Friday’s Exit Strategy: Five Traits of High-Valuation MSPs
You’re striving to build a high-valuation MSP — a business that lifts your personal net worth while also providing job security for your highly valued employees. But what are the core traits of a high-valuation MSP? Glad you asked.
First, let’s talk about valuations. In an M&A transaction, the typical MSP is valued at anywhere from 5 times to 7 times annual EBITDA (earnings before interest, taxes, depreciation and amortization). So let’s assume:
- You own an MSP with $5 million in annual recurring revenues.
- The MSP has 10 percent margins.
- That means your annual EBITDA is roughly $500,000.
- At five to seven times annual EBITDA, your company is worth roughly $2.5 million to $3.5 million.
Of course, a few important qualifiers:
- Cogent Growth Partners, a buy-side M&A advisor, cautions MSPs that EBITDA valuation discussions can be very misleading.
- Some readers suggest MSPs are actually worth far more than 5X to 7X EBITDA. There certainly are examples of larger MSPs and IT services providers fetching 10X and even 11X EBITDA valuations. Office Depot, for instance, paid roughly 10X EBITDA for CompuCom in October 2017, according to ChannelE2E’s calculations.
Five Traits of High-Valuation MSPs
Now, back to the point of this blog entry: What are the traits of a high-valuation MSP? To paint the picture, let’s examine two hypothetical MSPs — Acme Company and Beta Company.
In our example:
- Acme and Beta each have the same annual revenues — about $5 million.
- Both MSPs get acquired by the same firm. The buyer is named Gamma Company.
- Gamma’s buyout of Acme is 30 percent more expensive than Gamma’s buyout of Beta.
The obvious question: Why is Gamma paying a premium — a 30 percent higher valuation — for Acme, especially when Acme and Beta have the same exact revenues? The answers likely involve these five traits of high-valuation MSPs:
1. Profit Margins: Acme likely is a best-in-class MSP — which generate 18 percent EBTIDA, with some top performers closer to 30 percent, according to Service Leadership Inc. CEO Paul Dippell.
2. Consistency of EBITDA Growth: Over a three- to five-year period, Acme likely grew its annual EBITDA dollars faster than the overall MSP market growth rate, which tends to involve 10 percent to 13 percent annual growth rates.
3. Low Customer Churn: Acceptable churn rates in the SaaS market are five percent to seven percent annual customer churn, according to Bessemer Venture Partners. On a monthly basis, that equates to 0.42 percent to 0.58 percent customer churn, according to Sixteen Ventures. MSPs and SaaS companies have similar recurring revenue business models. But the MSP model is a bit less sticky since IT support is easier to swap out than data-intensive SaaS applications. So, acceptable MSP customer churn on an annual basis is likely closer to 10 percent. Related: IT Glue CEO Chris Day points to seven ways to improve client retention and reduce churn.
4. Strategic Market Penetration: Acme likely serves a high-value, highly regulated market, where customers pay a premium for expertise. Examples including the legal and financial services verticals. Healthcare can also make that list, though many niches within the healthcare sector have extremely tight IT budgets.
5. Intellectual Property: Acme likely built unique IP in the market — a piece of software or defendable best practice that rivals can’t emulate.
PS: Of course, the list above is open to strong debate. Service Leadership, for instance, points to at least 14 Key Performance Indicators (KPIs) that influence an MSP’s valuation.
An Example MSP
CareWorx is an MSP that recently received $17 million in private equity funding. I don’t know the company’s valuation but industry chatter suggests it’s strong. Most PE firms that dial me are seeking MSPs with at least $20 million in annual recurring revenues, and roughly 20 percent EBITDA margins. I’m not suggesting that CareWorx specifically fits those metrics. But it’s a safe guess the company has some core features — size, scale, margin, market focus — to attract PE investment dollars.
CareWorx CEO CEO Mark Scott, the former co-founder and CEO of N-able Technologies, has successfully focused CareWorx on a key healthcare market segment. The effort involves IT services for senior care facilities. Pure demographics — the aging Baby Boomers — suggests that segment will grow for years to come.
CareWorx also has its own intellectual property. The MSP is emerging as a platform provider. Key steps include building out a multi-tenant version of ServiceNow. Another key step potentially involves CareWorx’s visit to the IBM Think conference earlier this week in Las Vegas…
Stay tuned. More details may surface down the road.
What About Top Line MSP Revenues?
In the meantime, let’s take another look at my Top 5 list from above. You’ll notice that I didn’t put top-line revenue on the list.
No doubt, top-line revenues are a huge part of the overall valuation conversation. But I left it off the list to emphasize an equally huge point: too many MSPs chase revenues without properly calculating and maximizing the underlying profit margins.
Instead of chasing higher revenues, take a hard look at your existing business. Speak with pundits from TruMethods, Service Leadership, HTG Peer Groups or another organization that really understands IT service provider business models, associated costs, profit targets, and valuation models.
Get a reasonable understanding of your current annual EBITDA/profit margins. Then, figure out how to retool the business a bit to move toward best-in-class MSPs that generate those 18 percent (or above) margins.
Joe Panettieri (@JoePanettieri) is co-founder and executive VP of After Nines Inc. and its IT media platforms — ChannelE2E and MSSP Alert. His great grandfather arrived to the United States from Italy around 1917, charting the way for three generations of entrepreneurs.