Considerations When Prepping Your MSP or IT Service Business for a Liquidity Event or Capital Raise: Part 2

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

By Andrew Gaffney and Dominick Robusto

Part 2: The Importance of Revenue Quality

In this section, we continue with an expansion on the importance of building high value, recurring contracted revenue. We are witnessing an ongoing transition from revenue models predominantly focused on growing top-line through non-recurring revenue to models focused on creating strong go-forward stability via multi-year contracted revenue. Each MSP is at a different stage of this transition, and we understand shifting revenue composition can take years to accomplish organically. Regardless of where you are on the continuum, we can guarantee that the discipline and focus you are applying to actively transition your business is valued by the market. Here are some key considerations as it relates to revenue in the context valuation in M&A transactions and capital raises:

1.      View revenue (and profitability) through the lens of a lender.

Before we jump into specific financial profile qualities that interested parties search for, we should briefly discuss one predominant underlying driver- leverage. Plain and simple, the use of debt can increase a buyer’s equity returns. The more leverage a buyer can comfortably layer onto a business, the higher the baseline valuation will be. With this understanding, debt providers have an easier time underwriting companies that have a financial profile defined by multi-year contracted recurring revenue and substantial cash flow generation compared to companies predominantly comprised of non-recurring revenue.

2.      Contracted recurring revenue drives value.

Rapid growth and interest in the IT services sector has largely been driven by a business and revenue model shift from primarily non-recurring (VAR / consulting) to contracted recurring services with healthier margins and greater long-term stability. Active buyers and private equity funds are heavily focused on and will pay premium valuations for business with 60-70% recurring revenue. With that said, if your business has 20-30% recurring revenue and has shown momentum transitioning towards multi-year contracted revenue, this is attractive as well. Ultimately, the proof is in the data and the conversion story will be important to the market. Understanding that recurring revenue is the preference, not all non-recurring revenue is created equal. Highly strategic public cloud migration, system integration, cybersecurity, or other highly sought consulting expertise accompanied by long-term reoccurring project horizons is also viewed in a positive light, as is a customer base with attractive average tenure and a history of consistent annual revenue. In the end, the IT market is highly fragmented and competitive today, and premiums are paid for certainty of revenue based on recurring services contracts with strong margins and historical retention rates.

3.       Size and growth do matter, but mostly in terms of profitability.

Lots of folks like to focus on top-line growth and scale, but bottom-line scale and stability based on recurring revenue and healthy margins creates a strong case for downside protection, continued go-forward profitability, and the opportunity to juice returns with leverage. Understanding that historically value-added resellers (‘VARs) transitioning to a MSP business model might have been focused on product resale revenue accompanied by low margins, our suggestion would be to stay disciplined with your transition and continued to drive recurring services, potentially at the expense of the topline.  Product resale revenue may make for an attractive topline, but EBITDA stability is generally what matters. There are distinct premiums being paid for MSPs with $3-5M in EBITDA and even more so for $10-20M . We can assure you $20M in topline with 25% EBITDA margins is generally more attractive than $100M with 5% EBITDA margins. The one caveat here is growth, and MSP’s that can drive consistent annual recurring revenue growth of 30% in lieu of bottom-line margin can often drive an attractive valuation based on revenue, as long as the revenue mix is attractive and there is a convincing story showing a path to reasonably strong cash flow.

4.      Knowing your customer is critical.

Understanding we touched on this subject in Part I, it is worth reiterating that having a strong understanding of customer trends within your business is key to achieving a premium valuation. Is growth being driven by customers that joined the business three years ago and have steadily increased their spend and services take-rate? Or is growth being driven by new customers and sales, or a combination of both? An experienced financial advisor will be able to help create cohort, net retention, ARPU, tenure, service take-rate, and gross churn analyses, but having this data in a clean exportable form is essential to understanding the underlying trends of the customer base. These trends help create a fulsome view of revenue quality, stability, and continued profitability which as we know have a direct correlation with valuation.

5.      Services mix is important, but you do not need to offer everything.

We have seen several MSPs across the country lose their identity and quality of service by offering too many services from too many partners. Yes, survey data and our experience suggest businesses generally prefer to work with fewer technology vendors, but they also appreciate expertise and working with vendors that know their strengths. While not a rule, we have seen the most success from MSPs that retain a certain level of service focus and expertise, which usually acts as the lead-in for selling additional services/capabilities (land and expand). It can also support differentiated positioning within this highly competitive sector.

6.      Conversion of revenue to free cash flow is critical.

Many of the top buyers and investors in the industry are heavily focused on free cash flow.  Gone are the days of pure EBITDA focus. Although certain GAAP accounting policies such as capitalized labor can result in greater EBITDA, most buyers will overlook this. If you have a capital-intensive component to your business (i.e. private cloud hosting), be diligent about tracking growth versus maintenance capital expenditures. Do not forget the key metrics that allow you to provide certainty around the go forward capital intensity of the business and ROIs related to customer opportunities that call for material capital expenditures. 

7.      Vertical specialization is highly sought after,

While certainly not the top priority, many buyers and investors are actively seeking specialization, and will often be willing to pay a premium for it. Of particular interest are highly regulated sectors which tend to have more stringent security and compliance requirements (i.e., financial, health care, etc.), as well as attractive niche sectors such as senior living. At a minimum, it is worth considering how you might best position your business in terms of vertical expertise and whether there are some strategic changes that could be made to enhance the uniqueness of your offering and targeted sectors.

8.      Customer concentration can be transactionally challenging.

There is only so much you can do here. It is natural for a MSP to have some level of customer concentration, and obviously it does not make sense to turn down revenue opportunities that will result in increased concentration. Be aware that a less concentrated top 10 or 20 customers is much preferred, and any customer north of 10-15% of total revenue may result in more scrutiny during due diligence, not to mention a potential need for structural protections for the buyer. This could include a separate escrow released based on customer renewal, contingent consideration, or other structural mechanism to provide a buyer or investor a reasonable amount of certainty they will get what they pay for.

In Part III, we lay out some of the key data and KPIs we see most often requested by buyers and investors.

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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.