Maximizing the value of your IT solution provider business in the timeframe you want
For the past several years and hopefully many more, private equity and other professional investors, have been attracted to the IT solution provider (TSP) business—and the managed service provider (MSP) business model especially.
This is fortunate because capital coming from outside the industry provides wealth-extraction options that owners in less appealing industries don’t have. This article explores how TSP business owners who maximized value upon exit accomplished that wealth goal.
Business valuation explained
A business valuation is a more or less accurate estimate of how much your business might be worth. To be clear, there is only one point in time when a valuation is precisely accurate, and that is right at the moment the asset is sold. Just a second later, and the value can only be estimated. As the saying goes, “a thing is only worth what someone will pay for it,” and then only at the moment of transaction.
Nevertheless, being able to estimate likely value is an important part of growing and realizing a value that substantially meets or beats the shareholder’s expectations.
There is no standard way to value private companies. Accounting firms will often use some form of discounted cash flow (DCF), but this method essentially focuses on the future financial value of likely profit streams and doesn’t consider the appeal of one industry sector versus another. Put another way, it risks over-estimating value in less appealing industry sectors and under-estimating value in appealing ones.
Public companies are valued daily, and popular stocks are valued in tens of thousands of transactions a day. For valuing private companies however, it is more typical that every valuer has their preferred method.
We’ll share what we have found to be a useful method for estimating the value of TSP businesses for planning purposes—a good “rule of thumb” or an “eyeball” way of judging value at the start. As you get closer to actually selling (or buying) a company, you will likely want to get additional expert opinions, multiple bids (if selling), and/or somehow gain exposure to a stream of similar deals.
Importance of having a value creation strategy
No matter how great your company is, you can’t run it forever—sooner or later, you will exit.
TSP owners who most often realize the value they want or more, are those who have a value creation strategy. That is, those who specifically articulate to themselves and their advisors: how much value they want to create (“$10 million”), by when (“December 2029”), and how they will likely extract it (“sale to my children, my management team, outside investors, employee stock ownership plan, etc.”)
These three factors—especially the value and timing—then form the basis for all other plans and decisions made in running the company. If the desired goal is $5 million in 3 years, the trajectory of the company’s performance will need to be materially different than if it is $8 million in 10 years.
Solid thinking—including counseling by a financial or wealth planner—should go into this, but that doesn’t mean it’s static. The value creation strategy should be validated or adjusted in the fourth quarter of each year, as the starting point for planning the subsequent year’s budget.
That budget must be the next step up from the current year, for a company to be on the path to the desired value within the desired timeframe. This is how the top performers align each year’s progress towards their ultimate goal.
While solid planning should go into it, the value creation goal (money-wise) and timeframe, don’t have to stay the same until the date of exit. Needs and goals change. A value creation strategy that was initially, say, $8 million in 10 years might evolve four years later, into one of $10 million in seven years. That’s one year longer but 25% higher than the original strategy. Or the value might be lower than initially set, and the timeframe may be shorter.
All of that is fine—the distinction between those who most often substantially attain their goals, versus those who most often do not, is the fact that they stay engaged in this planning, annually and earnestly, and use it as their guide for all decisions.
Mergers and acquisitions
For TSPs, the mergers and acquisitions (M&A) market is strong, with valuations holding high. That can, and will, change based on a variety of factors. Hopefully, those factors will continue to offer sellers higher values and favorable deal structures.
Happily, as we shall see in a moment, the financial performance that optimizes company value also happens to be one that optimizes the amount of cash the business generates. This means that even if the market for TSPs should weaken, those who had attained high value but not yet exited, still own an asset that produces strong cash flow. Part of this cash flow can then be invested in other industries—through ownership of private or public companies—that are valued highly at that time.
As of August 2022, TSPs with a high proportion of their revenue coming from recurring revenue services, such as managed services or private cloud, have the most appeal and are attracting the highest valuations and most favorable deal structures.
Here, it is important to differentiate between the generic term, “monthly recurring revenue” (MRR) versus “managed service revenue.” In short, all managed service revenue is MRR, but not all MRR is managed service revenue.
