Mergers and acquisitions in the MSP space

by SmileBack
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8 min read
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Ryan Grant Little, Managing Director of SmileBack, interviewed Daniel Welling of Welling MSP, a consultancy specialized in providing mentoring, solutions, and people to the managed services market. Daniel is a leading expert on mergers and acquisitions in the MSP space and following is an abridged version of a conversation on that topic between the two. Enjoy!

MSP mergers and acquisitions as a trend

First-person experience

You’re the founder of Amicitia (founded in 2002), and you ran that through until 2014 in the UK, what happened in 2014? Were you acquired by another MSP?

Yes. It was the culmination of 12 years in business, a well-timed meeting with our acquirer and a coming together of myself and my business partner in terms of where our minds and ambitions were, beyond the business, so the timing was right for us to exit. We were acquired by another MSP based in a different geography from us. So, their interest in the business was to establish a foothold in the South of the UK. And the businesses were of similar sizes. So operationally, it worked as a merger although in shareholding terms, it was an acquisition.

You didn’t leave the MSP space, but helped acquirers and sellers replicate the success that you had. Can you talk a bit about some of the trends that you’ve seen?

There’s a lot more intelligence and information available, which is the result of a number of the communities that have developed over the years. Intelligence and information about the benefits and risks for both buyer and seller as well as then other players such as staff, customers, legal and accounting professionals, and general advisors.

The growing popularity of MSPs

You mentioned earlier that at Amicitia you didn’t identify as an MSP at the beginning. And so more and more the managed service provider as a term is gaining purchase among companies doing this kind of work. Is that how you see it?

Exactly right. I think the term MSP was born a few years before Amicitia was sold and it certainly gained in popularity over the recent years. As to defining an MSP, generally it’s any IT services business that is not focusing on either selling products or in transactional one-time revenues. Their goal is to increase and automate their revenue. And in doing so, they want to improve the service they offer to their customers by making the management of an end user’s IT more predictable.

What’s driving MSPs to consolidate?

You mentioned a number of features that are specific to the MSP industry. I wonder if some of those are why MSPs tend to consolidate more than lots of other industries.

Certainly. A mature MSP, with high recurring revenue makes for an attractive acquisition from a buyer’s perspective. It stands to reason if you’re buying a business, and part of the reason you’re buying that business is because of the margin that it will deliver. As a result, knowing that that margin is contracted or at the very least committed is an advantage that helps you lock in on a value. That makes the process of acquiring and selling from the other side easier than in a marketplace where revenue is very hard to predict and commit.

MSP owners tend to be approaching retirement age. That could be one of the reasons that’s driving this as well: as a chance to exit.

The industry itself is reaching 40 years. My first role was in 1995 in the IT market and I think it—certainly in terms of the personal computer and adoption by the SME market—was really just beginning in the 1980s. Another reason is probably more growth limitations. The ability to acquire customers or staff to effectively run a different business is certainly a different proposition and requires a different set of skills. So, unless the owner and senior managers are prepared to go on that journey, then exiting is the right thing to do. There is no staying the same: you are either growing or contracting.

SmileBack - Daniel Welling (Welling MSP) - MSP megers and acquisitions (M&A) - Buyers vs Sellers
Daniel Welling – MSP M&A Valuation

Risks and benefits for buyer and seller

Transition process

So, for a buyer to be attractive, they should have a plan in place. I could imagine there’s some level of key-man risk as well in this industry where this is the person who has probably founded the company and grown it. You want to figure out what it’s going to look like without them there, whether it’s a consulting arrangement where they stick around or if they want to leave the next day.

Yes, and I think that there are pros and cons in all of the eventualities that you alluded to there. Starting from the buyer’s perspective, they will want the owner to settle any wobbles from key staff and customers. Therefore, the former-owner is key to that transition process. The buyer won’t want to have to deal with big egos. They will want someone there who’s part of the team and shares the ongoing vision of the business.

The buyer wants to secure the assets that they’re buying and is typically buying key staff, and the client relationships underwritten by any contractual commitment to revenue. Or they’re buying the client relationships not underwritten by contractual commitments, in which case, the clients are far more susceptible to post-acquisition wobbles regardless of whether the thing that they get is better or worse.

It is a slow and steady adoption of any differences between MSP and client so the owner will play a key role in that in the early days, introducing new contacts for the customer.

MSP acquisition target’s criteria

On that point, where guaranteed revenue trumps casual revenue, you’ve probably got a checklist for this type of thing as a buyer. When you’re looking at an MSP acquisition candidate, what are the main requirements on your checklist and what are the red flags?

