While there are countless factors impacting the valuation of an MSP, the major drivers of valuation are remarkably consistent over time. At Evergreen, we have purchased over 50 MSPs since 2017 and while the MSP industry has changed a lot over that period, the factors we consider when valuing a business have not.
In 2019, we published our MSP Acquisition Scorecard, a document we use at Evergreen to assess each acquisition opportunity. Below I will explain the rationale behind each key variable and what it means for you as an MSP business owner:
1. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization): This term has become popular in the world of M&A, but it’s really just a fancy term used to approximate pre-tax cash flow. In most MSP businesses, EBITDA is a good approximation of cash flow because most MSPs are not capital intensive, meaning they don’t regularly purchase fixed assets (like buildings, heavy machinery, etc.). That means they don’t have much in the way of depreciation. The exception to this is MSPs that engage in capital intensive lines of business, like private cloud hosting or hardware-as-a-service, where assets are purchased, capitalized, and then depreciated on the P&L. Depreciation is a real expense, so when evaluating capital intensive MSPs, a buyer must look at EBIT or EBITDA Less Capital Expenditures to get a true approximation of that company’s cash flow.
Takeaways for MSP Business Owners:
- Larger companies (from a revenue and EBITDA standpoint) are more valuable than smaller companies. The lower supply of larger MSPs combined with the greater demand from private equity firms for larger investments means that a larger MSP is worth more than a small one. Crossing the thresholds of $3m, $5m, and $10m of revenue without acquisitions and while maintaining best in class EBITDA margins will generally lead to upward trends in the EBITDA multiple applied to your business.
- Avoid capital intensive lines of business! I have spoken with many MSPs that have engaged in capital intensive lines of business (most commonly private cloud hosting) thinking that it will be positive for their valuation because they will report a higher EBITDA number. This isn’t true in practice and can lead to MSP owners making large investments in equipment that don’t generate the return they expected and have a negative impact on cash flow.
2. Recurring Revenue: These two words are responsible for so much of the growth in MSP valuations. Acquirers of MSPs (and most other businesses for that matter) value predictability in revenue and profits. The recurring revenue business model is the purest form of predictability and is therefore more valuable. At Evergreen, we look for a minimum of 50% recurring revenue, which includes both recurring managed services and recurring resold product. Recurring managed services have a much higher value than recurring product, but we include both in our minimum threshold.
Takeaway for MSP Business Owners:
- Focus on growing recurring managed service revenue. The more recurring revenue you have coming from services you deliver, the more valuable your business will be. Recurring product is a nice addition, but it’s important not to lose focus on your highest value services.
3. Recurring Customer and Revenue Retention: This is an under-discussed metric in the MSP industry. The best MSPs have over 90% customer retention – that means that a company with 100 managed services customers at the beginning of the year will end the year with 90 managed service customers if they don’t add any new clients. More importantly, the best MSPs have over 100% recurring revenue retention, meaning that a company with $5m of recurring revenue from 100 customers generates at least $5m of recurring revenue from that same group of customers (excluding new clients) the following year.
Takeaway for MSP Business Owners:
- Institute annual price increases and focus on selling new services to existing customers. Regular price increases and selling new services to existing clients are the two most powerful levers business owners can pull to achieve 100%+ recurring revenue retention rates. We encourage business owners to regularly analyze their recurring revenue by customer over the past 3-4 years to monitor how their MSP is performing on these two metrics.
4. Growth: At the risk of stating the obvious, growth in revenue and profits is important. How that growth is achieved is also important. A business where growth is dependent on the owner’s ability to sell is less valuable than a business where growth is achieved in a systematic, team-driven manner.
Takeaway for MSP Business Owners:
- Seek to remove yourself from day-to-day operations so that you can work on the business instead of in the business. This will require hiring great senior management and empowering them to make important decisions. Many business owners are able to remove themselves from the service delivery and existing customer relationship aspect of the business, but struggle with removing themselves from the sales process. To scale your business beyond a certain point, sales will have to shift from owner-driven to team-driven.
5. Customer Concentration: As a general rule, having a single customer generating over 15% of your recurring revenue is going to have a negative impact on the value of your MSP. Clients getting acquired or going out of business are the two biggest reasons that MSPs lose customers, both of which are out of the MSPs control. As a result, having a significant amount of revenue coming from a single customer (or a handful of customers) increases risk and lowers valuation.
Takeaway for MSP Business Owners:
- Don’t take on every customer. While it’s exciting to land large new customers, don’t forget to consider some of the risks and challenges associated with having too many eggs in one basket.
An MSP Valuation Calculator?
By now most of you are probably saying, “Okay, that’s all great, Ramsey, but can you just tell me what my MSP is worth?”
The answer is yes. We operate MSP Valuations, which allows you to fill out a short questionnaire focused on the factors above and receive a free valuation estimate. The questionnaire takes less than 10 minutes, is completely confidential, and can serve as a useful estimate in a world where straight answers are hard to come by.
This guest blog is courtesy of Evergreen Services Group. Regularly contributed guest blogs are part of ChannelE2E’s sponsorship program.
