Podcast: MSP Finance Team EP059 – M&A Strategies With Hartland Ross From The Host Broker

Hartland Ross joined Adam Morris and Daniel Welling in the latest episode of “It’s a Numbers Game,” chatting about marketing as well as mergers and acquisitions for MSPs.

Discover effective marketing techniques for organic growth, learn the ins and outs of M&A in the MSP space and get tips on preparing your MSP for a successful sale.

Tune in here.

Selling Your MSP: By the Numbers

When you sell your MSP with The Host Broker, our processes assure that your business is going to receive enough interest from potential buyers to return fair market value (or greater). In today’s blog, we’ll demonstrate by looking at milestones in the selling process from a numbers perspective.

Thousands of Potential Buyers

For our new listings, we create a one-paragraph summary of the business which acts as a teaser for interested buyers. It identifies the nature of the business, the geographical scope, some high-level financial metrics, the seller’s reason for exiting, and anything else that is unique about the business. We distribute this blurb across multiple channels:

  • We send it to a few thousand subscribers via our weekly mailing list, of which 25% to 35% open it each week.
  • We list it on our website, where >100 buyers login to review listings each week.
  • We post new opportunities to Reddit, where hundreds of Redditors view our posts.
  • We list via online brokerage platforms, where hundreds view each listing.
  • We share listings with partner brokers, whose own audiences number in the thousands.
  • We have an “MSP Wishlist” where buyers indicate the profile of MSPs they are interested in. For each new listing, we review the MSP Wishlist and all matches are reached out to. There are typically 10-30 matches or more for each listing.

While it is difficult to come up with a precise tally, when you add up the estimates for each channel, it is safe to say the number of potential buyers reached when you list with The Host Broker is in the 1000’s.

Dozens of NDAs

When a buyer is interested in receiving more information about a listing, their next step is to request and sign a non-disclosure agreement. Once signed, we then send them a package containing more information about your business including a Company Overview document, balance sheets, and profit & loss statements.

For a typical MSP listing, we’ll have several dozen potential buyers who sign the seller’s NDA.

Many Discovery Calls

After a buyer has reviewed the package, if they are interested in moving forward, the next step is usually to arrange a discovery call with the seller. Sometimes, a buyer may have questions they’d like answered prior to having a call. In any event, the call gives both parties an opportunity to become acquainted and to ask each other questions about operations, key clients, employees, company culture, or anything else that is important to them.

Ultimately, most MSP listings result in 10-15 phone calls between interested buyers and the seller although this can be increased or decreased based on how rigorous the qualification process is.

Several Offers Submitted

After a call with the seller, the buyer will decide whether or not to put forward an offer. Often this will take the form of a Letter of Intent. An LOI is a non-binding agreement which establishes expectations for the key deal terms such as the valuation, payment terms, exclusivity, non-compete clause, access level to materials during due diligence, what is being purchased and more. The LOI typically has an expiration date. Some buyers will instead put forward an informal offer detailing the valuation and payment terms, then will graduate to a formal LOI upon request from the seller.

Most owners of MSPs who list with The Host Broker end up with 3-6 LOIs to choose from, again depending on how stringent the qualification process is.

One LOI Signed

By going through the selling process, sellers end up with several competing LOIs to choose from and can be confident they are being offered a fair price for their business. But price isn’t the only consideration. Sellers also consider which LOIs have the most favorable payment terms, their rapport with the buyer, whether the non-compete clauses align with their future plans, whether their employees/clients will be well-served by the potential buyers, and more.

Factoring all that in, the seller chooses one LOI to sign, and proceeds to the due diligence period.

Few Months of Due Diligence

During the due diligence phase, the chosen buyer gains access to and reviews key documents including financials to verify their accuracy. Legal and operational reviews are conducted. If needed, this is also when the buyer may secure financing, and their bank may have additional requests for documentation. Negotiations and adjustments rarely, but sometimes may occur based on the findings.

This phase is a thorough examination of the business working towards finalizing a purchase agreement and may take 2-4 months.

