Full Report June 2016


Exit Strategies Toolkit

A corporation is an independent entity, whose conscience is the collective product of its founders and its funders, rather than the ideals of any one person, including yourself. There are many subjective ways to judge the value of its business model and objectives, but only one certain way to ascertain that value objectively: by assessing its exit strategy.

This Exit Strategies Toolkit from CompTIA offers a thorough, comprehensive, but plain-spoken framework for developing a business model that enables a viable exit strategy that prospective partners and investors will appreciate.

You wouldn’t launch an IT project without first planning its full lifecycle. So don’t launch your IT business without considering how it might wrap up. Download this toolkit now and consider the bigger picture.

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Section 4: Putting Your Business ‘On the Market’

Many exit strategies unfold over multiple years or even decades. But sometimes, exits involve accelerated timetables. Perhaps you’ve received an unsolicited offer for your company. Or maybe your personal priorities, health or financial standing have changed -- and it’s “simply time to sell.”

Sellers, of course, need to find buyers. And that typically requires putting your business “on the market” in a discrete, carefully planned manner that doesn’t alert employees or customers. Here’s how best to embark on this quiet, confidential journey.

Creating a Shortlist of Potential Buyers

To gain the best valuation and find the most attractive buyers, Divestopia recommends that you (or your broker) identify potential buyers that have:

  • Expansion plans that are similar to your business’s objectives
  • A vested interest to diversify into your company’s market or skill set -- either horizontally, vertically, regionally or technically
  • Recently undertaken acquisitions
  • Surplus cash
  • Announced a public listing
  • Recently announces a consolidation program
  • Sold off part of their business
  • Similar makeups to your business -- but in different geographies
  • “Roll up” or “private equity” strategies in place

Where to Find Potential Buyers

Now that you have the basics down, it’s time to put your business on the market. Here are a few tips to get you closer to potential buyers. The number of companies that you reach out to may be dependent upon your exit strategy. For instance, if you are looking to do a geographical equal company merger, there may be only a dozen companies that you’ll pursue. If you are looking to sell to a third-party within your industry (and geography/specialization is not an issue), you may outreach to thousands of companies to find a handful that may show interest. In either case, there are multiple paths that will help you find the best potential buyers. Regardless of the steps you pursue make sure all interactions are confidential:

  • Local Market Outreach: If your focus is purchase or merger in a specific geographical area, try: Word of mouth; contacting your area business bureaus and business associations; local market advertising.
  • Online: To extend your reach of potential suitors, use online tools (some free/some nominally priced) and come up with a solid list of companies to whom you’d like to reach out. Examples include: Data.com (formerly Jigsaw, owned by Data.com); LinkedIn; online business listings and more.
  • Hire a Broker: Don’t have any idea how to get started? We recommend working with a broker. The right brokers are seasoned professionals who know how to find the right type of potential buyer/merger partner for your business. They can assist in developing the outreach strategy, identifying a short list of prospects and conducting the first round of outreach, setting meetings, etc.

Steps of the ‘Typical’ Sale

Terrific. You and/or your broker have identified one (or more) interested parties. Although no sale can be classified as typical, most corporate sales do follow a certain set of steps, as outlined below:

  1. Letter of Intent (LOI): This is an ‘offer letter’ which sets general sales parameters and typically asks for a timeframe on non-compete while you complete the due diligence/discovery process for the potential acquiring partner. As Matthew Brenneman, attorney at law, states, “Think of an LOI as an engagement ring, but not the marriage itself.”
  2. Due Diligence/Discovery Process: After the LOI is signed, the acquiring company will ask for deeper information on your business. This is typically tedious work; made easier if you have good records of your financials and other business documentation. Expect to provide the following information, at minimum:
    • Financials:
      • YTD sales, covered to prior year, compared to budget
      • Monthly income statements, monthly balance sheets
      • Revenue bookings for year, compared to prior year, compared to budget
      • List of customers, yearly spend
      • Product development expenses
      • Projected P&L statements for following year to two years
    • Employees:
      • Overview of employee roster
      • Compensation, including benefits, bonus plans, payment policies, etc.
      • Benefit expense
    • Operations:
      • Vendor and supplier list with financials
      • Description of Products sold
      • Pricing strategy for products
    • Contracts:
      • Client contracts
      • Vendor contracts
  3. Asset Purchase Agreement (APA) or Merger Agreement: Congratulations, you are close to the finish line. But don’t throw a party yet. The acquiring company still has the ability to change the deal structure based on discovery, timing, etc. Assuming the process has gone smoothly the acquiring company will prepare an APA. This document will cover every aspect of the acquisition or merger, including financials; term of payout; non-compete agreements; employment/consulting agreements and more. Work with an attorney to assure you understand everything in the APA before you sign your name.
  4. Trademark, Copyright and Domain Name/URL Assignments: Upon closing, you will sign over all trademarks, copyrights and domain name assignments to the acquiring company. Make sure your documents are up to date so this doesn’t cause problems at the finish line.
  5. Employment and Earn-outs: Depending on the terms of your agreement, your executives may have employment agreements with the new firm, and/or an earn-out agreement that must be met to guarantee a full payout of the acquisition price. Earn-out timelines typically range from 30-days to 3-years.

