M&A Adviser To Solution Providers: To Boost Valuation, Get To 50 Percent Recurring Revenue
Joseph F. Kovar
The reality is that maximizing a solution provider's value depends primarily on increasing recurring revenue, customer satisfaction and financial fitness, says Linda Rose, principal at RoseBiz.
It is a good time for solution providers, particularly MSPs, to be on the lookout for merger or acquisition opportunities, but companies contemplating such a move should explore several ways to increase their value.
That's the word from Linda Rose, principal at RoseBiz, an Encinitas, Calif.-based M&A adviser to technology services companies, who Monday told an audience of MSPs at this week's XChange 2020 conference that no single solution provider can do everything for customers on its own.
"That's why we see so much happening in the M&A space," Rose said.
Rose, citing a study from research firm Forrester, said 40 percent of solution providers likely will retire by 2024. That, she said, is a big trend given that there are 500,000 solution providers globally, including 162,000 in North America alone.
"If you're looking to acquire a company, there's a lot of people looking to sell. ... We have never been in a better time to sell. Interest rates are low, and will probably go lower."
Rose cited a study, the Citizens M&A Outlook 2020, to say that 90 percent of companies in the IT industry see business valuations either remaining stable or increasing in 2020. However, 58 percent of buyers say valuations will increase in 2020 versus 39 percent of sellers.
"Buyers are more bullish than sellers," she said.
Rose divided solution providers into five categories based on their valuations. She said there is a sixth category, that of systems integrators, which she did not address because such companies are typically valued over $100 million.
The first category is the value-added reseller, which typically sees 10 percent to 20 percent of revenue coming from recurring revenue, along with gross profit margins of 25 percent to 40 percent. Companies interested in their geographical location or human capital might be interested in acquiring such a company, with the purchase price of between three and nine times EBITDA (earnings before interest, tax, depreciation and amortization), with higher annual revenue generally leading to higher multiples, Rose said.
The second category is MSPs, which can expect recurring revenue to account for about 40 percent to 60 percent of revenue and gross profit margins of 35 percent to 45 percent. Businesses interested in strong gross profits and strong EBITDA might pay multiples of between five and 10 times EBITDA, Rose said.
The third is hosters and providers of infrastructure and Platform as a Service. Rose said such companies may get 85 percent or more of their revenue from recurring revenue, with 40 percent to 55 percent gross profit margins. Potential buyers of companies in this category are looking for gross profit and year-over-year growth and might pay between five times and 10 times EBITDA.
The fourth, custom developers, typically get 40 percent to 60 percent of revenue from recurring revenue, and enjoy gross profit margins of 50 percent to 60 percent. Rose said purchasers of such partners are looking for vertical specialties and repeat revenue, and might pay between six times and 12 times EBITDA.
The last category is ISVs and Software-as-a-Service developers where companies might get up to 95 percent of revenue from recurring revenue and see over 65 percent gross profit margins, Rose said. A buyer interested acquiring in this type of company is likely looking for vertical specialty and year-over-year growth, and might pay between six times and 15 times EBITDA.
"Not every partner is the same," she said.
Rose identified eight factors that drive the value of solution providers, including financial fitness, management muscle, value proposition and verticalization, customer satisfaction and retention, sustainable success, sales and marketing maturity, intellectual property, and revenue readiness.
She said she asked several companies to rank those eight to understand which were the most important.
"And you know what?" she said. "They all came back differently."
That said, the reality is that maximizing company value depends primarily on increasing recurring revenue, customer satisfaction, and financial fitness, according to Rose.
"If you do not exceed your sales in 2020 by $1 over 2019, if you increase your customer satisfaction, you increase your company's value," she said.
For the financial fitness side, Rose said it important for every company thinking of being acquired to ensure it can show potential buyers its GAAP financials, and in particular make sure it moves away from cash-based accounting to accrual-based accounting where the cost of goods sold for every sale is recorded the month of the sale.