Several Weeks to Finalize a Purchase Agreement

Once due diligence is complete and both parties are satisfied, their attorneys take over to negotiate the purchase agreement. It usually requires multiple rounds of iterations to align the purchase agreement with the buyer and seller’s intent and to ensure legal compliance.

Finalizing the purchase agreement typically takes several weeks, but once agreed to, is signed, and the acquisition is official!

One Last Thought

Selling your MSP with The Host Broker guarantees exposure to thousands of potential buyers through various channels, results in multiple competitive offers, and culminates in one purchase agreement that is satisfactory for both parties. Contact The Host Broker to explore whether selling your MSP is a good fit for you.

How to Avoid Selling Your MSP for Only $14,000

In this podcast episode, Joe, Jeff, and Hartland Ross discuss the importance of having an exit strategy and processes in place for MSPs to avoid burnout and increase the value of their business. He also highlights the benefits of acquiring and growing a book of business and advises sellers to understand the limitations of their business and what it is worth. The conversation also touches on the emotional process of selling a business, and how one may want to consider what they plan to do once the business is sold.

Beyond Valuation: What Sellers Consider in Determining the Best Offer

So much attention is paid to the valuation in M&A for IT services businesses but sometimes the importance of other factors isn’t fully appreciated. Buyers should realize that sellers also judge offers by the deal terms, payment structure, timeliness of the sale, and whether the sale is an asset or share sale. Additionally, having a level of trust between buyer and seller, having a cultural fit between both companies, and addressing the seller’s role post-close are crucial factors for putting forward an attractive offer. The combination of these factors, which we’ll discuss in today’s blog, may influence a lower valuation offer to be seen as the better offer from the seller’s perspective.

Deal Terms

The deal terms refer to the specific conditions of the sale and have a significant impact on the perceived strength of an offer. Deal terms can include structures such as bonuses or earnouts, which are performance-based payments. Earnouts are often preferred by buyers when there is risk associated with the acquisition. For instance, if the business has a key client that makes up the bulk of revenue, an earnout can help mitigate the risk of that client leaving; or maybe the business has customers in countries where there’s a tumultuous business climate, and an earnout mitigates the of regulatory risk. On the flipside, because earnout payments are based on the future performance of the business, they may also be an attractive option for sellers who believe their business will continue to grow post-sale.

Payment terms refer to how the buyer plans to pay for the business, whether it’s a lump sum payment on close or installment payments over time as well as the frequency of these payments. Sellers likely prefer a lump sum payment on close, but installment payments can allow a buyer to get to a higher valuation, aid with cash flow, in addition to providing some security by maintaining a degree of leverage.

Another important factor is whether the sale is an asset sale or a share sale. In an asset sale, the buyer only purchases specific assets of the business — most importantly the customer list and annuity stream (goodwill) — but also potentially equipment, inventory, or even real estate. In a share sale, the buyer purchases the entire company, including all assets and liabilities. Asset sales are typically less complicated and less risky for buyers, while share sales can make taking over operations much simpler but may come with lower valuations. There are also tax implications, with sellers usually benefiting from a share sale and a buyer usually benefiting from an asset sale. Most transactions we broker are asset sales due to the simplicity and generally lower costs.

Rapport and Trust with Buyer and Seller

From the onset, sellers want to feel confident that the buyer is trustworthy, reliable, and committed to completing the sale. This trust and confidence can be established through sincere communication, transparency, and trying to build a rapport with the seller. While negotiations typically start with an online meeting, eventually taking the time for an in-person meeting (if feasible), can go a long way. Buyers who make the effort to get to know the seller, understand their goals and motivations, and demonstrate a genuine interest in their business may put themselves ahead of a competing offer at a higher valuation.

Read our blog about why ‘First Impressions Do Matter’.

Culture Fit

Culture fit refers to the compatibility of the buyer’s organizational culture with that of the business being sold. A lack of cultural fit can complicate the sale and post-sale transition, resulting in a drop in employee morale, productivity, and retention which has the knock-on effect of creating customer churn. Buyers are well advised to assess the existing culture of the business, identifying areas of compatibility and incompatibility, and present a plan to bridge any gaps.

