Mergers and Acquisitions, Mergers and Acquisitions, Small business, Security Staff Acquisition & Development

MSP Acquisitions: How to Buy Or Sell A Small IT Service Provider

So, you want to buy an IT services business -- perhaps for a regional land grab, a vertical market push, or simply to expand your customer base. What are the steps in the journey toward one or more MSP acquisitions? Network Depot
The folks at Network Depot -- an MSP serving the Washington, D.C., area -- certainly know. Network Depot acquired Evolve Technologies in January 2012. Fast forward nearly four years, and key executives who were involved in the deal -- Network Depot's Rich Forsen and Chris Amori plus former Evolve CEO Dave Sobel (now at Logic Now) -- say the business combination turned out well. But what was the anatomy of the deal? The answers come directly from Forsen, Amori and Sobel. When I checked in with them for an update, the trio sent me deeply detailed thoughts about the deal -- essentially organized into these five areas:
  1. The Process: Key steps for a successful MSP exit (seller) and acquisition (buyer)
  2. Early Negotiations and Valuation: How to structure a deal
  3. Due Diligence & Sale: The key steps involved
  4. The Challenges: Key hurdles to a potential deal, and how to overcome them
  5. Key Learnings: Tips for potential sellers and buyers
Now, let's take a closer look at each step or stage, as described by Forsen, Amori and Sobel.

1. The Process: Key steps for a successful MSP exit (seller) and acquisition (buyer)

For starters, a successful deal requires a meeting of the minds in three areas, according to the trio. That includes: A. Basic value of the company.  If the seller has unrealistic expectations on valuation, then there is no point moving forward. In this case, Sobel (the seller) understood that the value of his company was in its future earnings rather than historical earnings. B. Customer Service.  Smart sellers have a vested interest in their customers -- and ongoing customer support.  In this deal, Sobel felt comfortable selling to Network Depot because of Network Depot's established reputation for customer service. C. Service Plan Alignment. How does the seller’s service plans mesh with the buyer’s plans? The seller might have a nice stable of recurring revenue clients, but if the plans are underpriced then the potential buyer could suffer from overall margin shrinkage. If the seller has well-priced plans, it becomes an easy transition into the buyer’s programs. Sobel's business (the former Evolve) had very reasonable MRR (monthly recurring revenue) contracts. The contracts aligned well with Network Depot's focus on  full service, flat fee and largely unlimited plans.

2a. Early Negotiations and Valuation: How to structure a deal

Valuation is always the sticky point, the trio points out. The seller has often invested many years in the business, considers many of their clients as friends, and sometimes feels the business is worth the “sweat equity” they have "invested" into it.

Unless the buyer is looking for a niche product and willing to pay, the valuation of the business is probably going to come down to “what have you done for me lately.” In  other words: What is it worth TODAY? And in the case of the Evolve buyout, what will it be worth tomorrow?

There are multiple ways Network Depot and Evolve could have structured the deal. They include but are not limited to:

A. Multiple of Gross Annual Sales. In situations where there is all services, (no hardware, projects, etc), then Gross sales could be considered.

B. Multiple of Earnings (profit). This is more common, and more complicated. Adjustments need to be made to back out owner’s income (if not the prime biller) and expenses (i.e. car).

2b. The Payout

Next, there are multiple ways to consider the "payout" -- or when the seller pays the buyer. They include but aren't necessarily limited to:

A. Lump Sum: The buyer writes a check for the full amount and move ons. While this favors the seller, it is a much bigger risk for the buyer, and as such, not an option that Network Depot considers.

B. Payout Over Time: This can include but isn't necessarily limited to:

  • Buyer receives a payout based on guaranteed equal monthly installments over a period of time.
  • Buyer receives a variable payout based on retained sales. This could be paid faster or slower towards the agreed value of the company, or simply be a percentage of sales for “x” future periods. This reduces risk for the buyer, and increases the risk for the seller. Indeed, the seller has to trust that the buyer isn't going to derail the acquired business and customer retention.

C. Hybrid: A smaller “good faith” lump sum up front, and then monthly payments (variable or not) thereafter. This is Network Depot's preferred approach as a buyer, and Evolve agreed to the approach as the seller.

