the buyer got guaranteed continuity of service. It prevented the kind of mass exodus that often destroys value in service-based acquisitions. Luna: It turns the human capital risk into a managed expense rather than a wildcard. Lucas: Exactly. And that is the broader lesson here. Value isn't just about the numbers on the income statement; it is about the structural integrity of the business model. When you remove discretion from your revenue streams, you remove volatility from your valuation. That is a powerful tool for any owner looking to exit. Luna: It forces you to build a business that can survive without you, which is ultimately the goal of any successful entrepreneur. Lucas: Well said. As we look ahead to the next quarter, I am curious if you think we will see more demand for these types of contracts as interest rates remain elevated, or if buyers will start accepting more risk again. Luna: Given the tighter credit conditions, I suspect the demand for safe, predictable cash flows will only grow stronger. Lucas: That seems likely. Until next time, keep your contracts tight and your exits clear.