Cultural integration is a two-way street, and the seller also has a responsibility to be open to the buyer’s culture and values and to work collaboratively to achieve a successful integration. By working together, the buyer and seller can ensure that the sale of the IT services business is a positive and productive experience for all involved, and that the cultural fit is aligned for long-term success.

Owner’s Role Post-Close and Payment

Sellers are often emotionally attached to their business and want to be involved for a period post-sale to ensure that it continues to be successful after they leave. In other cases, they might be motivated to retire, or to focus on other business endeavors, in which case they would view a lesser role appealing. In either case, sellers are interested in knowing what their involvement and compensation will be post-sale.

Discussions should be had about the transition period, the seller’s involvement in the business, and any potential consulting or advisory roles. Buyers can also communicate their plan for integrating the seller’s knowledge and expertise into the business. By addressing these concerns upfront, buyers can build trust with sellers and establish a positive relationship that can lead to a stronger offer.

Timeliness of Offer

A timely sale is important to most sellers. In addition to being prepared and organized, buyers can also ensure a timely offer by having funding secured in advance. This helps to streamline the process and ensures that the buyer can move quickly once an agreement has been reached. If a buyer is unable to secure funding or is otherwise delayed in the process, it can cause frustration and uncertainty for the seller and may cause them to prioritize other offers.

Final Thoughts

While there’s no doubt the valuation is very important, these other factors we discussed in today’s blog are also key considerations for sellers when evaluating offers for their IT services business. Favorable deal terms, rapport and trust with the buyer, culture fit, employee retention, the seller’s role post-close, and the timeliness of the offer all play a role. Buyers who take these factors into account when making offers are more likely to successfully close deals. The more favorable elements a buyer can integrate into their offer, the more likely their offer will be compelling, and there is the real potential to be a successful bidder despite a lower valuation.

First Impressions Do Matter. Hey Buyers we are talking about you!

Mergers and acquisitions (M&A) are complex transactions that require a great deal of preparation, negotiation, and collaboration between the parties involved. One of the most critical aspects of any M&A deal is making a good first impression. Unfortunately, many buyers overlook the importance of a first impression, assuming that the valuation and payment terms are all that matter to a seller. However often the seller’s perspective is that they want a good home for their clients, their employees, and themselves if they’re staying on post-acquisition.

In this blog post, you’ll learn the importance of a good first impression in M&A transactions as well as provide tips on how to make a positive impression on the seller.

Why First Impressions Matter

The first impression sets the tone for the entire transaction. If the buyer comes across as disrespectful, unprepared, or uninterested, the seller may feel hesitant to move forward with a transaction. So it is important for the buyer to make a positive impression on the seller and demonstrate their professionalism, respectfulness, and interest in the seller’s business. By following these tips, buyers can establish a positive relationship with the seller and increase the chances of a successful deal.

How to Make a Good First Impression

Show up on time.

Whether it’s in person or virtual, being punctual shows that you respect the other person’s time and are serious about the transaction. It also demonstrates your reliability and professionalism. If there are unexpected delays or issues, communicate them promptly and clearly to the other party. Being on time is a simple but important way to set the tone for a successful M&A transaction.

Dress professionally for video calls.

Dressing professionally for video calls is an important aspect of making a good first impression in an M&A transaction. It demonstrates that you take the transaction seriously and respect the seller’s time and effort. To dress professionally, choose clothing that is appropriate for a business setting, avoid distracting patterns or colors, and consider your background and surroundings. Also, ensure that the lighting and audio quality of the video call are suitable. Although these may seem obvious, the following are all based on experiences we’ve had. Taking calls in moving cars or coffee shops with background noise is annoying and frustrating for others on the call. Constantly dealing with your dog barking or kids yelling is equally annoying. Wearing hoodies, exposing armfuls of tattoos, smoking or drinking alcohol while on the call, should also be avoided.

