Considerations When Prepping Your MSP or IT Service Business for a Liquidity Event or Capital Raise: Part I

Considerations When Prepping Your MSP or IT Service Business for a Liquidity Event or Capital Raise

By Andrew Gaffney and Dominick Robusto

Part I: Ten Things to Consider Prior to a Transaction

As businesses worldwide continue to navigate a rapidly changing IT and communications environment, the managed services provider (“MSP”) and broader IT services landscapes are receiving more attention than ever. Demand for fully managed, outsourced IT services is on the rise for a variety of reasons and sector tailwinds are abundant. The amount of MSP investment and consolidation activity is immense, and the momentum seems to be growing each day. Almost every IT-focused private equity fund we talk to is interested in this highly fragmented sector and with each passing week there seems to be a new private equity-backed MSP platform that will be chasing add-on opportunities. Needless to say, the level of interest in the space is exciting and MSP owners should be thrilled with the opportunity that lies ahead, and no time is better than now to start thinking about the future of your business. Regardless of where you are in building your MSP, consider the following 10 things as you prepare for and pursue a liquidity event or institutional capital raise:

1.     Start prepping yesterday.

Whether you are looking to pursue a transaction this year or in 3-5 years, it is important to start making strategic decisions today with an exit event in mind. While impossible to quantify the incremental value of incorporating best practices and proactive preparation, we can assure you of a few things based on our firm’s history of advising close to 400 TMT businesses over the last 20 years. Early preparation has the potential to uncover opportunities that could drive increased growth, profitability, and equity value in the long- term. Organization, clean GAAP-prepared financials, and the ability to generate requested KPI data quickly and accurately (see #4 below) are all essential to setting yourself up for a successful result. Post-transaction, most of our clients leave with a greater understanding of their operations, driving go-forward strategic initiatives and ultimately enhancing future value. Whether the preparation results in incremental EBITDA- or simply provides the granular data necessary to highlight key trends within your business, these data driven metrics can result in a differentiated positioning thesis and ultimately an increased valuation. If nothing else, removing common stresses through adequate preparation and proper data aggregation is worth the invested time.

2.     Start thinking about revenue quality, not just quantity.

Yes, it is true, larger MSPs tend to demand higher valuation multiples, but it is more complex than most MSP owners might expect. This subject is so critical we felt it warranted an entire part of this series you can find in Part II. For those of you that prefer a more high-level summary, see below for a consolidated version of our thoughts on the topic:

o  Contracted recurring revenue is a leading value-driver, and showing incremental traction is no longer the minimum criteria if a premium valuation is the expectation.

o  Revenue size is less important than the conversion of revenue to gross margin, EBITDA, and ultimately free cash flow. The conversion of revenue is heavily evaluated by sophisticated buyers and high cash flow conversion is critical.

o  Double-digit revenue growth, while driving cash conversion, is ideal. However, if EBITDA is being reinvested into growth, diluting current and historical profitability, illustrating a clear runway to free cash flow conversion is key.

o  Services mix driving revenue is critical to valuation but maximizing diversity of services and partners is not necessarily viewed favorably compared to a more focused solution set and partner list catered to your target customer needs.

o  Revenue concentration in attractive, growing verticals such as financial services, health care, and professional services is often garnering premium valuations as buyers are paying for expertise.

o  Customer revenue concentration can create deal challenges and detract from valuation, but it is not uncommon and can typically be managed in the context of a transaction.

3.     Get your financial and legal house in order.

Spend the time to ensure your financial reporting is in accordance with generally accepted accounting principles (‘GAAP’). This may mean investing in audited financials for some, and for others it may mean hiring a strong third-party accountant to review and compile financials. In most cases, we recommend our clients go through a sell-side quality of earnings (“QoE”) prior to marketing the business, even if they have been audited. The reasons for doing so are numerous, but in short it:

o  Provides more certainty around how buyers will view adjusted EBITDA, which will typically be the core focus regarding valuation.

o  Uncovers non-recurring/non-operating costs that can be added back in the presentation of EBITDA, while providing professional, third party validation of any other proposed adjustments to EBITDA.

o  Illustrates stakeholder commitment to the transaction to the marketplace.

o  Accelerates the learning curve and diligence process for interested parties, minimizing the time between final offers and transaction close.

o  Prepares you for financial and accounting due diligence to come.

