Q&A: What’s the Deal with Channel M&A Today?
In the first column in this series on channel M&A, “Is it Time to Sell Your IT Services Business?” we asked and answered the question, why now? That’s because transactions usually don’t happen in a vacuum, but are often driven by – and always impacted by – what’s going on in the marketplace. Fluctuations in demand, innovations in technology or shifts in the supply chain or changes in regulations, etc., can influence not only when companies should sell but buyout they might get.
Since these are inescapable realities, if you’re thinking about selling your channel business, you need to have a handle on the current M&A trends in the tech channel. To find out, we consulted a few leading attorneys in the tech channel – each with specialization in transactions involving either MSPs, VARs or telecom agents. They include:
Telecom/IT/Cloud Lawyer, who has represented a variety of telecom companies, including telecom agents and master agents. He has provided legal advice and counsel to many of the most highly-regarded agencies in the industry and has served as corporate counsel in numerous transactions with an aggregate value of several billion dollars.
Bradley Gross, founding partner of the Law Office of Bradley Gross, P.A., who specializes in transactions involving MSPs, VARs, technology solution resellers, cloud solution providers, IT professionals, technology and media companies worldwide. He has been named, on seven occasions, to the list of Superlawyers for IT law.
Whitehouse & Cooper, who focuses on general business law, technology law, marketing law, e-Discovery, and other areas that affect businesses. Whitehouse entered the legal profession with more than a decade of experience in the IT industry. His unique blend of technology and business experience is an invaluable asset to the clients he represents.
We asked the following six questions with sellers in mind, but they are equally informative for buyers – and a perfect segue for our next series of columns looking at channel M&A from the buy side. Look for those starting next week with our how-to column, “To Buy or Not to Buy.”
1. What transaction types – scale, scope or diversification — are you seeing most?
Bronston: My firm has handled most of the deals in the telecom agent space and they’ve all been about scale. The bigger you are, the more likely you will be one of the handful of agents a service provider will select to consolidate their channel program under. Many providers don’t want to deal with mom-and-pop agencies anymore. They would rather just deal with a handful of master agents who, in turn, are responsible for managing thousands of subagents.
Historically, M&A in the telecom channel has been primarily master agents buying master agents. The primary motive has been the desire to gain scale. That’s sort of a fundamental guiding principle in the business. Everybody wants to have scale because it opens doors that might not otherwise be open. The more revenue you have to spread over your fixed infrastructure costs, the more profitable you become, and the more staying power you have.
Gross: I am seeing a greater number of mergers and acquisitions of smaller MSPs (between $1 million and $10 million in revenue) than in previous years. It appears that, with increasing frequency, smaller MSPs seek to leverage the customer relationships of their takeover targets, as well as expand their geographic footprint, so that they can remain competitive and relevant in an industry that is often dominated by larger service providers.
Most of what I see is scale, not scope. Perhaps it is because it has become easier (because of technology) to resell and offer services, so a larger number of companies are doing so. As a result, the services offered by the MSPs are similar, but the MSPs have trouble growing. M&A solves that problem—of course, it brings a host of other problems, but that’s another story.
Whitehouse: We are primarily seeing economies-of-scale transactions such as companies that were competitors, perhaps in different geographies, acquiring one or the other’s book of business to increase client base and be able to reduce overhead expenses.
2. What are current valuation multiples for VARs, Agents and MSPs?
Bronston: I’d say somewhere between 4X and 8X EBITDA is the right ballpark. However, every deal is different and the bigger you are, the higher the valuation you can command in terms of a multiple of earnings. Scale is king and always has been.
Gross: For MSPs, the multipliers I see most often float somewhere between 4X and 8X EBITDA. I also see similar multipliers for gross revenue measurement, which is another way that MSPs are valued.
Whitehouse: Multiples vary depending on the business model of the company. While everyone would love to achieve a 3X multiple, that is not always feasible.
3. What factors are driving up values for channel companies?
Bronston: The sense of urgency that buyers have to become bigger faster. The need to achieve scale quickly is a buyer-based fear, but one that is well-founded; just look at all the providers who have consolidated their channel programs under a handful of masters so they don’t have to deal with small, mom-and-pop agents.
But that’s out of the seller’s control. On the seller’s side, it’s all about the earnings they can generate. Buyers want to know how long it will take to get paid back for the amount they are going to spend to buy your company. So, no matter how many sales partners you have and no matter how many provider agreements you have, if you don’t make any money, you won’t be an attractive target.
Gross: The top factor that I see is the ratio of services to product sales. MSPs that are heavier in services generally command higher multipliers than MSPs that have large product sales revenue.
And when it comes to sales, MSPs that focus on private cloud services are the most valuable, followed by MSPs that offer professional services, such as consulting services, vCIO, etc. Companies that focus more heavily on product sales often become commoditized businesses, so they simply don’t command higher valuations. Customers often don’t maintain long-term allegiances to companies that focus on product sales; they will quickly switch to a competitor if the competitor’s prices are lower.
Whitehouse: The more recurring revenue a company brings to the table, the more valuable that company is to be acquired.
