4 Factors Impacting Valuation and Deal Structure4 Factors Impacting Valuation and Deal Structure
Knowing how potential buyers view internal and external valuation factors helps owners improve sale chances.
September 19, 2023
Consolidation is nothing new in the managed service provider space, but today’s economic situation is driving changes in valuation and deal structures.
Many internal and external factors influence deal structure and valuation. External factors include the economic growth rate and interest rates. Internal factors include financial (growth rate, churn rate, sales pipeline, revenue mix and margin) and operational (management team, concentration, contract terms and structure) considerations. Understanding their interplay can help with successful negotiations.
The Economic Growth Rate Impact
Economic growth rate is an indicator of how quickly an economy is growing and can affect valuations in several ways. When the growth rate is high, there tends to be a surge in activity across the entire MSP sector due to increased demand for services, access to capital and an overall optimism that portends a strong return on investment.
This has a positive impact on valuations and brings advantages that sellers can potentially capitalize on, including:
An openness to valuing a business on forward-looking projections, rather than just on historical financials.
Greater willingness to pay a premium for higher-growth companies/assets.
Ability to negotiate better deal terms and monetize strategic value of assets (e.g., customer base, market share).
More liberal approach to allowing earnings before interest, taxes, depreciations and amortization (EBITDA) adjustments.
More aggressive views on achievable synergies/efficiencies post transaction close.
Conversely, when the growth rate is low, valuations tend to be lower as buyers become more conservative and risk-averse. A stagnant or shrinking economy brings the following dynamics to sellers:
Valuations are based on trailing financials (i.e., trailing 12 months).
EBITDA adjustments are often limited to verifiable nonbusiness amounts.
Buyers allow synergies only for items seller is confident in achieving relatively quickly.
There is more use of an earnout structure to protect against downside risk and to provide sellers value for forward results.
The Interest Rate Impact
Interest rates play a crucial role in determining MSP valuations and deal structures. Fluctuations in interest rates can significantly impact the financial outlook of these transactions, influencing factors such as borrowing costs, cash flows, deal structure and overall profitability.
In a low interest rate environment, financing costs are lower and buyers have greater access to capital, which means sellers can expect:
Deal structures that favor more cash up front.
Less use of equity.
Less use of seller financing as its attractiveness to buyers diminishes.
In a higher interest rate environment, deal structures move in the opposite direction with:
A greater preference for rolled equity, when buyers ask a seller to reinvest some of the proceeds from the sale back into the company.
Less cash up front.
Seller financing having the ability to add significant value to sellers as a low-risk way to put sale proceeds to work and diversify risk between equity and debt holdings.
Financials are how businesses keep score, but financial considerations that impact deal structure and valuation go beyond just the P&L and balance sheet. A sophisticated buyer in a fragmented market has more potential acquisition targets than they can execute against, so beyond the P&L and balance sheet, here are the factors influencing which companies they pursue and what multiple they are willing to pay:
Growth rate – A $10 million business consistently growing at 8% a year is worth more than a $12M business with stagnant growth.
Churn rate – There is a certain amount of churn that is unavoidable in the MSP industry, but churn above the industry average is a red flag and will pull down multiples.
Sales pipeline – A verifiable pipeline with a consistent close rate.
Revenue mix – Not all revenue is created equal. Sophisticated buyers are going to pay a better multiple for recurring service revenue than re-occurring project revenue or nonrecurring hardware/software resale.
Margin – Is the company selling services at the right price to the right customers and servicing them at a good level of profitability?
Valuation is more an art than a science. While certain financial metrics can be a simple equation, operational considerations play an equally important role in valuation and deal structure. These are the operational factors that help a buyer determine what this company can do under its ownership. Some of the key factors a buyer will look at include:
Management team – A strong management team, beyond just the owner(s), goes a long way to demonstrating the scalability of the company.
Concentration risk – A significant portion of revenue (i.e., greater than 10%) tied to single a client is a strong argument for a buyer to make some portion of deal consideration contingent on that client staying for a period of time.
Contract terms and structure – Well-written contracts that a buyer is comfortable stepping right into drive valuation up. Contracts that are poorly written or lack basic industry-standard language introduce additional risk for the buyer, who will likely need to repaper clients — ask them to sign new contracts — thus driving up attrition risk.
Understanding both the external and internal factors of your company, how they are viewed by a buyer and how they impact deal structure and valuation can help a business owner take the right steps to improve these factors before exploring the sale of their company.
Christian Fulmino joined Dataprise in 2022 as a senior vice president and head of corporate development and M&A. He has more than 20 years of experience in buy side M&A. He has a bachelor’s degree in finance from Rider University and an MBA from Cornell University. You may follow him on LinkedIn or @dataprise on X.
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