Mergers and Acquisitions, Angel investors, Channel investors, Mergers and Acquisitions, Private equity

Friday’s Exit Strategy: Small Businesses, MSPs and the Valuation Bubble

Most times you can't see a market bubble forming. But sometimes, you can hear it forming -- if you take the time to listen closely.

A prime example: On Wednesday afternoon, I was seated in a small cafe at the San Francisco Marriott Marquis. The place was packed with RSA Conference 2018 attendees. I had about an hour before my meeting with SonicWall CEO Bill Conner and Chief Revenue Officer Steve Pataky. (Side note: Their new MSSP partner program has already gained 200 partners...) As usual, at sat and blogged ahead of the SonicWall meeting.

Seated at the table next to me was the CEO of a startup IT security company. Even if I tried, it was impossible to ignore his bravado. Over the course of an hour, he had two face-to-face meetings intermixed with about a half-dozen phone calls. Every meeting and/or phone call had a private equity firm on the other end of the line. And during every conversation, the outspoken CEO shared stats about rising valuations for cybersecurity startups -- attempting to build the case for his company's own valuation ambitions. Not once did I hear him mention profits...

It was a sign of the times at RSA, where I heard numerous back-hall conversations about M&A, valuations and potentially frothy deals... for sellers.

Burned After July 4 Barbecues?

It reminded me of 2000 or so, when you'd go to your neighborhood barbecue and non-tech folks were busy talking about tech stocks. 'Everybody' was an 'expert' until the dot-com crash came roaring into town. And let's not forget 2007, when you went to your neighborhood barbecue and non-real estate folks -- including the Jones family in every neighborhood -- talked about tapping into even more home equity because real estate prices 'never' fall.

Fast forward to your 2018 neighborhood barbecue. When July 4th rolls around here in the United States, it's a safe bet more than one small business owner or tech entrepreneur will talk about his or her personal exit strategy. And that, my friends, will be a surefire sign that the M&A market for SMB and MSP owners is getting overheated.

The anecdotal evidence is already emerging. Indeed, small business M&A sale prices reached record highs in Q1 2018, rising 3.4 percent from Q1 2017, according to BizBuySell. That's not necessarily the same as valuations reaching all-time highs, since we don't know the actual deal multiples. Plus, the BizBuySell data focuses on all types of small businesses -- not just MSPs and IT service providers.

Looking for 'Quality' MSPs

In the MSP sector, it's getting increasingly difficult for buyers to find quality sellers that generate $8 million or more in annual recurring revenue. That anecdote comes from sources who will speak during Kaseya's MSP M&A Symposium -- which will kick off Kaseya Connect 2018 next month in Las Vegas.

With that scarcity in mind, it's a safe bet quality sellers can demand a premium for their businesses. Historically speaking, MSPs were valued at roughly 5X to 7X EBITDA, pundits say. But platform MSPs -- large enough to attract Private Equity Firms -- can fetch higher premiums. And those with 20-plus percent profit margins and intellectual property can earn an even higher premium.

Of course, I'm sure savvy buyers include well-crafted earn-out terms in each deal. The language attempts to ensure sellers work hard to earn every dime from a proposed deal. And of course, there are plenty of M&A deals that have low valuations, because frankly, the seller wasn't running a quality business.

Trust, But Verify -- Or Walk Away

All that said, the smart money suggests we're nearing some sort of market bubble. We may already be in it. If you're heading to the negotiating table, steal a page from Ronald Reagan: Trust, but verify. Buyers need to have 110 percent confidence in a seller's business and financial data before paying any type of market premium. And sellers need to be 110 percent confident that the buyer is properly capitalized for earn outs and other longer-term financial incentives.

PS: There's nothing wrong with paying a premium for quality. Just make sure the quality is legitimate.

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.

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.