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It’s not all about EBITDA. Consider terms, cash at closing, equity and other metrics.
December 31, 2015
Over the past few months, we’ve taken a look at ongoing M&A activities in the IT services sector and how to make your business more valuable as you get ready to surf the current consolidation wave. We’ve also talked about how these companies are transforming to reduce risk and drive value to investors.
In our final two articles, we will focus on some the key transaction elements, such as the transaction structure and the deal documents. This month we will focus on purchase price and terms. Next month we will look at other key deal terms.
There are many elements that lead a buyer to make a certain offer and determine the highest price he is willing to pay for a given company. These include the unique capabilities the buyer is gaining from the seller, technical skill sets and certifications, best practices, build vs. buy decision, cross-selling opportunities and access to new clients, geographical footprint, scalability, integration, customer concentration or lack thereof, how dependent the business is on its owner, the management team, and what the buyer brings to the table — how much he can impact and improve the business.
The most important criteria for valuing an IT services business are the key financial metrics: adjusted EBITDA (“Earnings Before Interest, Taxes, Depreciation, and Amortization”), net income, gross margin, revenue, and especially recurring revenue. While the other factors can play a role in setting the terms and can move total valuation up or down by 10 to 30 percent, the effect is generally not more than this.
The primary metric that determines the purchase price is “adjusted EBITDA,” which represents the company’s normalized EBITDA after accounting for all owner-related expenses that would be eliminated after the acquisition and any one-time, extraordinary and non-recurring expenses that the buyer will not incur after closing. Identify these adjustments (also known as “addbacks”) before starting the process of talking with buyers. Trying to make the case for a higher price later in the process is an uphill battle.
In contrast, most buyers will not consider expenses that could be eliminated due to synergies with the buyer in valuing companies because this is what “the buyer brings to the table” (but, nevertheless, it can be helpful if these synergies have been identified).
In the past, valuation was typically based on some average or weighted two- to four-year average of whatever key metric was used. More recently, however, in the very dynamic IT services space, TTM (Trailing Twelve Months) metrics have become the norm.
The old adage still holds true: “You can set the price if I get to set the terms.” Recently a client of ours rejected a $9.5 million offer and accepted instead a $7.8 million offer. Why? The terms!
In the case of the sale of a middle-market IT services firm, the key purchase-price components are cash at closing and a combination of deferred and/or contingent payments such as earnouts, seller notes, and stock in the acquiring company. The structure of the deal will depend on who the purchaser is; a strategic buyer will typically require a one- to three-year earnout that will most likely be capped, while a financial buyer will require the owner to roll over 20 to 40 percent equity and have a plan for an exit five to seven years down the road.
Understand the differences between all aspects of a deal with a financial vs. strategic buyer before engaging with these buyers in the goal-setting stage of the process.
One important deal decision a seller has to make is that, since she is giving up control of the company, what is the minimum amount of cash she should accept at closing? A rule of thumb is that cash at closing ranges between 60 and 70 percent, but that number will depend on many factors, including if the earnout is capped or if there is a significant upside opportunity for the seller.
Another piece of advice we give our clients is that they consider whether, in a worst-case scenario, the seller ends up not receiving any deferred or contingent payments. Can they live with the fact that the total price they received for the company was the amount they received at closing?
Equity in the buyer company as part of total consideration makes sense in situations where the buyer is planning to file for an IPO in the short- to mid-term, or in the case of mergers of equals, which are not uncommon in the IT services space.
Additionally, in financial transactions involving private equity buyers, equity rollovers are common. This is where the seller continues to own a substantial portion of the company after the sale.
“Earnouts” are ways to shift risk between the buyer and the seller by giving the seller a chance to be paid more for his company if certain assumptions are proven out over time. Typically, an earnout is spread out over several years, and the seller receives payments annually based on the financial performance of the company in each annual period, provided that the company reaches certain threshold performance levels.
Earnout structures vary widely based on:
Whether the earnout is based on EBITDA, gross margin, or revenue;
Whether the performance threshold holds steady or increases (or decreases) in years two, three and beyond;
Whether the earnout payment is capped;
Whether the earnout starts at Dollar 1 or there is a minimum threshold that must be met before the earnout is paid; and
Whether there is opportunity for a “make-up” year (or other make-up opportunity) in case the target is missed one year.
One important point sellers should consider before agreeing to a structure is that if the total valuation is conservative and based on past, lower metrics, then the earnout should also use those base numbers and not assume a significant growth, unless the seller has a near 100 percent participation in the growth. In addition, scenarios involving a threshold that has to be met before the earnout is paid can result in the seller ending up with a very low multiple. We highly recommend a detailed analysis of various what-if scenarios.
Cristian Anastasiu and Michael Schwerdtfeger are managing directors at Chapman Associates, a national mergers and acquisitions firm providing middle-market companies across various industries with the same resources, expertise and representation that is usually available only to much larger companies. Michael’s e-book “The Inner Workings of a Deal: Tips for a Successful Transaction” is now available for free download. Follow him on Twitter at MBSMergers.
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