Ok so by now, everyone knows that the industry is seeing a massive hike in M&A activity. The flurry of companies rushing to strengthen their existing offerings by snapping up other capabilities is at an all-time high, so of course this was the topic on the tip of everyone’s tongue at IT Nation Connect last week.

ConnectWise’s Arlin Sorensen

At the conference, we sat down with industry veteran Arlin Sorensen, vice president of brand and ecosystem evangelism at ConnectWise who coaches partners on business strategy and personal succession plans, to get a fresh perspective on things.

With the uptick in M&A activity in mind, we asked Sorensen to take us through his M&A playbook. After heading up 10 such deals, Sorensen is a bit of an expert on the topic.

“It starts with helping owners understand what it is they’re trying to accomplish,” says Sorensen. “The mistake we see is that they don’t think about it until they want to do it. And you can’t get a business ready to transition in a year. You need at least three to five years to maximize it.”

According to Sorensen, it all starts with understanding what your personal wealth target is. How much money do you need to have accumulated when you quit getting paid so you can have the lifestyle you want to have? That is the foundation, the first building block. Once a business owner understands that, then they know that they can assess their current worth.

“There is always a gap,” says Sorensen. “A lot of folks don’t connect the dots, they just assume it’s going to be there. What I hear all the time is, “I worked hard. I worked hard for 30 years. That’s worth something.” Well actually, it’s not. No one will pay for hard work. They pay for free cash flow or profitability.”

So that’s where it all starts. Knowing what it is you’re trying to do, and then building a plan from that perspective. First, you must decide how fast things have to happen. Then you have to factor in taxes, the cost of the professionals you’re going to use to do the deal (because what you get at time of close is not what you get to take with you). Next, you do the math and get to a number that is needed to build their business in terms of value. Then you use the valuation multiples and back that into how much revenue do they need at what percent EBITDA (earnings before interest, tax, depreciation and amortization) to get to the value.

“That to us is the foundational thing,” says Sorensen. “If you don’t know that answer, it’s really hard to have success because you’re not even sure what you’re trying to accomplish. And most partners haven’t really thought through that, which is a problem.”

The massive valuation gap could become quite serious as a growing number of MSP business owners try to sell their businesses over the next few years. One cannot operate on…

…the assumption that “it’ll all work out.” Helping MSPs to close that gap — with more recurring revenue education — is key for Sorensen.

“The saddest calls I get come from partners that are trying to sell their company,” shares Sorensen. “I get a phone call, they say, “Can you look at my financials? People are trying to take advantage of me.” And they send me their financials and I look at them and I say “they’re not trying to take advantage of you. You haven’t built a business that’s got real value. You’ve lived off of your business. It’s provided a lifestyle, but nobody else is going to pay you for that lifestyle.”

That’s the message to start with. Figuring out what it is you want to do, and how long you have to do it. From there, you focus on building your business the right way. Then, and only then, can you figure out how and where to sell it.

“There is a lot of partner-to-partner stuff happening,” says Sorensen. “You have all the private equity starting to come in on the partner’s side to do roll-ups, so there’s a lot of money flowing into the space. But there’s one common theme, and that is they want to buy the good companies. They’re not looking to buy break-even companies or marginally profitable companies. It doesn’t help them.”

So, the key is building and running a profitable company that has value. That’s the message Sorensen and his team try to drive home. It’s not rocket science: You’ve got to build a company that’s profitable so it can pay for itself over time.

And then, you get into deal structures.

“Another place I see partners make mistakes is with deal structures,” laments Sorensen. “They don’t understand how important deal structures are. From my perspective, you could have an offer for $10 million that’s not as good as an offer for $5 million just based on what the requirements are for you to get the full $10 million. So you’ve got an element of cash that’s always a part of it.”

Another key thing that Sorensen says folks must keep in mind is that there is always a surprise, and that MSPs must be prepared for that.

“I have plenty of bad news experience,” says Sorensen. “There’s always something you’re not expecting. I don’t care how much due diligence you do, there are always skeletons in the closet somewhere. And you’ve got to be ready for that.”

The final takeaway?

“I think, as an industry we have to start looking at risk as a real issue because cyber is definitely a risk that has to be addressed,” says Sorensen. “The economy is going to change, and we must be prepared for that.”