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.
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.
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 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.
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.
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.
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.
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.
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.
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.
Additionally, the COVID-19 pandemic has added lots of one-time expenses that could obscure the true health of the business:
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.
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. Why not know more about your business and how it performs compared to your industry peers?