One of the most common questions I get asked when speaking with the many entrepreneurs of cloud and managed IT service companies, is “what are companies in my industry selling for, and how are they valued?”. My response varies depending on a culmination of factors, yet after a high-level assessment, it’s somewhere between 1-3x revenue. So, what drives this range, as there is quite a bit of variability between 1-3x? What time frame is this multiple tied to? While there’s no perfect science to get to an exact figure, as the market bears what the market bears, below, please find 6 key drivers of value, with their reasons, which will provide a sense of where you may fall within the range:
- Amount of Revenue: there’s always a premium for larger companies as the adage goes, its more work to do a smaller deal than a larger one, as naturally a smaller company has less sophisticated and organized accounting and reporting. Not to mention, smaller companies do not move the needle compared to that of a larger company, as well as it’s generally harder to reach “scale” i.e. a larger size, thus larger companies are rewarded value-wise. In the lower middle market, the key revenue threshold which divides the small vs. large is $10mm, then step functions up from there to $25mm, $50mm, 100mm, etc. The exception here may be if a company is growing fast and projecting $10mm in the current year, and they’re run-rating (mid-year performance extrapolated out) an amount on pace to comfortably hit the projection of $10mm.
- Margin of the Revenue: While revenue size is very important as noted above, equally if not more important are margins attached to this revenue at the Gross level, as well as at the EBITDA levels. There are two noteworthy examples here, one being VARs, which have become highly undesirable businesses due to low margins and disintermediation. Typically, Gross margins here are 10-20% and do not have a recurring nature to them, which is a double whammy. As a result, these companies are being valued somewhere between .25-.75x of revenue, or even a multiple of Gross profit. Another example is resellers of public cloud services, AWS and Azure for instance. It’s fascinating, as these resellers are in a hot, high growth space (public cloud), and have recurring revenue, where there is strong demand from acquirers and investors who are seeking acquire a “platform”. However, folks are reluctant to pay a strong multiple for these companies as their gross margins on such revenue is still in the “VAR range”, of ~10-20%. Also, it remains to be seen the long-term viability to grow such margins, as where is the true value proposition to demand a higher vs. lower margin on revenue? Companies have combatted this issue by wrapping other services around the resale business, which is helpful to the cause margin-wise, yet be mindful that sophisticated investors/acquirers will segment out the revenue by type and apply a lower multiple to the resale vs. the services (project vs. managed), despite there being robust growth and a recurring nature to it.
- Recurring vs. Non-Recurring Revenue: It’s no surprise that recurring revenue is highly sought after, and the reasons are quite self-explanatory. Thus, recurring revenue will generally receive a higher value than one-time or project-based revenue, however, the Achilles heel of recurring revenue or subscription-based businesses is their churn. So, if you look at two businesses, both with $15mm of ARR (annual recurring revenue) and one may be receiving a 3x multiple and the other 1.5x. The key difference may be the churn of one being 5%/mo, vs the other being .5%/mo. High churn negates the stable nature and value of recurring, in terms of being able to predict future cash flows, so this is certainly something to be mindful of. While project-based businesses are inherently less desirable, some IT services silos who are experiencing rapid growth, such as ERP cloud consulting (CRM, SAP, Oracle), and the public cloud partners, are seeing strong multiples, due to the robust performance and large go-forward market opportunities. Another example where project-based revenue receives strong value is if they have sticky, repeat revenue who can be substantiated year over year, as well as those with multi-year contracts. These types of companies have been valued of late in the 2-3x range.
- Composition of Revenue: This is an interesting one, as you can compare two recurring revenue businesses with $10mm of ARR (annual recurring revenue), yet one may be worth double the other. A good example here would be a horizontal player, vs. a vertical player. Naturally, the horizontal player will be less specialized than that of the vertical player, therefore require less specialized solutions, personnel, and thus pricing will be less. The horizontal player has a larger market opportunity yet faces greater competition. The verticalized player requires more specialization and thus will charge more for their solutions. Further, this provider will have naturally created a stronger barrier to entry, and in turn have less competition. While the vertical player may have a smaller market opportunity, they will have a better likelihood to monopolize that smaller opportunity, than the horizontal player, in a stable profitable fashion. This is attractive to private equity and strategic acquirers who are seeking to grow their investment 3-5x over 3-5 years, rather than acquire the next Uber. Further, with larger consolidators exploring buy vs. builds for offering more solutions or use cases, the acquisition of smaller specialized players makes a lot of sense, vs. another competitive yet smaller horizontal player. Vertical centric examples include healthcare, legal, financial, security/compliance, and or application-centric specialization such as ERP, CRM, etc…, or perhaps a combination of both.
- Growth of Revenue: This one when combined with the positive elements above, is arguably the most critical factor to sway the revenue multiple to the top end of the range. Companies seeing 30-50% growth, where it’s sustainable and predictable within a large market, is the most attractive and will likely generate the highest multiple. Realistically, to receive a strong multiple, IT/cloud service companies who are generally bootstrapped, are expected to see growth in the ~25% range, while maintaining healthy gross and EBITDA margins, ~50% and ~20% respectively. What is key here is to be mindful of which buckets of revenue will generate the most value long-term, to strategically position your company as such, for instance only offering resale revenue if they will take services along with it, which may reduce overall revenue and growth, yet increases margin, as well as customer penetration/stickiness, which drives overall value.