 Additionally, it is essential to make sure all aspects of your legal framework are up to date and organized – corporate documents, customer contracts, vendor contracts, etc. Any elements of the business that have the potential to create transaction issues, including taxes (income, sales, and use, regulatory, etc.), should be addressed proactively with competent counsel or advisors. 

4.     Start tracking key financial data and KPIs.

While the types of managed services you offer will change, most of the data and key performance indicators (‘KPI’s) you should be tracking will be applicable across MSPs. Buyers and private equity funds typically want to see 3-5 years of detailed historical data related to financials, customers, sales, churn, support, etc. Make this a priority for your business, even if it results in additional investment in systems or a new employee hire. By procuring consistent historical data and visibility into your business, you will be able to support strategic decisions, reveal negative (or positive) trends, and ultimately drive value enhancement in a liquidity event or capital raise. 

5.     Have a deep understanding of your customer lifecycle.

Part and parcel to having clean KPI data is having a strong understanding of the evolution of your customer and how this has affected your revenue growth. Buyers are going to have strong interest in understanding what specific factors are driving growth. Expansion can come in a number of different forms, but common factors third parties would like to understand is if customers are organically growing with the business (buying new services / increasing their average spend) or if growth is being created by new customer acquisition, geography expansion, etc. An experienced financial advisor will be able to help create cohort, net retention, ARPU, tenure, service take-rate, and gross churn analyses. Nevertheless, having the data in a clean exportable form is essential to understanding and being confident in the underlying trends of the customer base. These trends help create a fulsome view of revenue quality, stability, and go-forward profitability, which all have a direct correlation with valuation and allow for the most flexibility in positioning a business to the market.

6.     Prep your mind and business for the inevitable due diligence deep dive.

Building an MSP from the ground up is hard work. Selling an MSP, with the greatest opportunity of success while maximizing value and other key transaction terms, is a lot of work as well. Business owners that have previously been through a major liquidity event or capital raise will know that sophisticated buyers, particularly private equity investors or institutionally backed strategic buyers, will want to turn your business inside out as a part of their due diligence process. They will request to talk to your top customers and your key people. On top of this, they will want every piece of operating and financial data your systems can generate. It is invasive, often uncomfortable, but generally necessary. Buyers need to be able to check all the boxes as they have a fiduciary duty to their investors to leave no rock unturned. While having a knowledgeable advisor can be invaluable in phasing out the due diligence process to limit unnecessary exposure, you should prepare for what will ultimately be a comprehensive review of every aspect of your business.

7.     Commit to a transaction, continuously testing the waters leads to value deterioration.

There are few things that can detract from the value of an MSP owner’s business more than gaining a reputation for wasting the time of prospective buyers or investors. We have seen it over and over.  Most commonly, we see businesses that are vaguely for-sale all the time, with owners having conversations with potential buyers quite regularly but never formally exploring a sale. In the worst cases, a business may go through an entire sell-side process that lasts 3-6 months, possibly even signing a formal offer with a prospective buyer, only to get cold feet or dramatically change valuation expectations. Speaking of which…

8.     Get valuation guidance from a professional with sector experience.

Without question, not all MSPs are created equal. While generally trending up over the past few years, we have seen market valuation multiples vary widely based on a diverse set of factors (see Part IV, which goes in depth on key MSP valuation drivers). Before spending time exploring a transaction, we highly recommend receiving candid advice from a professional with experience in the industry to provide you with an educated perspective on what your MSP business might yield. Obtaining inaccurate market valuation guidance is not constructive towards achieving your end goals. If the guidance is below market, you could be setting your expectations too low and ultimately leave dollars on the table. However, it is more likely you will receive guidance that is too high, resulting in unachievable expectations and potential disappointment down the road.

