This Is the Stuff MSP Deals Are Made Of
Selling your business is one of the biggest decisions you will ever make, and likewise, buying a business is no small undertaking either. Acquisitions come in all shapes and sizes, and while almost everyone has considered the dollar number they are looking for, often less people have thought about what deal structure makes the most sense for them.
Because a transaction is such an important part of a business’s journey, understanding the different components of a deal’s structure is critical so you can holistically evaluate what the best deal you is. Deal structures in the MSP industry will vary based on several factors such as the type of buyer, size of the business, and post-close plans of the buyer and seller, however there are a few common components that you can expect to make up the total enterprise value in most deals.
Below I will explain some of the most popular elements of MSP deal structures that you are likely to come across and what they mean for the seller and the buyer.
Cash at Close:
Aptly named, this is the amount of a deal that is wired from a buyer to a seller at the time of close. In most MSP deals today, particularly private equity buyouts, the cash at close makes up a large portion or the majority of the total purchase price. This is the most seller friendly component of a deal and represents the biggest risk to the buyer. Sellers are able to de-risk and immediately receive the proceeds from the transaction, which can be especially attractive if a seller is looking to move on. Buyers with more committed capital will usually be able to do more cash-heavy deals.
It is also common for a portion of the cash at close (usually ~10%) to be held back in an escrow. While it is rare, escrows are designed to protect buyers in the case that a legal claim needs to be made after a deal closes related to events outside of the ordinary course of the business. Escrowed funds are generally released to the seller within the first two years after closing.
Earnouts are a portion of the purchase price that are paid out to the seller upon the business hitting certain target metrics after a sale. In the purchase of an MSP, earnouts are typically tied to growing revenue or EBITDA by a certain percentage in the year(s) following a sale but can also be designed to encourage things like margin improvement or retention. Targets, duration, and payout vary from deal to deal and across buyers. Earnouts can be a good tool for aligning incentives, giving the seller the opportunity to earn additional cash for growing the business and providing some downside protection for the buyer. The duration and targets of an earnout would be laid out in a written offer.
A seller note is essentially a loan from a seller to a buyer to help finance the purchase of a business. Seller notes can be a great way for a seller to lock in a strong return on a portion of the sale via the interest rate and the loan is not tied to the company performance like an earnout, so it is lower risk. Likewise, they can be beneficial for even well-funded buyers because seller notes are essentially debt for the buyer, which means they can buy the business with less equity and thus enhance their return on equity. Like traditional loans, the terms can vary in duration, interest rate, and amortization vs. interest only payments. A typical duration is 5 years and interest rates on seller notes are generally in the 6-8% range.
Retaining equity provides an upside opportunity for an owner after sale and is a fairly common structure in large private equity buyouts, especially when the management team is staying on. It is often referred to as a “second bite at the apple” since sellers would also share in proceeds on the next transaction or recapitalization that the business goes through. The benefit for a buyer is that the sellers will ideally still be motivated to increase the value of the business, like the reasoning of an earnout, as they will have a vested interest in it. The shares you roll could either be an ownership stake just within your own business, the combined entity of your business and the acquirer’s business or have exposure to a broader portfolio of businesses.
While retained equity has the possibility for significant upside, there is conversely an associated risk. Retained equity could also be a way for a buyer to reduce their cash outlay and the business’s value may not grow at the anticipated rate. If retaining equity is something you are interested in or part of an offer you are receiving, it is important to ask questions to help understand what the buyer’s plans are for growing the business post-close, how long their expected hold period is, and what past performance has been.
Revenue Share/Business Development
If you are considering buying a smaller MSP yourself, there are a lot of creative ways to structure a deal that may look different than a larger buyout. Often larger MSPs are looking to buy a book of business and a few employees but don’t need to outright own the full business. In these cases, some form of business development or revenue share partnership can make more sense. This can look like paying a small amount of cash up front, a percentage of sales over a specified time horizon, 100% performance-based payouts, or just paying a commission for the transfer of specific contracts. Depending on what you are looking to get out of the business, you can creatively structure a deal to protect your downside risk (customer churn, employee attrition, etc.) and appropriately pay for what you are getting.
To make all of this more tangible, here are some sample deal structures that we commonly see in MSP M&A transactions:
Sample Deal 1
- $10m total deal value
- $7m of cash at close
- $1m in an earnout tied to 10% EBITDA growth in the first year post-acquisition
- $2m in a 5-year seller note at a 7% interest rate
Sample Deal 2
- $10m total deal value
- $8m of cash at close
- $1m in retained equity
- $500k in an earnout tied to 10% recurring revenue growth in the first year post-acquisition
- $500k in an earnout tied to 10% recurring revenue growth in the second year post-acquisition
Deals can vary in structure and amount, but odds are you will find some combination of the components listed above. Hopefully this sheds some light on how each of those components can impact you when doing a deal and can help as you think about what makes the most sense for you.
Guest blog courtesy of Evergreen Services Group and authored by Alex van Lent, M&A Professional, Evergreen Services Group. Read more Evergreen Services Group guest blogs here. Regularly contributed guest blogs are part of ChannelE2E’s sponsorship program.