Avoid talking about politics or controversial issues.

Avoiding politics or controversial issues is important during an M&A transaction and discussion process, as these topics can be divisive and create tension between the buyer and seller and these days are very polarizing. It is crucial to keep the conversation focused on the business and transaction, rather than personal or political beliefs. By avoiding controversial topics, the buyer can create a comfortable and productive environment for the discussion of the transaction. The conversation should focus on the business and its strengths, areas for growth or improvement, the buyer’s company and culture, and how they plan to integrate the acquired business into their operations.

Compliment the seller on the business they’ve built.

Complimenting the seller on their business indicates that the buyer values the seller’s efforts and accomplishments and has conducted thorough research on their business. Specific and genuine compliments can help to establish a shared understanding of the business’s potential and facilitate productive discussions about the transaction. The buyer can also ask the seller about their goals for the business and their vision for its future to ensure that both parties are aligned in their goals for the transaction.

Speak to your corporate culture.

The buyer should highlight their own company’s strengths and what sets them apart from other companies, emphasizing their values and approach to business. The buyer should emphasize their approach to treating employees to demonstrate their commitment to maintaining a positive work environment and employee well-being after the transaction. This can be achieved by discussing specific employee benefits, programs, and company culture, while also showing interest in the seller’s current approach to employee well-being. By highlighting these aspects and outlining how the acquired business will be integrated, the buyer can build a positive relationship with the seller and set the stage for a successful and smooth transition.

Use positive body language.

Positive body language demonstrates confidence and friendliness, which can help to put the seller at ease and establish a positive rapport. It’s important to maintain good eye contact and a friendly smile throughout the meeting or video call, as this shows that you are engaged and interested in what the seller has to say.

Be attentive and respectful.

During any business meeting or negotiation, it’s crucial to be attentive and respectful towards the other person. This means actively listening to what they have to say and asking relevant questions to show that you are interested in their perspective. By being attentive, you can better understand their needs and concerns and address those concerns proactively. Additionally, showing respect towards the other person can help build trust and establish a positive working relationship.

Follow up.

After an initial meeting with a seller, it’s important to follow up with a thank-you note or email to show appreciation for their time and interest. This helps establish a positive relationship with the seller, to clarify your interest level, and to ask questions. Then if there are follow up questions asked by the seller, it’s important to answer promptly to demonstrate the buyer’s seriousness and how easy it will be to work with them. Following up effectively can help build trust and establish a strong foundation for a successful M&A transaction.

Final Thoughts

Making a good first impression is crucial for any M&A transaction. A positive first impression sets the tone for the rest of the deal, and it can make all the difference in establishing a productive working relationship between the buyer and seller. It’s important to be punctual, dress professionally, avoid controversial topics, compliment the seller, speak to your corporate culture, use positive body language, be attentive and respectful, and follow up promptly after the initial meeting. By following these tips, buyers can create a positive environment for the transaction and increase the chances of a successful deal. A good first impression demonstrates the buyer’s professionalism, respectfulness, and interest in the seller’s business, and sets the stage for trust which is key for a smooth and successful transaction.

Questions to Ask When Selecting an M&A Advisor

As the IT services industry continues to grow, mergers and acquisitions (M&A) have become a crucial strategy for MSPs, hosting companies, and other IT service providers to expand their capabilities, their team, their customer base and to remain competitive. However, the likelihood of a successful transaction largely depends on selecting the right advisor. M&A advisors help companies find potential acquisition targets and/or buyers, negotiate deals, and manage the transaction process. The wrong advisor can lead to mistakes, missed opportunities, and ultimately, a failed transaction. Selecting an M&A advisor with industry experience, professional skills, and a large business network is essential. In this blog, we’ll discuss the questions to ask and things to consider when selecting an M&A advisor for IT service providers.

What is Your Level of IT Industry Experience?

