For Microsoft partners thinking about the future, it’s go big, go vertical, or go home.
The IT industry is well along the path of consolidation. The marketplace is too fragmented, the price competition too intense, and the cost of sales for traditional partners is getting much too high to sustain as many players as there are presently.
Companies that will grow in the future will be those that have a well-defined offering set with a fair degree of market specialization. These forward-thinking, growth-oriented companies are now acquiring competencies that provide greater depth to their area of focus. They’re doing so because they know that’s what corporate customers want, and that’s where the money is.
So the questions being asked by acquisitive, interested executives are: “How big of a company can I afford to buy? How much should I pay? How should I finance it?”
The obvious answer: it depends.
It depends on the type of company—cloud services, professional services, ISVs, VARs, and so on—size, balance sheet, appetite for risk, project versus annuity revenue, client concentration of revenue, and more. However, because I want you to walk away with something meatier than “it depends,” here are some general observations based on what we’ve experienced first-hand at Revenue Rocket:
1. Most IT services firms can buy companies about one-half their size.
We’ve managed bigger deals where companies were buying firms of equal or even greater size, but these are more the exception than the rule. In some cases, more risk-tolerant executives will take on a larger acquisition if the selling company has solid retained earnings and a sufficient base of annuity income.
2. About 80 percent of the time, deals are struck in the range of 5-6 times trailing year earnings before interest, taxes, depreciation, and amortization (EBITDA).
Within IT, we’ll need to broaden that range to accommodate the varying types of firms:
- Staffing companies generally sell for 2-4 times trailing year EBITDA
- VARS generally command a selling price of 3-5 times trailing year EBITDA
- Services firms will be the most expensive at 7-8 times trailing year EBITDA
And for services companies, the high side of this range should be reserved for those firms that are well-aligned with your strategy and derive at least 50 percent of revenues from cloud and annuity-based business.
3. The most common form of financing is the 50/50/3 model.
In this model, 50 percent is cash on signing, and 50 percent is earn-out/pay-out over three years.
In most cases, companies finance the first 50 percent with cash-on-hand or with some form of debt financing; however, in some instances, we’ve seen all-cash-upfront deals. The caveat in these circumstances is that they generally come with, on average, a 20 percent discount applied to the deal. On the other end of the scale are all-earn-out deals, or deals paid out over a period of time depending on some sort of success factor, like future earnings. Truth be told, we raise red flags on these types of deals; they tend to be too expensive, as 74 percent of the time these earn-out models get paid at or above the expected pay out.
For more tips on what you should considering before acquiring a business, check out my conversation with MPN’s Partner Profitability Lead, Jen Sieger:
Use these observations as starting points to consider as you contemplate an acquisitive strategy for your cloud business. Needless to say (but worth saying anyway) is that the exact determination of size, valuation, and terms only comes out in the due diligence and definitive agreement phases of the merger and acquisition process.