In terms of revenue we have already covered a couple which were: what is the likely income going to be? And how is that secured or not secured? Then there’s obviously an element of how operationally mature the MSP is. Who is managing the clients? Is it the owner or do they already have a person or team of client managers in place? How do they deliver the service? Are they using an array of MSP tools to make sure that service delivery is efficient and consistent? The answer to all of those questions can represent an opportunity or a risk to the buyer. Then again, if the MSP is not particularly well run and the buyer can see opportunities for efficiency without risking the client relationships, that can be an opportunity in and of itself but will be reflected in the purchase price.

So it’s like, if you’re buying a house, you can choose a fixer-upper, or you can choose something where you move in tomorrow and everything’s taken care of, and either choice is ok and will show in the price.

Great analogy. Yes, and both properties will appreciate generally as the market appreciates. And the cost of fixing it up is that you are only going to save money if you do the work yourself. If you are paying a contractor/trade to do the work, then actually it is probably going to be the same value as if you bought the finished product.

The seller perspective

What can companies that want to be acquired do to make sure that their systems and culture are set up well?

Simply: do exactly the same as if your plan was to grow the business. If you’re building a business and acquiring customers organically, looking after your staff, creating great culture and healthy, long-term client relationships – all of those things are good for building a business that will be attractive to a buyer. There is almost a myth that you can dress or work the business towards being ready for exit. Sure there are some rules, for instance, if you’re planning to sell the business, it’s probably not a good idea to sign a 10-year lease on the office with no break clause because who’s to say the buyer would want to retain that office. But, from an operating the business perspective, if you spent money on acquiring new business, so sales and marketing functions, if you suddenly stop investing in that in order to artificially inflate your profitability, a buyer will find that out the minute they start looking at the business. So, this concept or method of dressing a business for sale will actually not yield a result for the seller.

Successful MSP mergers and acquisitions

What do successful mergers or acquisitions look like on the cultural side?

It’s a difficult question, because culture means different things to different people. I think the underlying theme that I’ve seen and what I would advocate is being very open and engaging with everyone that is involved in the process. There will be some things that buyer does better than seller and there will be some things that seller does better than buyer and that includes practical things as well as the ethos and vision and values of the business.

Most people will consider what culture means to them in terms of the environment they operate in, the way in which they’re managed, the responsibility that they have. There’s going to be lots of sensitivities around all those topics. But I think the best outcomes that I have seen are where everyone operates in a very open and collaborative team. Without any ego or baggage in terms of “we are better than you, you are better than us”, just very open and what works well for both of us, and so, let’s knit together.

MSP M&A: Valuation methods

Qualification anchor concept

Everyone will want to know the answer to the valuation question. I have got some good information from you about three different methods that you would use. It would be interesting to hear a bit about the qualification anchor concept.

It starts with a sensible conversation. Both parties are negotiating from the very first conversation and you need some way to qualify it. It’s like any sales process: generating, working through them, building relationships, discussing, consulting with each other. And then building trust to the point where both parties are willing to agree to a transaction. Valuation is key to that and valuation and price are two different things. I look at triangulating by using different methods as appropriate.

Daniel Welling – MSP M&A Valuation

One method is basing on contracted revenue on a time one multiple. You can come up with a valuation based on this and then make adjustments to the price based on things like how long the revenue of the business is contracted.

Another way is contracted revenue gross margin times two and the trick here is that gross margin is somewhat subjective. But a middle-of-the road MSP should have about 50% gross margin. So a similar answer in this case to the ‘Contracted revenue on a time one multiple’ method.

A third method is the good old-fashioned EBITDA multiplier, which works for businesses that are in the millions. Here you have to make sure that the owner’s compensation is factored in at a market rate since they might be paying themselves in other ways like dividends. Then for a smaller company the EBITDA multiple is probably around five times, and up to 10 times for a much bigger company with other attributes such as niche dominance and IP.

The fourth and last method I use is valuation by business plan. That’s really a case-by-case basis, where buyer sits down with seller and really looks at what their revenue is and what it’s likely to be, and in that way establishes what the likely margin is going to be. So the buyer can then can present that to the seller in terms of the margin that they’re going to make and so how they would fund the acquisition, and of course, for buyer to establish when they’re going to make money from it.

If it looks like it’s going to take the buyer 10 years with all things being perfect for them to recoup their money, they’re probably not going to be too keen on the deal. But if they can see in a reasonable timeframe when they’re going to get their money back and then start to make a profit, then the acquisition becomes more attractive and it’s about finding that happy ground between those two points.

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