Many M&A advisors are generalists, and the IT services market isn’t easy for a generalist to wrap their head around. So you’ll want to work with an advisor who has experience in the IT industry and has an understanding of your business model, pertinent financial metrics, and the services you provide. Ask about the advisor’s experience in the IT services market and their knowledge of the latest trends, developments and valuations. Ask about the advisor’s experience in closing deals, their success rate, and their track record in the IT services industry specifically.

What Size Deals Do You Advise On?

M&A deals can vary greatly in size and complexity. Ask about the advisor’s experience with deals of a similar size and complexity to yours. You want to work with an advisor who can handle the specific challenges or nuances of your business.

How Do You Mitigate Risk?

M&A deals can be risky. You can invest a lot of time and money in a deal only for it to fall apart. Ask about the advisor’s approach to risk management and their experience in dealing with potential risks. Look for an advisor who can help you manage the risks associated with your deal and protect your interests.

How Do You Approach Client Confidentiality?

M&A deals require a high level of confidentiality, not only with the advisor, but between the buyer and seller. Ask about the advisor’s approach to client confidentiality and their track record in this area. Look for an advisor who has a plan for confidentiality to be maintained throughout the transaction.

How Large is Your Network of Contacts?

An M&A advisor’s network is crucial in finding potential buyers or sellers. Do they have other brokers they work with? Do they have a large contact list or mailing list to reach out to? Look for an advisor who has a broad network of contacts in the IT services industry and can provide you with access to potential buyers or sellers.

What is Your Fee Structure and Compensation?

Look for an advisor who is transparent about their fees and who can provide you with a clear understanding of the costs involved in the transaction.

Final Thoughts

When selecting an M&A advisor, it’s important to ask the questions we have highlighted in this blog as they are among the key factors that will impact the likelihood of a success transaction. Consider the advisor’s experience, expertise, and network, as well as their approach to risk management, confidentiality, and fee structure.

Selecting an M&A advisor is not a decision to be taken lightly. IT service providers should take the time to carefully consider their options and choose an advisor who can provide them with the best chance of success. By asking the right questions, IT service providers can select an M&A advisor who can help them achieve both their personal and business goals..

Contact The Host Broker today to schedule a time to ask us all these questions and more.

6 Red Flags to Spot in Buyers Interested in your IT Service Business

When it’s time to sell your IT service business, you want to find a deal that’s fair to everyone — great compensation for you, growing future profits for the buyer, and a fitting new environment for your team — without wasting a lot of time. 

Some buyers, however, don’t think that way. Whether they are not serious about the deal, want to aggressively negotiate down the price, or try to lock you into an exclusivity clause to keep their options open, you should be able to spot typical buyer red flags and avoid them to find a great new home for your business.

Tip: Want to sell your IT business without setbacks? The Host Broker will connect you with thousands of trusted buyers of IT firms and walk you through the process step by step, avoiding common pitfalls.

1. Lack of Questions

If you meet with a potential buyer and they don’t have constructive follow-up questions, you should be concerned. 

Lack of questions might mean that the buyer didn’t prepare for the meeting, willing to waste everybody’s time. It might be a sign that they are disorganized and don’t have a proper process in place. It hints at lack of commitment.

Asking questions already answered in the provided documentation, such as “how many employees do you have?”, is no better. It shows that the buyer hasn’t reviewed even the basic information about your business. 

What are some good questions to ask to avoid getting things off on the wrong foot? A few examples questions that demonstrate that the buyer is thinking about next steps could include: 

  • Are we using similar backup and disaster recovery systems? 
  • Are we adjusting EBITDA in the same way?
  • How do we migrate your infrastructure to ours? 
  • Is it going to be difficult to switch merchant accounts? 
  • How would you see an announcement to your customers being made? 

2. Ignoring Important Elements of the Deal

Buyers who don’t pay close attention to what matters to the seller should cause suspicion. 

If the seller says that their employees or customers mean more to them than the final price, a reasonable buyer would provide assurances about cultural fit and taking care of the existing customer base. 

Instead, if the buyer becomes picky with employees’ lifestyle benefits or some customers not paying enough, it’s likely they will change these things as soon as they take over. 

