- The ‘tail’ refers to the thousands of MSPs in the UK most with revenue of less than £2m, many sub £1m.
- These firms generally have owners approaching (or past) retirement age, and who presumably don’t want to work forever!
- Their growth has plateaued as a result of inability to grow the client base beyond referral using formal sales and marketing methods. Or they have fallen into the trap of enjoying a higher income from the business, due to not reinvesting in growth (a trap that comes unstuck when a few clients all drop off at the same time!)
- They have low profitability but provide ‘a living’ to the owner, usually in the form of dividends. In truth “tax efficient dividends” can flatter an owner as to the value of the business.
- The topic of exiting the business is shrouded in mystery and is feared despite this being, maybe, the biggest sale the owner will make!
When it comes to M&A, there are many players involved, including Business Brokers, Finance Brokers, Investors, Staff and Customers and others. However for this article I am focusing on Sellers, Buyers and Valuation.
The Seller's Perspective
- Wants highest price (they can only sell it once);
- Sees the blood, sweat, tears and emotions invested;
- Wants to do right by staff and customers (balanced with their own self-preservation);
- Should have a life plan post sale (and probably do not dare to have one for fear of losing focus today);
- Should consider what they would be prepared to pay (and be REALISTIC when working out what that number means on paper and in practice if they were in the buyers’ shoes) and
- Wants to receive the ‘best’ offer when time is right to exit.The ‘tail’ refers to the thousands of MSPs in the UK most with revenue of less than £2m, many sub £1m.
The Buyer's Perspective
- Wants to pay the lowest price (or to be precise the lowest price that the seller could be persuaded to accept);
- Sees the staff, contracts and customer relationships as key assets (assets that must be maintained for him to realise the value post acquisition);
- Wants to retain required staff and profitable customers (and ideally not carry forward baggage, such as negatively-minded staff or troublesome customers);
- Has a plan post purchase to achieve return within 2-years (taking into account that there will be unexpected costs, customer losses and typical business related dramas. Buyer needs, say, 6-months’ of trading margin as a cushion) and
- Wants to be in front of ‘valuation qualified’ targets and to do so when the time is right for the seller to sell. The buyer will become as invested in the deal and doesn’t want a seller who could have a change of heart at the last minute.
The Qualification Anchor
- Assuming seller and buyer find themselves at the right time, or as close to the right time as possible, they need to (alongside getting to know one another) establish an efficient way of communicating and qualifying one another;
- Negotiating a price requires a starting point or common understanding and they need to advance discussions without rushing or moving too slowly;
- A valuation can be an anchor (is the £ valuation of interest to the seller and can the buyer afford the £ valuation and model a suitable return)? Valuation is a factual, disassociated view both parties can collaborate on, without prejudice, to an eventual price to be established later on in the proceedings;
- Price is linked to valuation (of course) but allows risk, reward and situational adjustments (explored later on) and
- The ‘right’ seller and buyer pairing may not yield the ‘best’ price for either party; I have heard a saying that when neither party is happy, the deal is right...or something along those lines.
My Valuation Methods
Based on my own experience and speaking with M&A active MSP peers; these 4 approaches can triangulate a ‘fair’ number:
- Annual Services Contract Revenue: 1 x Multiple. This is the revenue number the buyer is likely to be able to count on as contracts probably all renew at different times;
- Annual Services Contract Gross Margin (GM): 2 x Multiple. this gives the same answer as valuation 1 in 90% of cases. Most MSPs would expect a 50% GM. A higher or lower GM is likely caused by different accounting treatment or non-standard pricing;
- EBITDA (adjusted for active shareholder/role renumeration): 5 x Multiple. A higher multiple may apply for companies with larger revenues, those on a steep growth, those which have some brand value, market position, IP etc;
- Business Plan: A value based on future cash flow. This should yield the highest valuation for the seller all things being equal, and conversely gives the buyer the clearest view of how they will get their money back.
All approaches are plus/minus Net Assets (i.e. minus debt or plus retained profits).
Here is a valuation example to demonstrate.
Target business facts:
- £1million revenue
- 10% EBITDA (after shareholder market rate salary)
- £400k annual services contract revenue at 50% gross margin and, say, 25% net
- Zero Net Assets
Valuation examples using the various methods above:
1. £400k (estimated ‘contracted’ revenue on a £1m t/o and not taking account of one time products sales like PCs and ad-hoc services such as installation/projects, again which could be considered one-time).
2. £400k
3. £500k
4. £600k (this is a guestimate as facts’ are limited!)
Average £475k
Price Effects On Valuation
There’s risk & reward for both parties, so they need to think about
- Length (and strength) of contracted revenue i.e. how much of a cash risk is the buyer taking?
- Forecasted non-seller-dependent growth (and evidence of trend);
- Staff liability (length of service) especially if the buyer is part funding the deal through staff reduction;
- Payment profile for the deal. Here is a massive consideration for both parties. If all the payment is contingent on margin achieved then the risk is very low for buyer and very high for seller and vice versa, so either extreme needs balancing either with moving the payment profile to be more equal or countered against other considerations. For example, all money in advance could mean a lower overall price;
- Professional costs relative to deal size (legal & accounting costs). Advisor costs will be broadly the same for a £1 deal as for a £1million deal. This makes smaller deals less attractive;
- Seller’s role post sale: The seller could be liable for transitioning relationships with clients, staff and suppliers to the new owners, or may be assuming responsibilities in the buyer’s business. For example, if the seller prefers selling to delivering, they may choose to continue as a Sales Director. Involvement beyond completion will generally de-risk for both parties as long as each understands the other’s expectations;
- Seller’s motivation to sell (specifically the ‘need’ for time or cash today). If the seller has no urgency for cash or to free his time, the buyer may wish to explore how either can become an opportunity or risk and whether the seller may therefore ‘hold out’ for a higher price or change his mind about selling;
- Buyer’s motivation to buy (and achieve EBITDA, for example if Private Equity backed). The other side of the coin from the previous point;
- And the list goes on…
In conclusion, let’s go back to the beginning and substitute your numbers in the example valuations. It’s worth what someone is prepared to pay for it; so what would you pay for it?
Questions, comments and observations? You can reach me, Daniel Welling, at Welling MSP.