Every savvy buyer will be looking closely at a potential acquisition's GAAP numbers, she said.
"If you're not sure you're doing GAAP accounting, please get someone to look at your books now, not when you are getting ready to do a deal," she said.
Solution providers also need to understand their gross profit margins, which Rose said are more important than actual earnings to a potential buyer because the buyer will be looking to reduce redundancies like dual marketing departments after an acquisition.
Average solution providers might be showing annual revenue growth of 15 percent to 20 percent and gross profit margins of 25 percent to 40 percent, Rose said. Best-in-class partners, on the other hand, have average revenue growth of 20 percent to 25 percent with 35 percent to 45 percent gross margins, while high-growth solution providers average around 25 percent to 40 percent revenue growth and 35 percent to 45 percent gross profit margins.
Rose suggested solution providers who are currently "average" get to the best-of-class level before considering selling their businesses.
"This is achievable," she said. "If you go to the high-growth level, that is sustainable for two to three years, but not over the long term."
Rose offered solution providers a number of other tips that will help them improve their valuations.
For instance, she introduced the "Rule of 40" which states that a company's growth rate plus its EBITDA margin should be equal to or greater than the number 40. As an example, she said a growth rate of 25 percent annually plus an EBITDA margin of 15 percent would equal 40.
"If it equals 40, you're in a good spot," she said. "If you're at 30, you're still good."
Rose said that as long as the total number is greater than 40, it does not matter what the two percentage rates are. For instance, she said, a company with 100 percent annual growth can operate at a loss. "But that's not sustainable over the long term," she said.
Solution providers should really try to get at least 50 percent of their revenue as recurring revenue, Rose said. "Once you are at 50 percent, you're going to get some eyebrows lifted," she said.
To get to 50 percent takes time, with most companies at the most able to add 20 percent to the recurring revenue column per year, she said.
Rose suggested solution providers do not sign three-year contracts with customers, but instead focus on one-year contracts, with the first 90 days being a trial period where the customer can cancel any time.
This is because technology changes too quickly in three years, she said. "You want to take risk away from the customer," she said.
Also, Rose said, adding 24x7 support with a fast response time is one way to raise revenue by 20 percent. She said smaller solution providers might balk at the prospect of having to support customers on the weekend, but noted that they typically will not have a lot of calls during that time. Calls can be handled by someone that is given other days like Fridays off, she said.
Rose's presentation was a great opportunity for solution providers to take a look at how they value their businesses, said Corey Tapper, president of Techevolution, a Lynn, Mass.-based MSP that is currently looking to bulk up its business via a few acquisitions of small MSPs prior to exploring a possible sale at a later date to a larger company.
"She gave me ideas on how to better look at what I need to do to improve my company's valuation, and the valuation of the companies I might want to buy," Tapper said.
Techevolution is already working with an adviser from the venture capital world that Tapper said he has known for a long time.
"An adviser is very important," he said. "If you go into a deal blindly, whether you are buying or selling, it won't work. You don't want to spend a lot of money on lawyers and advisers and find the deal doesn't close."
David Stinner, founder and president of USitek, a Tonawanda, N.Y.-based MSP, said Rose’s no-nonsense assessment of how MSPs can drive higher valuations made it the “best” session at the XChange conference.
"This session was really focused on how we can make our business better,” said Stinner. “It is going to have a huge impact on improving my business. It is going to help me set my goals for continuous process improvement. This puts me on a path to align with best practices."
Stinner said he is not interested in selling his business, but is interested in buying other MSPs. "This shows me what metrics to look at in evaluating other MSPs," he said.
USitek has been successful driving more than 50 percent recurring revenue services by focusing on recurring revenue rather than revenue growth, said Stinner.
"It’s all about learning to improve processes and not being reactive," he said. "It is all about best practices. The key to our success has been focused on profitability and EBITDA rather than revenue growth. We are focused on lowering churn and increasing customer satisfaction. Building an environment for happy employees is key to driving customer satisfaction."
Steven Burke contributed to this story.