Other important elements of the deal are know-how, certifications, and geographical presence. 

If your business works with specific technologies (e.g. Citrix, Oracle, VMware), the buyer should be aware of that and concerned with being able to maintain the same level of service. 

If your business services clients in a particular industry (e.g. government or healthcare), the buyer should make sure they have all the necessary certifications, clearances (ex FedRAMP) etc to continue that work.

If your business has clients that require on-premise work in different geographical locations, is the buyer able to support these customers as needed?

3. Lack of Familiarity With Industry Terminology

No one wants to sell to an incompetent buyer who would run the business into the ground a few years in. The buyer’s lack of familiarity with industry terminology is one of the easy-to-spot red flags that they might not be the right choice. 

When an MSP sells to another MSP, industry terminology is rarely a problem. However, if a buyer comes from a different space — finance, oil and gas etc thinking it would be exciting to diversify and own an IT business, you should think twice. 

It’s hard to understand the implications of running servers, maintaining infrastructure, making the right technological hires, and supporting customers when you know very little about the industry. 

Besides the disruption poor industry knowledge can bring to customers and employees, it can also have a serious effect on the seller if there are earn-out clauses or seller financing involved. 

4. Moving Too Quickly To Close The Deal

There is no shortage of potential buyers who do next-to-no due diligence before submitting an offer or LOI. The reason is that they don’t want to miss out on a deal and try to beat their competition to it with the idea that they will negotiate the deal down later if they miss something. 

The buyer then starts their due diligence only after getting the seller on a no-shop or exclusivity period.

This creates a asymmetry, since the buyer can still find reasons not to go through with the deal they don’t like (e.g. not liking the exposure to a particular industry), but the seller is likely going through the process in good faith and ultimately wasting their time.

If the deal is not signed, the seller has to start the whole process all over again. 

5. Not Providing References

It’s always a good idea to check the buyer’s references and see how their past acquisitions have turned out. Even if they haven’t done a deal before, checking the quality of their references is an important step. 

If the buyer has done deals in the past but can’t provide a single reference and is making excuses — a critical red flag. 

6. Contentious Behaviour

If the potential buyer always tries to find something wrong with the business and asks confrontational questions that put the seller on the defensive, there is little chance for a trusted relationship to develop. 

Examples of contentious behaviour could be nitpicking negative Google reviews, saying that revenue projections are hard to believe (without providing evidence), questioning the competence of employees after reviewing ticket history etc.

When the buyer doesn’t believe they are buying a great business, they are more likely to prove themselves right post-purchase. 

Why Buyer-Seller Conversations Are Important

When you meet with potential buyers, listening to what they say, how they behave, and what questions they ask (or don’t ask) can be a strong indicator of a good or poor fit. 

Watch out for: 

  1. Lack of questions
  2. Ignoring important elements of the deal
  3. Lack of familiarity with industry terminology
  4. Moving too quickly
  5. Not providing references
  6. Contentious or argumentative behaviour

Avoiding red flags in negotiations comes with experience of seeing bad acquisitions play out. But you don’t have to go through it if you rely on an experienced IT service business broker. 

The Host Broker can put your business in front of thousands of qualified buyers and guide you through the whole process. Contact us to ask any questions, and we’ll give your business a fair evaluation — for free. 

Selling a business is an important milestone that happens only once for most entrepreneurs. Make sure to take heed of the red flags above, and you’ll avoid many common mistakes.

What Questions Should an MSP Owner Consider Before Selling the Business

What questions should an MSP owner consider before selling their business? Find out in a webinar presented by The Host Broker and eBridge Marketing Solutions with special guest, Josh Peterson, the CEO of Bering McKinley and BMK Community.

The first question to consider is: what valuation does the owner need to achieve their goals? We emphasize the importance of considering this question early on and not waiting until the owner receives an offer or lists the business for sale. We also mention the personal and financial factors that should be taken into account when determining the valuation and the need to consult with a CPA to understand the tax implications of the transaction.