4. What are the biggest sticking points, disagreements or points of contention in channel transactions?
Bronston: I know it sounds self-serving to say this but if your provider agreements are not well negotiated, you can substantially reduce your exit value or, even worse, completely undermine your ability to sell at all. If you don’t have solid provider agreements your commission stream is more tenuous, thereby increasing the risk that your primary asset (i.e. your cash flow) could disappear.
There is no such thing as a bulletproof agreement; anybody can try to poke holes in an agreement, regardless of how well drafted it is. However, I can state unequivocally that having a well-negotiated, thoroughly vetted agreement dramatically improves your chances of preventing a provider from picking a fight with you.
Gross: The largest sticking points I see in channel M&A transactions are identical to the sticking points that I see in other industry M&A transactions. One sticking point is the determination of working capital, i.e., the amount of money that a company requires to have on-hand on order to keep the business going. If you are dealing with a service company with monthly recurring revenue, the acquiring company usually requires less money to be on hand for the transaction to occur. If, however, the target company is a product sales-type company, the acquiring company will require more money in the bank to support the takeover company’s operations.
Another big sticking point is earn-outs. Sellers want their money upfront with little or no earn-out periods; buyers want to hedge their risks by requiring longer earn-out periods. I have found that targeted takeover companies that are service-oriented can usually demand smaller earn-out periods, as opposed to product sales-type companies, which usually get stuck with longer earn-out periods.
In addition, companies that have “sticky” relationships with their customers can get away with shorter earn-out periods. If the incoming (i.e., acquiring) company believes it can engender the same warm and fuzzy feeling in its acquired customers as the acquired company enjoyed, shorter earn outs can often be negotiated.
Whitehouse: Valuation remains a sticking point, and we recommend having a professional business appraisal performed to assist with that portion of the discussion. Many business owners also want to ensure their current employees (including the owners) are treated fairly in the transaction if they will remain engaged in the post-acquisition environment.
5. What are current transition and earn-out terms?
Bronston: No buyer wants to purchase a stagnant or, even worse, shrinking asset – every buyer wants the asset they buy to grow. Every seller wants to be compensated for the growth they claim they will forego by selling today. Thus, most deals contain some sort of earn-out that enables the seller to take chips off the table while enjoying a (albeit smaller) piece of the upside.
Gross: Earn-outs range from two to five years generally, but I would say three years is the average. Earn-out terms depend on many variables, such as the complexity of the acquired business, the stickiness of the relationship between the acquired company and its customers, and the type of services sold by the acquired company (e.g., services vs. product sales).
From a seller’s perspective, the best earn-out deals are those that focus on a handful of variables, all of which are under the seller’s control. For example, if the sellers are able to make autonomous decisions, keep control of their employees and departments, continue implementing sales strategies, etc., then the odds of the seller meeting their earn-out goals are better than situations where the seller has little or no control over the way the business is conducted after the sale date.
From a buyer’s perspective, the best earn-out deals involve many variables that reflect the way that the buyer wants to do business. Put another way: The buyer will want the business to be run his way, and if the business cannot be run in that manner, then from the buyer’s perspective, the seller shouldn’t be rewarded with a generous earn out.
Whitehouse: We generally advise against any earn-out terms beyond five years unless special circumstances exist, with around two years being the ideal timeframe.
6. Do you think more or less consolidation will happen in the channel in the next 12 months? 3-5 years? Why?
Bronston: Much more. Fear of the unknown and fear of missing out. There will always be a subset of folks in the industry who are nervous about the future and therefore want to exit. Fear of the unknown is going to motivate them to take chips off the table, perhaps prematurely because they still have a lot of growth potential left.
Some sellers are scared about the prospect of their primary providers being acquired. They think the acquirer won’t honor their partner agreement. Maybe the acquirer doesn’t want a channel program. Or perhaps the acquirer wants to make the deal more profitable by terminating commissions. Based on experience, these are not necessarily irrational fears, particularly in this industry.
Other sellers are afraid they can’t pivot into providing consultative solutions instead of merely selling circuits. I know this is contrary to conventional wisdom but I don’t think pivoting into solution selling is nearly as big of a concern for the average agent. I’m not saying it’s not a concern at all; I just think it’s been a bit overblown. There are plenty of educational resources available to teach them how to sell the new breed of solutions. Plus, they can always partner with someone else who has the requisite expertise. I just think the fear regarding solution selling has been overblown insofar as M&A is concerned. It could be driving some consolidation, but I don’t think it’s causing partners to press the panic button.
Gross: I think consolidation and growth will increase in the next few years. Consolidation will increase because demand for managed services is growing, and, in my opinion, there are too many smaller MSPs that simply don’t know how to handle the increased demand. There will be a shakeout of sorts. The shakeout will largely revolve around infrastructure. It goes like this: When a smaller MSP’s infrastructure fails, its clients will leave. To stay afloat, the smaller MSP will merge with a company that has better infrastructure.
Whitehouse: More. With so many cloud providers in the market today, technology will make shifts over the next few years that require a readjustment of the MSP/VAR business model. Smaller companies may not be as nimble and able to adapt to the changes, making them ripe for consolidation. They would be wise to increase their book of recurring revenue as much as they can before that acquisition occurs.