As you consider your own exit strategy, you should also keep in mind the macro-economic forces -- and demographic forces -- around you. Those forces will surely impact company valuations -- both for the near term and for the long haul.
For instance, M&A (merger and acquisition) activity within the small business sector is expected to accelerate now through at least 2022, according to Business Renewal Solutions, an industry think tank.
Roughly 250,000 private businesses in the United States typically change hands each year, the firm reports. But as the Baby Boomer generation approaches retirement age, that number will more than double to more than 500,000 businesses per year, Business Renewal says. In total, more than 7.7 million business owners will be looking to exit their businesses over the next 10-15 years. Some estimate that these businesses represent over $10 trillion in wealth.
Those M&A trends are unfolding in the IT channel, according to ChannelE2E, which covers IT service providers from Entrepreneur to Exit (E2E). Some of the activity involves business owners “aging out” of the market. Other M&A deals involve IT service providers buying their way into specific vertical markets or regions. And the latest wave involves VARs and MSPs acquiring expertise in such areas as software development, cloud services, corporate compliance, the Internet of Things (IoT) and big data.
Demographics, Macroeconomics and Impact on Valuation
Like any marketplace with buyers and sellers, the “price” of goods (in this case, the valuation of companies) can rise or fall based on the overall ecosystem’s balance of buyers and sellers. In a market with too few buyers and too many sellers, valuations fall. Naturally, a market with too many buyers and too few sellers drives up valuations.
Although many owners are aging out of the market, the balance between buyers and sellers in the IT services sector is relatively balanced -- though ratios can certainly vary from region to region. Overall valuations have held steady and/or increased slightly from 2013 to 2015, according to Service Leadership Inc., a research and consulting firm.
Generally speaking, MSPs are worth 6 to 7 times annual EBITDA (earnings before interest, taxes, depreciation and amortization). Valuations, however, can vary widely based on the metrics below.
Financial Valuation Metrics
Understanding what makes your business valuable is key to achieving a proper valuation. The following metrics can help to frame the valuation conversation between buyer and seller. But ultimately, your company’s valuation is based on the price another company is willing to pay for it.
- Revenue Mix (Managed Services, IT Projects, and Reselling): All revenues are not created equal. Managed services revenue -- especially if it’s tied to multi-year contracts -- is more valuable than reselling revenue, one-time hardware refresh revenue, and other one-time sales. According to Service Leadership Inc.’s 2015 market research:
- The VAR portion of your business generates 10 cents of valuation for each dollar of revenue. (Translation: $100,000 in valuation for each $1 million in value-added reselling).
- Break-fix hourly support generates 45 cents in valuation for each dollar of revenue. ($450,000 in valuation for each $1 million in break-fix support).
- IT project or professional services generates about 63 cents in valuation for each dollar of revenue. ($630,000 in valuation for each $1 million in IT project revenue.)
- True managed services generate $1.27 in valuation for each dollar of revenue. (A $1.27 million valuation for each $1 million in managed services revenue.)
- EBITDA: Earnings before interest, taxes, depreciation and amortization. EBITDA margins and trends provide investors a snapshot of short-term operational efficiency and longer term growth opportunity. A few EBITDA considerations to keep in mind:
- Target EBITDA Profit Margins: Generally speaking, the best-performing MSPs have EBITDA profit margins of 20 percent or more, with some world-class companies pushing toward 30-percent EBITDA margins.
- Valuations and EBITDA: High-quality MSPs are valued at 6- to 8-times their annual EBITDA. In other words, an MSP generating $1 million in annual EBITDA is typically worth $6 million to $8 million, though the figures can vary based on a range of additional factors (i.e., the economy, business growth rates, location, etc.) On the flip side, a VAR with the same $1 million in annual EBITDA is typically valued at 4- to 5-times; so this VAR is worth between $4 million to $5 million.
- Scaling Valuations Even Higher: Consistent and growing quarterly or yearly EBITDA is valued higher than a company with random highs and lows. Also, according to Pleasant Bay Capital Partners, the larger your business’s annual EBITDA, the higher your valuation multiple; with scales increasing exponentially at $5 million marks. Some general examples:
- EBITDA under $5 million: lowest multiple on valuation
- $5 million to $10 million: valuation multiple rises
- $11 million and above: very strong multiples; hire a broker
Other Important Variables:
- AMRR: Average Monthly Recurring Revenue: What can the acquiring/merging company rely on in terms of monthly revenue (and monthly cost.)