The second question is about the financial metrics that should be focused on to increase the valuation of a managed service provider (MSP) for sale. The valuation methods for an MSP are related to cash flow and net profit. Recurring revenue is another metric that can increase valuation. For smaller MSPs, attaching a cost of goods sold to each item of revenue and knowing where the profitability comes from is essential.

The third question is whether having a sales team in place can increase a company’s valuation. Having a sales team shows maturity and planning, and gives buyers confidence that the company has a system and process in place that will continue to produce growth. However, the assumption is that the sales team is productive and can justify their cost. Relying solely on word of mouth and referrals is not unique and will not increase valuation. Overall, having a sales team can help increase valuation, but it’s important to ensure that the team is effective and can produce results.

We also discuss whether an MSP’s clients are month-to-month, or have break-fixed contracts, that can be converted to longer contracts. There can be a healthy mix of recurring, project, and hourly revenue. But it is important to realize that buyers are looking for certainty in revenue streams and a customer base that will be with them long term. MSPs whose clients are on shorter term contracts may require a greater earn-out component.

The company culture and employee morale are also important factors for sellers to consider when preparing for an acquisition. Buyers will want to make sure that there is a cultural fit, and if the company is a bad place to work, it will be a red flag that will impact the valuation of the business. A good way to measure employee satisfaction is through the employee net promoter score (eNPS), which can help identify areas for improvement. A positive company culture will make employees more likely to stay, which will make the business more valuable to buyers. Remote work can also increase employee satisfaction, especially in areas with traffic congestion and long commutes, and can make the business more attractive to buyers from other regions.

The technology stack and infrastructure are also very crucial when selling an MSP. Sellers benefit when their CRM and PSA tools are similar to those of potential buyers to make integration easier. Having a better-built stack makes a business more attractive to buyers.

The next question is “What % revenue is associated with the top 5 clients?”, where we discuss the issue of customer concentration and its impact on a potential buyer’s perception of a business. For example, having a single client representing over 20% of a company’s revenue or the top five clients representing over 40% is seen as risky. However, sometimes there isn’t much an MSP can do about a situation where a large client grows substantially, in which case a buyer may wish to structure the deal with an earn-out or retention strategy to mitigate the risk.

Lastly, we discuss the cost of replacing the owner’s role in a business, which is an adjustment made to the profit and loss statement (P&L) when calculating adjusted EBITDA. The cost of replacing the owner depends on their role and geography, and it affects the valuation of the business.

If you have any questions, please don’t hesitate to contact us.

Adjusted EBITDA Explained for IT Service Providers

Any business owner who tracks their books knows how valuable EBITDA (earnings before interest, taxes, depreciation, and amortization) can be. EBITDA measures core (or operating) business profitability, before debt, taxes, or asset maintenance come into play. Even though EBITDA is not part of GAAP, it’s almost universally included in income statements because it helps external parties better understand how a business is performing. Knowing EBITDA answers a critical question — is this a fundamentally good business? 

If EBITDA is negative, for example, it tells you that the business has serious operating issues. It might be spending too much on marketing to attract new customers, having too few customers to cover fixed costs, or even not charging enough to offset variable costs for each customer. 

That said, positive EBITDA doesn’t mean a business is profitable, especially if it spends a lot on CapEx to operate. 

Still, EBITDA is routinely used in the business community to compare company valuations, usually expressed as a multiple. A growing technology company might sell for anywhere from 3 to 10x EBITDA. Large companies with a significant moat (e.g. proprietary technology) might expect even higher multiples of between 10 and 15x or more. 

While EBITDA tries to get to the core performance of a business by subtracting non-operating expenses, there still might be some non-recurring expenses that muddle the picture. Subtracting those can help clarify business performance even further — in a metric called adjusted EBITDA. 

What Is Adjusted EBITDA?

Adjusted EBITDA drills down further to analyze the core operating business by adding back additional one-off expenses or subtracting non-operating income – COVID-related loans for example. The expenses can vary widely and include debt write-offs, employee bonuses, legal expenses, COVID-related spending, etc.