 9.     Although not necessary for all MSPs, consider hiring a financial advisor.

While this is certainly self-serving, we will stand behind the benefits that most MSP owners will receive by hiring an experienced financial advisor to manage a sale or capital raise. Although the primary reason for engaging an advisor is to maximize both valuation and optionality for stakeholders, the value stretches far beyond these inherent benefits. An experienced advisor in-tune with the relevant buyer / investor landscape will be able to:

(a)    Position your business to each prospective counterparty.

(b)    Incorporate relevant industry themes within the positioning thesis.

(c)    Manage an efficient process from end-to-end that allows you to continue to focus on your business.

(d)    Provide invaluable market perspective on key economic and business terms for similar transactions.

Considering the fragmented nature of the MSP sector and the number of active successful small businesses that accompany the space, we recognize the cost of a seasoned financial advisor may prevent owners from justifying the expense. For those of you that find yourself in this category, our suggestion would be to avoid the allure of a generalist business broker. Recognize that most investment banks with expertise in this sector, including our firm, would be willing to spend time with you and provide introductions to active buyers or investors that would be a good fit for your business and transaction goals. A poor advisor is often worse than no advisor, as your time and money is valuable.

 10.  Do not let your foot off the gas- particularly once in market.

If you decide to run a process or engage with buyers / investors, it will be a distraction. With this understanding, do not let this distraction take attention away from operating your business. There is nothing that can derail the perfect transaction quicker than a business that starts to materially miss its projections via a slowdown in new sales or the loss of a significant customer. Operating your business must take priority over any transaction or run the risk of deterioration and an unsuccessful transaction… not an enviable combination!

Preparation is everything when it comes to navigating a successful transaction, and a little bit can go a long way. While these ten tips are by no means exhaustive when it comes to preparing your MSP for liquidity event or capital raise, we hope you find value in these points regardless of where you are in the transaction process. In Part II of this series, we will examine the crucial role of revenue quality in maximizing valuation of your MSP as you consider future M&A plans for your business.

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About the Authors

Andrew Gaffney / Managing Director/ [email protected]

Andrew Gaffney has over 25 years of investment banking and corporate finance experience, leading numerous strategic transactions including mergers and acquisitions, recapitalizations and debt and equity financings. He has worked with clients in a range of telecom, media, and technology (TMT) sectors including cloud communications, managed IT services, network services and software. Andrew’s clients include Broadcore, Broadsmart, Clearspan, DeCurtis, IFX Networks, Meriplex Communications, NexVortex, OnSIP, Simple Signal and Telovations. Prior to joining Q Advisors, he worked at SunTrust Robinson Humphrey, a leading middle market investment bank based in Atlanta. Andrew received a B.A. degree in History from Washington and Lee University and an M.B.A. with honors from The Wharton School, where he was a Palmer Scholar. In addition, Andrew holds the Chartered Financial Analyst designation.

Dominick Robusto/ Vice President / [email protected]

Dominick Robusto joined Q Advisors in 2019. Previously, he executed numerous mergers and acquisitions, equity and debt financings, and strategic advisory engagements for clients across the telecom, media, and technology (TMT) industries with an emphasis on software and hardware technologies within the Internet of Things (IoT) sector at KPMG. Specific clients on whose transactions he has been engaged include 3M Company, Absolute Performance, Inc., Atlantic Metro, Cognizant, Control-Tec, Kiosk Information Systems, Smiths Group, Telco Experts, Ubisense Group plc, and WCS. Dominick received his MBA in Finance with Distinction from Texas Christian University and his B.S. from Trinity University. Dominick holds the Chartered Financial Analyst designation.