- IP: those who have developed and own IP, which is used in delivering their service, should see an increase in value, possibly incremental to the 3x figure. Whether it’s around management of the environment, for optimization purposes, or generally to enhance the solution for the customer, as well as to automate the process/workflow for the vendor, this should lead to scalability and increased margins over time, and thus creating a higher near-term value. It’s important to note, that this solution should be unique or differentiated to what’s available in the market from a 3rd party tools perspective, as why would you re-invent the wheel, and spend considerable resources doing so. Also, to receive value for this component, the vendor should be actively using this IP within their business as an integral component of delivering their solutions, vs. a customized solution built for one customer, to which there are grand visions of what’s possible for the product, yet it has limited traction.
Cyrus Maghami is Founder and Managing Director of Harbor Ridge Capital, which advises lower middle-market technology services and software companies on M&A and institutional capital raising. Prior to Harbor Ridge Capital, Cyrus was a private equity investor for both Kayne Anderson Private Equity and Shackleton Equity which he made considerable investments in the IT services and software verticals. Cyrus Maghami is a Registered Representative of and Securities Products are offered through Fallbrook Capital Securities. firstname.lastname@example.org.
A liquidity event, or a sale of one’s business, can be the largest monetary event in a person’s lifetime, thus adequate preparation is key to ensuring a smooth, and successful outcome. Those who have been through a sale process may understand what’s involved, yet for those first-time entrepreneurs, an indescribable exercise awaits, which if unprepared, can lead to a whole host of terrible outcomes. Most commonly managers end up drowning in due diligence requests, where they lose focus on the business, growth slows down, and projections are missed. This usually will blow up the deal, either by the buyer lowering the price or by walking away completely if performance is materially lower than initially projected. Of course, this isn’t the outcome you want, so the key is how can one mitigate such outcomes and ensure the highest probability of a successful transaction.
Best practices of preparing and planning well in advance makes life MUCH easier when engaging in a sale or capital raise, smoothing out the process for all parties involved, reducing management’s time requirements, allowing for more focus on the business, and ultimately increasing the probability of a positive outcome on all fronts. Below are the key areas to focus on preparation-wise, which not only help with a future transaction, but can also be useful for owners and managers from a business intelligence and analytics perspective in better understanding their business.
- Make sure your books are in full GAAP accrual, going back at least 2 full years, if not 3
- Hire a third-party accounting firm to convert your books to GAAP accrual trailing 2-3 years, and going forward. This is a black and white concept, so if your books are currently partial GAAP/accrual, this isn’t sufficient
- This may cost $20-30k as a 1-time project, and take a few months, but is well worth it and must happen prior to a transaction closing
- As part of the accounting clean up, make sure your entries (chart of accounts) in the accounting system are all properly organized/categorized for all three financial statements (P&L, BS, SCF). For instance, all 1-time vs recurring revenue are in separate buckets, corresponding COGS, expenses, capex is capitalized and placed on BS/SCF vs. IS., etc.…
- Be able to readily produce monthly, quarterly and annual statements, directly from the accounting software. Investors/buyers want to see monthly financials for 24, 36 and in some cases 60 months, and track trends across lines of revenue, margins on revenue lines, expenses, etc…
- this specific request is a monthly P&L for the last 36 months on one tab in Excel
- this shouldn’t be a request which takes an accounting department or professional a week to produce. It’s literally a dropdown items that takes 30 seconds
- Key here is consistency of GAAP accrual accounting, with proper segmentation of revenue line items by service/product line, corresponding COGs, showing true gross margin by product/service, as well as accurate categorization of expenses
- Further, ensure revenue and expenses are in the proper month where they’re supposed to be, NOT when they were collected or paid. Also, pre-paid expenses or revenue are properly deferred and amortized. Again, GAAP and accrual
- If you are unclear whether you are GAAP compliant, have a call with an accounting firm and discuss your practices. If you’re still unclear get a second opinion
- This references any/all data which describes your business outside of accounting. Below are reports that most sophisticated investors/acquirers will want to see on a trailing basis initially, when analyzing your business for investment or acquisition:
- Revenue by type for last three years. Break out product vs. service. For service breakout 1-time vs. recurring
- Margin by type corresponding to all entries above
- Unit economics – for each unit of product or service, what’s the corresponding COGS to deliver such product or service?
- Churn – customers gained/lost by number and revenue by month trailing for the last three years
- Revenue by customer for the top 20 for the last three years; Include contract start/end dates. Names can be coded
- Bookings by month for the last three years – breakout new vs. existing customer growth, and recurring vs. 1-time revenue
- Other KPIs which management uses to run the business
- Above is pre-term sheet diligence. Below are items which will be requested post term sheet where you’re in confirmatory due diligence. This is a small subset, as the business and legal due diligence lists can span 10-20 pages each!