Unlike EBITDA, adjusted EBITDA varies for every company. Knowing how to calculate it properly (and reasonably) for your business can be the difference between being valued at a lower or higher multiple in an acquisition or investor negotiations. 

That’s why adjusted EBITDA is crucial for IT service providers that are looking to sell their business or bring in external investors. Getting the adjusted EBITDA right can increase the company’s valuation by a whole multiple (or more) — meaning hundreds of thousands or more added to the purchase price. 

Common EBITDA Adjustments for IT Service Providers

Although adjusted EBITDA is different for each company, there are still common adjustments that tend to be used by most IT service providers. 

Note: EBITDA adjustments can both increase and decrease the value of your company. While they are more likely to do the former, it’s important to be clear truthful, and reasonable, so others can see how your business really works.

Here are just a few typical EBITDA adjustments you’ll see ISPs make. 

Adjustments for non-recurring expenses:

  • One-time bonuses for the owner or employees
  • Excessive travel for conferences or business that includes elements of personal expenses – ex a boat tour or rounds of golf, etc
  • Legal expenses in cases where the company was sued or is suing another party
  • One-off corporate events 

Adjustments for non-operating income or expenses: 

  • Above or below market salaries for owners
  • Above or below market salaries for employees (oftentimes these are family members)
  • Non-operating real estate, vehicles, boats, etc.
  • Personal insurance including health for extended family 
  • Charitable contributions

Adjustments for non-cash items: 

  • Stock-based compensation for employees
  • Excessive depreciation or amortization 
  • Asset write-downs
  • Deferred taxes

Adjustments for changes in working capital: 

  • Non-recurring investments into operating capacity
  • A one-time sale of assets (ie generating non-operating income)
  • Expenses or income from a related company
  • Rent adjustments below or above market

Additionally, the COVID-19 pandemic has added lots of one-time expenses that could obscure the true health of the business: 

  • Changes in IT infrastructure for remote workers
  • Discounts for customers who couldn’t pay the bills
  • Lease terminations
  • Sales of office furniture
  • Severance for laid-off employees
  • Additional legal costs
  • Provisions for future losses

How Adjusted EBITDA Is Used by IT Service Providers

As mentioned above, while adjusted EBITDA is not a strict accounting metric, it helps outsiders (e.g. financial analysts) evaluate the core of the business without unusual gains or expenses. Adjusted EBITDA growth over a few years, for example, shows that the core business is in a good place and makes forecasting easier. 

In turn, this gives potential acquirers a solid base from which they can calculate the company’s valuation based on growth and future returns, without being distracted by extraordinary events, such as the COVID-19 pandemic. 

Since EBITDA and adjusted EBITDA are common industry metrics, they are often used for benchmarking and comparing different IT firms. If one company’s adjusted EBITDA margin is 40% and another one’s is 30%, we know that the former is more efficient and can take a closer look at its financials. 

Adjusted EBITDA Shows Healthy Business Growth

It’s easy to be swayed by one-off gains and happily book large increases in profitability. But why rely on lottery tickets and external events? 

Adjusted EBITDA helps keep the business grounded, growing its core operations, which results in more realistic and resilient measurements over the long term. 

Not sure where to start with adjusted EBITDA? Contact the Host Broker, and we’ll guide you through the process — and even give your business a free evaluation.

Know more about your business and how it performs compared to your industry peers by connecting with us today!

Deal dynamics: less than $5M in revenue for MSPs

Are you doing less than $5M of revenue as an MSP? In this latest episode of The Business of Tech, The Host Broker’s Hartland Ross joins Dave Sobel to talk about deal dynamics for MSP earning less than $5M in revenue per year.

If you enjoy this video, you might also want to check our previous interview with Dave Sobel where we discussed trends in managed services. Watch it here!

The Host Broker offers a free evaluation for owners of IT services businesses considering exiting. Learn about the acquisition process and find out what your company may be worth on the market.

Contact us to learn more about the dynamics of MSP and how to start earning more than $5M revenue in a year.