There is perhaps no industry being transformed more rapidly than IT Services and Managed Service Providers. Several private equity groups have planted their flags with investments in large platforms and are almost universally executing on a strategy to identify complimentary add-on acquisition targets. As a result, MSP owners and operators are receiving tidal waves of inbound calls and emails expressing interest in acquiring their businesses. With most private equity outreach attempts done indiscriminately without much specific targeting, it lends the question: what characteristics do strong targets that command premium valuations have?
While there isn’t and shouldn’t be a simple rubric or algorithm that you can input data into and receive a specific dollar valuation for MSPs, the most attractive ones that command outsized multiples generally have the following qualities:
- High Percentage of Contracted Recurring Revenue – many MSPs find it difficult to garner attention from investors and acquirers if less than 50% of their annual revenues come from contracted, recurring revenue. The strongest MSPs typically target 80% recurring revenue. The predictability that comes from strong contracts enables buyers to have high confidence in the acquisition target’s future performance and offer higher valuations than they would a company that has a high percentage of revenue coming from one-time projects or hardware requisitions. Contract length is also important here, as a company with locked in three-year contracts has a higher degree of predictable, future performance than an MSP that has to renegotiate contracts annually.
- Size – for better or worse, size matters, particularly for private equity investors looking to acquire a platform to grow and pursue an add-on strategy around. MSPs that have gotten to a size greater than $15 million in annual revenue are rare and command stronger multiples than smaller companies. Not to discourage any owners who haven’t eclipsed the $15 million revenue mark, they can still be aggressively pursued by buyers as an add-on target, but likely at a slightly lower EBITDA multiple.
- Margins – strong margins benchmarked against the industry average are a proxy for a well-run MSP. The other factor that plays a key role here is revenue mix, as not all revenue is created equally. There is a preference for higher gross margin services revenue (>50%) over lower gross margin hardware procurement (≈20% gross margins). Once factoring in overhead and other OpEx, if an MSP is operating near the 20% EBITDA margin mark, it is benchmarking well against its industry cohort and may command a high valuation.
- Retention – outside of directly measured customer satisfaction scores (like NPS, which we advocate for tracking consistently), nothing highlights a company’s ability to delivery excellent service and match its value proposition better than its retention metrics. MSPs should look at retention (or the inverse, churn) in two ways: logo retention and net retention. Logo retention is a simple measure of how many customers the business retained that were customers the period prior (year or month). A score of 100% is great but often not attainable, as there can be some churn driven by factors the company cannot mitigate like customers going out of business or merging, for instance. Net retention measures the percentage of recurring revenue retained, and in the best instances, can be >100% due to service and product expansion or upselling. Net retention is much more important than logo retention in most cases, illustrated in an example: A company may not mind if a $2,500/year customer that is difficult to please churns, but if they lose a $250,000/year customer, there will undoubtedly be a shake up in operations and the bottom line. Investors want to see both numbers as strong as possible, with 85% logo retention and >95% net retention being solid benchmarks.
While there is a deep list of other items that investors track and care about when vetting potential acquisitions, the four above are the core operational/financial metrics that are universally analyzed. All MSPs should be tracking these and know how their performance trends for each.
If you have any questions about how to measure the items above or related to the valuation of your MSP and potentially engaging the investor/buyer market to raise capital or exit, we would love to dive deeper, share additional thoughts, and discuss optionality that is available. Please reach out to a member of our Technology and Business Services group to schedule a call.