A key note on valuation: The trio says buyers and sellers should try to definitely “win” on valuation.  This isn’t “Shark Tank.”  In terms of this deal, Evolve's asking price was low during the first round of valuation conversations. "We actually told Dave that he should ask for more," Forsen recalls. It’s important to create the same good will in your M&A conversations as you do with your vendors and clients, Network Depot asserts.

3. Due Diligence & Sale: The key steps involved

Once you have general financial terms in place, the deal is typically subject to due diligence -- allowing the buyer to probe the seller's business to ensure the company's health and performance match the seller's claims. Due diligence can include:

A. Review of financials.  It’s important that everyone understands the reality of the condition of the business. The numbers are the numbers -- assuming proper and authentic record keeping is in place.

B. Review of Clients and programs. An actual buyer "check in" with selected clients to help the buyer understand customer expectations, satisfaction levels, etc.

C. Review of expectations that specific Clients will transition. In order to determine a potential value of future business, it is important that the seller is realistic in retention expectations.  In our case, Evolve reviewed its client list, and expected that over a two-year period Networker might retain half of them. In reality, Network Depot retained closer to 80 percent of Evolve's customer base.

D. Employee review (if acquiring employees).  Often a seller (especially those who are retiring) want to make sure their staff and their customers land softly. However, the buyer is under no obligation to retain employees who doesn’t fit their culture. In this particular deal, Evolve's employees were new, so Network Depot had a chance to immerse Evolve's staff in Network Depot's culture early -- retaining Evolve's talent along the way.

E. Outstanding seller commitments: What customer projects, if any, are does the seller need to complete and in what timeframe? Also, what vendors and infrastructure does the seller leverage -- and what does that mean in terms of potential ongoing costs for the buyer?

Assuming due diligence goes well, it's time for:

  • Contracts: Buyer attorney draws up contract for buyer and seller review. The seller retains a separate attorney to represent his or her interests, requested changes, etc.
  • Closing: Ownership changes hands and money, according to terms of the contract, changes hands.
  • Transition period: Plans on how the handoff will be made. In some cases customers will be more comfortable if there is a month or two where both parties are in their building and they understand that everything will be OK. In this case, Sobel was able to exit Evolve quickly because Evolve's staff provided customer piece of mind during the Network Depot acquisition.

4. The Challenges: Key hurdles to a potential deal, and how to overcome them

Of course, potential deals can hit all sorts of snags. Many never reach the finish line. We've already mentioned challenges involving valuation. Additional challenges can include:
  • For the buyer: Finding entrepreneurs who are serious about selling. "You need to kiss a lot of frogs," the Network Depot team notes. Also, infrastructure can cause some snags. Many MSPs and VARs are on incompatible PSA and RMM platforms. In the case of Network Depot and Evolve, they were both on ConnectWise, which made the deal easier to manage.
  • For the seller: Finding a buyer that will take care of of the seller's clients,  treat the seller fairly, and honor their commitments.

5. Key Learnings: Tips for potential sellers and buyers

For starters, potential buyers and sellers should constantly network -- interacting at trade shows and participating in  online community events. The visibility will keep you -- or your business -- front-of-mind as potential buyers or sellers navigate the market.

When researching potential acquisition targets don't go too far afield. Skip buying opportunities that would force your company to evolve into a market that isn't a fit for your business. Find fits. Don’t force it.

"In our conversations with other MSPs who have been through this process, most of them have not had our success. And usually it’s because they looked more at the money and less at the fit, and the customers they acquired were not “their” customers.   In our sales process, we’ve clearly defined what a Network Depot customer is, so when we looked into Evolve's customers, it was easy to tell that they would be well taken care of by us and appreciate the service," the Network Depot leadership says. "Bottom line, it’s all about retention."

Note: The information above is nearly entirely based on contributed notes from Rich Forsen, Chris Amori and Dave Sobel. ChannelE2E thanks them for their insights.

Joe Panettieri

Joe Panettieri is co-founder & editorial director of MSSP Alert and ChannelE2E, the two leading news & analysis sites for managed service providers in the cybersecurity market.