Most of the time, selling recurring revenue comprised of other companies’ offerings—examples are Microsoft and Amazon cloud services—is both lower in gross margin (profitability) and less sticky than selling your own service offerings.
For example, as of August 2022, current gross margin on Microsoft 365 is generally under 15%. Given that a well-run MSP spends 30% of revenue on sales, general and administrative costs, this means that for every dollar of Microsoft 365 sold, the MSP loses about 15% at the bottom line. That’s not a business model many investors would put a premium on. At the same time, the customer can easily switch that Microsoft account to another TSP; it lacks the stickiness of the managed services revenue.
Thus, top-performing (top value) MSPs do resell cloud services but they make sure their “wrapper” of managed services sold to the same customers equates to around five times as much revenue as the cloud resale generates.
Product-centric solution providers can drive additional value by growing managed services revenue and need not fully transition to the MSP business model to win interest from those looking for value-added resellers (VAR).
How can you estimate business valuation?
TSP business owners can get a ballpark figure for the possible value of their business—without having to yet hire a professional valuer or ask for bids. Here we combine two approaches:
- Estimated value based on revenue size and mix—this recognizes business model
- Estimated value based on production of cash flow—this recognizes financial value
- Then we average the two
The valuation multiples in the table below would change over time. Thankfully, although there have been substantial valleys following each recession, the trend has broadly been up for over 40 years.
Okay, set aside your phone, close the door, and get out your pencil.
Approximate Revenue Valuation
As of August 2022, approximate revenue multiples are as follows:
There are a variety of reasons why one stream of revenue is worth more to most investors than another—they boil down to gross margin and predictability. Higher in profit and more reliable? I’m going to place a higher value on it.
Approximate Cash Flow Valuation
At the time of this writing, approximate EBITDA multiples are as follows:
(Earnings before interest, taxes, depreciation, and amortization (EBITDA) is the most commonly used proxy for cash flow in these situations. This is calculated after the owners pay themselves a fair market wage for the role they play in the company.)
Putting These into Action
Let’s put these into action with an example.
Let’s say I have a $3 million MSP with close to average revenue mix and profit performance, per the Service Leadership Index® benchmarking service. As of Q2 2022, average revenue mix is shown in the rightmost column of this chart (which also shows average revenue growth):
If my $3 million in revenue is attributed to 51% managed services revenue, 36% product resale (traditional and cloud), 8% projects, 4% private cloud, and 1% hourly support, when I apply those revenue streams to the revenue valuation table, I get approximately $2.7mm in possible value:
Now let’s see approximately what the current market value of my profitability is. I’m at about the industry average, which for Q2 2022 is shown in the right-most column of this chart:
For Q2 2022, the adjusted EBITDA of the average MSP was 12.0%. “Adjusted” means after the owners take fair market wage from their income statement (not balance sheet), for the role they play in their company. We suggest this approach because it will be used by most valuers.
If I take my $3 million in revenue at 12% adjusted EBITDA (because my company is right on the average), I have $360,000 in adjusted EBITDA. Looking at the preceding EBITDA multiples table, I (thankfully) am not in the bottom EBITDA % category; I’m in the middle. This means each of my EBITDA dollars gets multiplied by seven to estimate value based on profitability.
$360,000 x 7 = About $2.5 million
So, to enhance the likelihood we’re in the right range (and because as an owner I want the most conservative reasonable number), I average the two numbers, and arrive at a possible value of $2.6 million.
Now I have a basic, approximate, understanding of what someone might offer today: $2.6 million.
Any given valuer is likely going to want to consider many more factors, for example, the company’s track record from the last three years, how much of my revenue comes from my largest customer, and any other factors that may be important to them.
Might a given valuer offer you, say, $3.1 million? Yes. Might they offer you $2.1 million? Also, yes. Remember, value is in the eyes of the investor. You do not have to accept their offer.
Unfortunately, we do not have time to examine the other side of the “Should I accept the offer?” coin: the deal structure. Instead, we will continue to explore how to improve business valuation.
How to improve business valuation and attain your goal
We are often asked by owners, “How do I double my value?”
(The frequency of this question should tell you something about how many folks, unfortunately, are not diligent about having a value creation strategy).
One might assume that to double value, they would have to double the revenue.