- Customer Diversification, Retention: How many different businesses do you serve; the average length of contract; and the average number of years your company has worked with customers. Similar to a SaaS company, IT service providers must show low annual churn (i.e., only 5 percent to 7 percent of customers should depart annually). Customer retention and diversity can also involve some nuances. For instance, some suitors may be seeking an IT service provider with a high concentration of healthcare customers. However, depending too heavily on a handful of customers can drive down your valuation.
- Multi-year contracts: While the SaaS world often allows customers to opt out of contracts, IT service providers can still demand longer-term engagements. The cost of acquiring, onboarding and support customers requires channel partners to pursue two- and three-year customer engagements. Anything less than that, and potential suitors will consider your revenue retention suspect.
- Growth Rates: Consistent quarter-over-quarter growth across your key metrics (EBITDA, AMRR and customer contracts, for instance) can greatly boost valuation.
- Specialties: Vertical expertise and certifications, for instance, can whet a buyer’s appetite for your business. Increasingly, the highest-value IT service providers have very specialized skills involving mission-critical cloud applications (particularly CRM or ERP), big data analytics and/or IoT (Internet of Things) expertise. Ultimately, IT service providers that help customers to monetize data have premium valuations.
- Geography: The desirability of your business’s location is in the eye of the beholder. A suitor desperate to move into your region will pay a premium. A suitor that already has a footprint in your geography will likely be less inclined to pay a premium.
Red Flags on M&A
Beware of easily avoidable red flags that will potentially lower your company’s valuation.
- Poorly organized financial reports: If your books are not in order and you are not immediately able to produce information about your business finances, your business valuation may suffer. Before you go into a potential exit scenario, get your books in order and create a cheat sheet that includes a snapshot of:
- Customer base
- Revenue year over year
- EBITDA year over year
- P&L for current year and prior full year
- Two year projections on all of the above
- Over-dependence on too few customers: Businesses are warned not to ‘put all their eggs in one basket.’ In terms of valuation, this is detrimental to business valuation. If over half the company’s revenue is wrapped up in one or two customers, the risk of business growth is too high and therefore valuation will be on the lower side. Be sure to work with multiple customers and spread risk so no customer represents a large part of your businesses revenue.
Remember: Strong EBITDA and solid recurring revenue contracts will attract the highest multiples. And having straightforward financial records and a good mix of long-term customers will help to raise your business’s valuation.
Wall Street’s Impact on Valuation
- Private Equity trends: Much like a trickle-down economy, the overall private equity sector can help to set valuations in the broader IT services market. Private equity firms have been particularly active in the IT channel over the past 24 months or so. Clearlake Capital Group, Court Square, Sverica Capital Management and several other PE firms now have ownership stakes in VARs, MSPs and integrators. Many of those PE firms have funds that acquire and “roll up” additional channel partners into their portfolios. That activity creates heightened awareness among service providers that aren’t quite ready to sell -- unless PE firms sweeten the deal.
- Venture Capital Trends: The venture capital market also impacts IT services providers and their valuations. The venture capital ecosystem deployed $58.8 billion across the United States in 2015, marking the second highest full year total in the last 20 years, according to PricewaterhouseCoopers LLP (PwC) and the National Venture Capital Association (NVCA). Those venture capital dollars, in turn, often spark new channel partner programs. If the programs are lucrative, channel partners can bolster their businesses and, in turn, raise their valuations.
- Price/Earnings (P/E) Ratio and Stock Multiples: P/E ratios -- which track a company’s stock price vs. its earnings -- influence valuations even for privately held companies. The average P/E ratio since the 1870's has been about 16.7. In 1999, a few months before the top of the Tech Bubble, the conventional P/E ratio hit 34 -- meaning that stocks were extremely expensive at the time, according to Yahoo Finance. Buyouts involving so-called Web Integrators involved extremely high valuations until the dot-com implosion and Wall Street correction arrived (1999 to about 2001).
- Debt financing: This is when a company raises money for working capital, capital expenditures or M&A activities by selling bonds, bills, or notes. The cost of debt financing ultimately involves interest rates. If interest rates climb, valuations can potentially fall since the “cost” of borrowing money becomes more expensive.