- Customer contracts for the top ten customers
- Contracts for all vendors
- AR/AP aging for last three years
- Corporate formation documents – articles of incorporation, board minutes, operating agreements, corporate structure (parents, subs) etc.…
- Any/all acquisitions or investment documentation
- Capitalization table
- List of employees by function, comp, date started. Same list for each of past three years
- Organization chart
- All marketing materials used for client pitches
- Graphic of systems and workflow used internally
- List of all past/current legal matters or litigation
- Monthly bank statements for the past 24 months
- Audited and reviewed compiled financials for past 3 years
- Tax returns for the past 3 years
- Documentation of all owned or pending IP
- Costs per acquisition for new customers. Average useful life of a customer
- Price lists
- As you can see it gets quite intensive, and this is just a subset. During diligence, it’s very common that the buyer/investor will hire an accounting firm to perform what’s called a Quality of Earnings (QOE) which the company pays for and costs between $25-50k. This is basically a summarized due diligence package of all aspects of the business. It encompasses many of the items above, yet it’s much more in depth. The more prepared you are, the more painless that specific request is
- Maintain accurate and proper organization of files, within categorized folders. For instance, folders should include: Financials, HR, Contracts, Legal, Corporate, Operations, etc…
- Once this is created and actively used, it becomes seamless to begin sharing significant amounts of data
- Going at this alone from a managers/owner’s perspective is doable, yet not advisable. These deals are not in your control and can die at any time. You can literally be working on a deal for 6 months, be a week away from closing, and it can die right before for a multitude of reasons outside of your control
- Therefore, mitigate your exposure with support around you. This includes a CFO or controller, as well as an investment banker, and proper legal resource
- The Controller/CFO supports you internally from a financial/accounting/reporting perspective, while the banker architects and manages the entire process, especially leading all deal related discussions as much as possible. This allows management to focus more on ongoing operations and sustaining the growth of the business during this process
- As mentioned above, its never too early to start getting your accounting correct, financial /operational reporting in order, and proper organization of company information
- The further in advance you begin, the smoother the implementation of such practices, vs. a mad rush when a deal is starring you in the face, creating an avalanche of work, causing a tremendous distraction away from the core business
- For those currently evaluating a transaction where they acknowledge their lack of preparedness, it’s highly advisable to momentarily take a step back from your discussions with the buyer/investor, until you have an investment banker at least review your financials, and provide feedback on the state of your financials, how they should be presented, and most importantly on the valuation you’re receiving, vs. what’s in the market
- Accuracy of your financials as well as how they’re presented can mean the difference of 20-30% of value. A savvy banker knows exactly how financials should be presented, with the most important drivers highlighted, naturally increasing the valuation
- This is in addition to the banker of course knowing what multiples are standard, especially those focusing on your respective space, based on their transaction experience, comparables in the space, and other proprietary information
Hopefully this provides a nice framework of steps to take and what to expect with any M&A or capital raise transaction, so you can adequately prepare in advance and ensure the highest likelihood of success.
Starting my career on the private equity side, we were taught and told that nothing is better than a “proprietary deal” which means, a deal which an investment banker or M&A advisor is not involved. The key reason is that you have a one-on-one dialogue with a company vs. being one of many when participating in a process run by an advisor. This bears obvious benefit to the acquirer, namely that they’re not in competition with other folks, thus acquirers have an inherent advantage from a negotiation perspective around valuation and deal structure. The irony of that dynamic is that in so many cases, we the investor lost out on deals because the entrepreneur felt the proposed structure was too aggressive, when in reality a preferred stock instrument for a growth investment is standard, and if they had an advisor on their side to inform them of this norm, perhaps such deals would have proceeded.
While this strong preference is seemingly understandable from the acquirers’ perspective, it can be highly detrimental to the entrepreneur, beyond the company getting a worse deal than if they have other interested parties at the table. That reason alone, should propel those who aren’t building their business for their health, to bring on an advisor to properly explore their options, yet in addition, not knowing what you don’t know for first time sellers can present significant risks, and in many cases awful outcomes. I recently spoke with an entrepreneur who mentioned they had been through two failed sale processes over the years, which naturally I cringed, as the amount of time, effort, money, distraction and tease of such an experience is horrible for one outing alone, not to mention two. While a failed sale process is a nature of the M&A beast where deals can die for a variety of reasons, the reason why it failed twice heightened my cringe, as in both cases they signed term sheets with fund-less sponsors, meaning private equity groups who don’t have a committed fund. I always tell folks, it’s hard enough to get the stars to align to close with a larger, well-capitalized acquirer, yet with a fund-less sponsor you are significantly decreasing the odds of a close, as they do not have committed capital, and rather are at the mercy of their wealthy individual backers, who may become unavailable or disinterested at a moment’s notice.
This is one example of terrible results which could have been mitigated by having a savvy advisor managing this process, and guiding the seller appropriately. Ultimately, by having an advisor with expertise in your space, you greatly increase the odds of a successful close, which requires careful, tactical planning, guidance and execution, step by step, in addition to allowing for the market to present the best offer for the business, by being strategically proactive, vs. reactive with those who solicit companies directly, wanting a proprietary dialogue and negotiation, hoping for an attractive, below market price.