For example, let’s say that, as the owner of this average-performing $3 million MSP, I say I would like my value to be $5 million instead of $2.6 million.
How did I arrive at $5 million in value?
- I am working with a financial planner
- They have told me that for every $1 million in investible cash I can give them, they can return $40,000 in income to me every year after I sell the company
- I would like a lifestyle of $160,000 a year
- Meaning, I have to give them $4 million as proceeds from the sale
- Given capital gains tax of 20%, if I sell the company for $5 million, I will clear $4 million after tax, which my financial planner will invest, and return $160,000 a year for the rest of my life
- I would like to accomplish this in five years
- If I can pull off a value of $5 million in 5 years, I will have met my value creation goal
What should my value creation strategy be?
If my company is $3 million in revenue and worth about $2.6 million, do I need to double to $6 million to double the value to $5.2 million?
That is one way I could do it. However, that’s a growth rate of almost 15% a year for five years in a row.
I’m an average MSP, and through the Service Leadership Index® Annual Solution Provider Industry Profitability Report™, I know that the average MSP has accomplished exactly 11.5% growth each year for the past five years.
So, to grow to $6 million in five years, I would have to materially out-perform my historical growth rate as an average MSP.
I know there are no “easy” ways to succeed in business, but is there an easier way than doubling in size in five years?
Happily, the answer is, “Yes.”
A sharp eye will have noticed in the two multiples tables above:
- Each dollar of managed services revenue is worth $1.45 in stock value
- But, each dollar of EBITDA is worth at least $6.00 and as much as $8.00 in stock value
This tells me that if I focus more on profitability than growth, I may be able to grow my value faster than if I grow my revenue.
And, in fact, because I’m only at average profitability, this is a correct conclusion: I have room to improve.
If I again employ the approach of using both the revenue and the EBITDA valuation methods, what would my company be worth today, if instead of having average profitability, I had the profitability that would get me into the top quartile of MSPs?
The Service Leadership Index tells me that, in Q2 2022, I would be in the top quartile for MSPs if I had about 18% EBITDA.
Now, I haven’t changed my revenue, so that valuation still holds at $2.7 million.
However, instead of putting 12% to the bottom line, I’m putting a best-in-class 18% to the bottom line. My EBITDA dollars are no longer $360,000, they are: $3 million x 18% = $540,000.
Plus, according to the EBITDA multiple table, because my EBITDA is now over 15%, I now multiply my EBITDA dollars not by 7.0 but by 8.0! This is because, generally, valuers will feel 18% is a safer and more predictable profit level than 12%, so they will pay a bit more.
Wow! I have $180,000 more EBITDA dollars, and my whole pile of EBITDA dollars now gets multiplied by 8.0 instead of 7.0. This is going to be good:
- $540,000 x 8 = $4.3 million!
Remember, for safety, we average this with the revenue valuation:
- The average of $4.3 million and $2.7 million is $3.5 million in approximate value.
I am materially closer to my valuation goal, by getting to the profit threshold that one-fourth of MSP attain (and I have a lot more cash flow to invest, as well).
To get to my value creation goal of $5 million, I now only need to grow my revenue sufficiently to go from $3.5 million in value to $5 million in value.
Rough math tells us that I need to grow to about 1.4 times my current revenue (as opposed to needing to double), which is $4.2 million in revenue.
That means I need only grow my revenue by 6.9% a year for the next five years, instead of almost 15%. Given that I’ve grown 11.5% a year for each of the last five years, I think I can safely plan to attain or beat the 6.9% number.
For this to come true, however, three conditions need to be true:
- I must get to $4.2 million in revenue in the fifth year, with an average MSP revenue mix
- I must be at 18% EBITDA in the fifth year
- Valuation multiples must remain the same as today or higher
I have no control over that last factor—market multiples may be up, the same, or down.
But I do have material control over my revenue growth and mix, as well as profitability. (And I’ve gotten to great profitability so I’m able to add to my nest egg proactively.)
Given that my future is at stake, I’d better be as objective as possible about my performance as compared to the best-in-class.
This means that, in addition to working closely with a financial planner, it is also essential for TSPs to benchmark with the Service Leadership Index® in order to track performance against the best-in-class, every quarter.