Section 5: Business Valuation Quick Start Guide

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.

Section 6: After the Exit

After a company sale, merger or other transition, expect stress levels to rise for your staff and your customers. These two groups likely did not know that an exit was imminent and don’t know what/if they have a role in the new corporate structure. Messaging, immediately, is crucial. Below are some tips in terms of messaging your staff and customers and assuring your transition plan is firmly in place.

Informing your Staff

  • Timing: This can be tricky. In most cases, you cannot legally tell staff about an acquisition or merger until the final paperwork is complete. There is a very small window of time to inform staff before press releases hit the wires. Pre-plan a staff meeting/call for either late the afternoon prior or very early the morning of the announcement. Leave time for questions at meeting/call - also be available for private conversations with staff throughout the day as individuals may not be comfortable asking about their roles in a group setting.
  • Messaging: Be honest and share as much as you can about the situation and the reasons behind the decision. Try to explain how this will impact staff members. Remember, from their vantage point, this isn’t about you, it’s about them.
  • Question and Answer sheet: Prepare a general Q&A sheet for your team and get it to them ASAP. You will want a united front to the industry and the more information you provide to your team, the more cohesive the messaging to the market.

Informing your Customers

  • Timing: It’s typical to give your biggest customers a head’s up directly before the news hits the wires. Pre-plan 20 minute calls with each of your customers (divide and conquer with business partners if necessary) and let them know what’s happening.
  • Messaging: Be honest and share as much information as you can. Your customers will want to know precisely what this change in ownership means to their service plans, their product support and their pricing models. Be prepared to answer a lot of questions about the acquiring company or the merger company and what they will bring to your customer to further enhance their current service.

Transitioning the Business

Transition plans can vary from three weeks to three years post transition. Depending on the timeline of the transition the process will vary considerably. Be considerate to your buyer, no matter the process and transition time, by providing the following:

  • Turnover reports. Create a status report for all customers, staff members and vendors. Try to include anything you think might be helpful for those who might be taking over the duties from you or your team.
  • Staff reporting direction. Help new management know what to expect from your staff. What are your team’s skill sets and where might they fall short. As with a succession plan, give new management a guide for positioning your staff in the most relevant positions.
  • Recommendations for new ownership. If you have recommendations on new product lines, new sales packages or up-sell opportunities with your current customer base, provide them this information. If there are sticky points with customers, let new ownership know these as well.

Navigating Setbacks

There may be situations when your business transition doesn’t proceed smoothly. Here’s how to potentially mitigate those challenges:

  • Earn-out Terms: In many exit scenarios, the buyer pays a portion of the sale price up-front (perhaps 50 percent of the overall price), and then delivers incremental payments (the other 50 percent of the sale price) over several quarters or years. In other words, only 50 percent of the buyer’s payment to you is guaranteed, and the other 50 percent depends on certain metrics after the company sale takes place. Earn-outs can be tied to any financial (or non-financial) metrics, but common options are revenues or adjusted EBITDA. From the seller’s point of view, earn-outs should generally be structured with relatively short terms, often no more than two to three years, and many times much shorter periods, according to StrictlyBusiness.com. Work closely with your legal advisor and push for “incremental upside” in any earn-out deal. For instance, your earn-out can potentially include “step up” bonuses if the business you sell greatly exceeds the buyer’s profit or revenue expectations during the earn-out period.
  • Earn-out Employment Agreements: Are you required to remain with the company after it’s sold, or will you resign from the business? Carefully discuss both scenarios with your legal and financial advisors. Walking away means you have no control over the business’s performance during a potential earn-out period. Remaining with the business could require accepting a role, position or title that doesn’t interest or excite you. Ultimately, you want to pursue the least painful path that delivers the highest probability for a successful earn-out.
  • Earn-out Lawsuits: In some cases, buyers fail to pay the full earn-out to sellers. The buyer may believe the acquired business is not meeting agreed upon objectives. The seller may disagree. With that potential scenario in mind, many earn-out agreements include Alternative Dispute Resolution (ADR) language -- which typically refers buyers and sellers to an arbitrator or independent accountant. Ask your attorney for additional guidance on ADR language.
  • Non-Compete Agreements: When acquiring a business, the buyer wants to protect that investment. And that often involves a non-compete agreement. The legal document prohibits you and/or certain members of your team from competing with the business you just sold for a set period of time. Always consult with your attorney before beginning any third-party discussions about a non-compete agreement. Sellers should try to limit the non-compete to very specific types of business, work or industries that will not limit your future business plans, according to the U.S. Small Business Administration. Try to come to an agreement and form contractual language around the very specific things that you should not be doing in any new venture, the SBA recommends. Also, consider limiting the non-compete time period (typically, one to two years -- but never more than five years) and geography, the SBA concludes.

