Acquiring a Managed Service Provider Business. Part II: Valuation, Negotiation and Deal Structure

By Gaidar Magdanurov | 20 September 2024

In Part I of this series of articles about MSP acquisitions, we discussed the reasons for the acquisition, target selection and due diligence process. In this article, we will discuss valuation, deal structuring and negotiation strategy for acquiring an MSP business.

Valuation of an MSP business

There are multiple ways to value an MSP business; choosing the valuation is a negotiation process, and the final results depend on the reasons for the acquisition. If it is purely a financial reason, the valuation tends to be based on the financial metrics. At the same time, if it is a customer base, technology or team acquisition, the valuation may be bound to the customer retention metrics rather than pure financials.

EBITDA multiple method

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is a common metric used to evaluate a company's financial performance. This CFI article provides more details about EBITDA.

The formula for EBITDA: EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization, or EBITDA = Operating Profit + Depreciation + Amortization

To put it into the perspective of the MSP business, EBITDA is primarily influenced by the scalability of the business (growing revenue while decreasing cost at scale), customer retention, and the ability to upsell additional services and increase revenue from existing customers.

The valuation is estimated by applying a multiple to EBITDA. The multiple depends on the size of the business and actual EBITDA values. Small MSPs with 1-2 employees and under $200k in EBITDA may be valued at 1-2x, while large stable MPSs can be valued at 4-8x. There is no scientific method to assign a multiple, and it will be a part of the negotiation. Knowledge of recent deals in the area and consultation with legal and financial advisors and private equity firms may help develop a competitive proposal applicable to the specific location. The rule of thumb for MSPs is that the higher the EBITDA, the higher the multiple they can expect.

Recurrent revenue multiple method

Another popular method to discuss valuation is applying multiples to the annual recurrent revenue (ARR) calculated as the value of all long-term contracts on an annualized basis. For example, a $12,000 yearly contract gives $12,000 to the ARR, yet a $36,000 three-year contract gives the same $12,000 to the ARR (1/3 of the total contract value).

The usual multiples for MSPs on ARR are in the range of 1-2x and open to negotiation. Higher multiples are applied to MSPs with a proprietary technology stack, allowing them to scale their business at lower costs and have a higher share of “sticky” services in their portfolio, like backup, disaster recovery, and security. Having significant ARR from reselling software and cloud-based services is also an opportunity for an MSP to negotiate a higher multiple.

It is important to note that non-recurrent revenue from one-off projects, time-based jobs, and reselling of non-subscription software is usually excluded from the calculation. If there is a substantial amount of income in that bucket coming in regularly, the revenue many be included in the valuation with a discount, usually less than 1x multiple.

Discounted Cash Flow (DCF) method

This method suggests estimating the business's free cash flow (FCF) in the long term, usually over a five-year period. It is more frequently used by private equity and purely financial buyers and rarely by MSP owners acquiring MSPs. The DCF calculations include multiple steps and formulas, and there is a good article in Investopedia explaining the process.

For this article, we can simplify it by building a financial model covering the next five years based on revenue retention and growth and then estimating the business's present value based on the future value provided by the model. For instance, a company that generates $300k of FCF now will have a $3.75M value in 5 years, with a present value of $2.3M. A company that generates $10M of FCF now will have a present value of $99.2M.

Factors affecting valuation

Independently of the method used to estimate the value of the business, there are common factors affecting the valuation.

Financial performance

Revenue growth, retention (revenue from the existing customers), profit margins, share of the recurrent revenue vs. one-off revenue. General directions for the MSPs trying to grow the value of their business are to transition as much business as possible to the subscription model, sign multi-year contracts, introduce price increases in their contracts upon renewal, and upsell additional services to the existing customers.

Customers

Critical parameters impacting valuation are average contract length (the number of years customers renew), average contract value (indicating the size of the customers), and customer churn rate.

Red flags would be that most of the revenue comes from only a few large customers rather than multiple customers and that significant revenue comes from the most recent contract. The MSP owner might have inflated the revenue by signing large and not-so-profitable agreements to boost the valuation before selling the business.

Services portfolio

The breadth of services allows for the upselling of additional services to existing customers and reducing customer churn. The rule of thumb for many MSPs is that every additional service a customer consumes reduces churn risk by 50% because switching to another MSP becomes more costly and takes significantly more time.

Team

MSP business is all about people. Key employees, their contracts, and time with the company are critical to keeping the business afloat after acquisition. The team's operational efficiency is a significant contributor to the valuation—SLA compliance (resolving tickets within the contractual SLA), the volume of tickets resolved per day, the time to resolution, and the number of endpoints managed by the technicians. Perfect financial metrics, but red flags in the team may significantly lower the valuation of the business.

 Negotiating a deal

The final valuation of the business and the transaction structure depends solely on negotiation. There is no single source of truth for valuation, and what can be more valuable for one buyer may be less valuable for another. Below is a simple process for preparing for the negotiation.

  1. Conduct a marketing analysis. Look at the information about recent deals in the area. Find comparable companies in the news and analyst reports. Build a case for the valuation based on similar deals.
  2. Identify the synergy from the acquisition – can you grow your customer base or upsell services to your existing customer base after the acquisitions, or can you sell new services to the customer base of the company being acquired? The synergy will help to justify a higher valuation, as well as to help you focus on the goals of the transaction, not solely focusing on the price.
  3. Consider different options to structure the transaction – cash, stock, earn-out structure – we will discuss it later in the article.
  4. List all the red flags and reasons to decrease the business's valuation. Look at the abovementioned factors and document all reasons the valuation may be decreased.
  5. Come to the negotiations with a realistic proposal and arguments to support it and be ready for multiple rounds of talks. For some MSP owners, their business is their “baby,” and negotiations can quickly become emotional.

After the price agreement is reached, it is important to discuss the timeline, integration process, and communications with the employees and customers. A single position and vision should be communicated internally and externally.

Structuring the deal

The deal structure can be a trading card in the negotiations. Cash today is more valuable than cash in the future, so a higher valuation with a smaller payout today may be preferable to a lower valuation with an all-cash transaction.

All-cash

Sellers get their money; buyers assume control. The transaction is clean and fast. It may require a loan for a buyer to pay the cash or a payment schedule consisting of installments taken from the company’s cash flow. Based on the experience of many MSPs, this type of transaction is easier to agree on yet brings the highest risk of overpaying and struggling with the performance of the newly acquired business.

Stock transaction

Sellers get shares in the new business and become stakeholders in its success, as their future earnings depend on the combined company's future performance. Pure stock transactions are rare, as most sellers seek a cash-out. Stock transactions may come with tax benefits in some jurisdictions and getting advice from a tax professional makes sense when considering the attractiveness of the stock transaction.

Earn-out structure

This structure suggests the earn-out period based on the company’s performance. Usually, it is structured with a portion of the value paid upfront and then the rest of the value paid during a two- to three-year period based on company performance. The usual metrics used for earn-out plans include revenue, EBITDA and customer retention, and an opportunity to receive higher amounts if the company outperforms its targets. This structure is usually employed when there is a need to retain the initial business owners and managers and motivate them to help grow the company.

 

More and more MSPs are acquiring other MSPs after a hybrid deal structure combining a portion of cash, stock and performance-based earn-outs. The flexibility in structuring the deal is a good card to play in negotiating the value that sellers will receive.

 

In the next article of the series, we will discuss integrating the newly acquired MSP.