Section 7: CompTIA Programming

CompTIA provides guidance and assistance for channel business owners. Here are some highlights from CompTIA groups who are here to help support you and your business journey.

CompTIA Future Leaders

The Future Leaders community is founded with the idea of understanding and embracing the multi-generational workforce and building best practices. Our goals are to consider the different characteristics of this next generation of IT leaders and what that means to their careers. We want to provide guidance on how IT community members best display and consume information, as well as understand the IT needs and drivers of the community and what this means to the channel. We also want to help future leaders grow in their careers and provide guidance to others on how they can help future leaders grow a career in their business. Future Leaders Community offers:

  • Access to best practices for understanding multi-generational workforce
  • Mentorship programs for future leaders
  • Information on IT needs as a means of uncovering new IT opportunities

Mentoring and Retaining Future Leaders

The best performing companies typically have reasonably low employee turnover -- especially among the highest-performing workers. An ideal turnover figure -- the rate at which employees leave each year -- is 10 percent of your staff, according to The Gallop Organization.

  • A figure dramatically higher than 10 percent annual turnover may suggest that your company suffers from low employee morale and other weaknesses.
  • A figure dramatically lower than 10 percent annual turnover may suggest that your business doesn’t hold employees to high enough performance standards.

The big question: What inspires loyalty, especially among millennials and other new-generation workers who may eventually run, buy or own your business? According to the Society for Human Resource Management, the top five factors that influence employee loyalty are:

  1. Job Security
  2. Benefits
  3. Opportunities to Use Skills
  4. Organization's Financial Stability
  5. Compensation

Still, a range of factors can further influence loyalty, according to CompTIA’s Future Leaders community. Members of that community say the following factors further drive loyalty:

  • “I value employers that tie performance to compensation and invest in their work forces. Employers who do not invest in their employees and expect to pay the same rates for different levels of value are misguided and stuck in legacy processes.”
  • “My employer has to offer growth opportunities; a culture that supports an open dialog with employees; and the opportunity for me to gain industry exposure.”
  • “Having a valuable and meaningful voice in the workplace is an important factor. I want to know that my opinions matter even if superiors do not move forward with my suggestions. Being able to have a say and make a difference is a vital part of staying motivated and allows for me to feel empowered to perform better for the company.”

Employee Retention and Your Exit Plan: A well-defined exit plan will include a list of your business divisions and/or departments, key executives who lead each business area, and associated headcount/budget for each area.

  • Even before a potential “exit” arrives, you should be doubling down on your best employees, grooming them for leadership positions and rewarding them accordingly for their performance. When a potential exit does arrive, your business should carefully consider if or how the deal should offer retention bonuses for key staff members. Those bonuses and other perks can minimize employee anxiety while boosting retention through the ownership transition. Speak with your legal advisor about potential employee retention plans as part of your exit plan.

Section 8: Closing Thoughts & Contact Information

Summary

Using this toolkit as your guide, you’re now ready to proactively address your company’s exit strategy. Through careful consultation with your ownership team, legal counselors and financial advisors, you’ll properly protect and maximize the value of your business -- even before a potential exit day arrives.

CompTIA Contact and Membership Information

To explore the benefits of CompTIA premier benefits for IT service providers, including access to all CompTIA research, education, peer communities of practice, industry advocacy, and philanthropy, please visit CompTIA on the web or contact membership@comptia.org.