ChannelE2E, recently sat down with Bruce Teichman and Rick Murphy, two of the partners at Cogent Growth Partners, a firm that matches MSPs with buyers for this video discussion on some of the hot topics in the current MSP M&A market. The pair spoke with ChannelE2E about the best accounting practices to showcase an MSP's business quality, the state of the M&A market in 2024, and also hinted at several topics they would discuss in the next edition of this video series.
Jessica C. Davis
Hey everybody, my name is Jessica Davis and I'm the Editorial Director of ChannelE2E. I'm here with Bruce Teichman and Rick Murphy of Cogent Growth Partners. They're an investment banker. They match MSPs with buyers and do an amazing job of that. And because of that, they have a unique perspective on the marketplace for managed services and valuations and all kinds of things that MSPs need to know about in terms of improving their businesses. And I wanted to start out today by asking a question. I know everybody talks about EBITDA when it comes to M&A and valuations, and I've heard an alternative viewpoint from you guys, and I wondered if you could talk about that, why GAAP (Generally Accepted Accounting Principals) accounting is important.
Bruce Teichman
Yeah, do you want me to go first? Yeah, well, besides, Rick has a presentation called EBITDA SCHMEBITA, so he could dig in a little further on that. But what we find that is very challenging is there's a lot of MSPs, I mean, probably the majority that are doing cash accounting on their books.
What that really means is when the money comes in is when they book the cost, as opposed to the period in which it is attached. So you have revenues coming in, but costs are often in different months. And it's very, very difficult to understand, hey, what do you make every month? What do you make in January versus February? It's all this sort of timing issues.
You can do cash accounting for your taxes. That's going to be the case. But you really should do accrual accounting, which is mostly GAAP-ish. There are some rules around that. And that means that you're booking your cost if you were to invoice, and we'll just use product as a simple example right, but if you're going to invoice a product in September to your customer, the COG (Cost of Good) around that product should also be booked to your accounting system in September. The cost of good -- and if it's service then of course you know the service dollars -- are being billed in a particular month and all the service labor against it should also hopefully be in that same period. And so that's really the accrual versus cash.
It's a big challenge when people are doing cash accounting, like I said, to really understand, hey, what's the company genuinely doing from a month-to-month, quarter-to-quarter, year-to-year period? There's a lot of, hey, in December, I'm going to put in this cost but I'm not going to invoice till January so I can reduce my profitability. There's some tricks of the trade if you will, but honestly it hurts these companies to do that because, if the banks are looking at their profitability in order to lend the money you want to have the most realistic picture you can.
The challenge with, EBITDA, which is Earnings Before Interest, Taxes, Depreciation, and Amortization, is this ITDA -- the interest, the taxes, the depreciation, amortization.
First of all, in a lot of MSPs, the difference between EBITDA and just cash flow or net income is really very close because there is not a lot of hardware and depreciation and hard assets and things that adjust it. But for those businesses that do have it where they're doing hardware as a service, where they have a private cloud component, where they have those things, it offsets again for the tax man that, that hey, my profits actually higher. But the actual cash effect and what the company genuinely made -- it's really misleading. It can be very misleading with EBITDA and that's why, according to GAAP, generally accepted accounting principles, EBITDA is not a GAAP measure.
Jessica C. Davis
I want to hear about the SCHMEBITA part.
Rick Murphy
The SCHMEBITA part is a couple of things, and Bruce set that up very nicely. Thank you much, Bruce. The SCHMEBITA part of that is, you know, there's a cash flow component to it. A really good example is something called deferred revenue, which a lot of business owners that are doing cash accounting don't really employ. Let's say I have an annual client, I'm billing them annually and they paid me $20,000 for my annual service. I'm not going to bill them again for another year. And it doesn't matter what month I bill them in. I took all that money in and then I haven't delivered the service yet. I'm going to be delivering my monthly services times 12, right? So that money should actually be housed on their balance sheet, which a lot of the big thing with GAAP accounting is paying a lot more attention to your balance sheet and paying attention to your profit and loss statement or income statement. When you're just focused on your product, on your P&L, your balance sheet's not telling you anything. You're not learning anything from your balance sheet. A lot of people don't book that that 20,000 deposit on their balance sheet, and then every month that they do service, you draw that into actual earnings. You draw that into actually income on your P&L.
You didn't earn the $20,000 today. So you can see where that would also artificially inflate a perception of profit, would artificially inflate a perception that I made some money this month, I could take some money out to the company for myself as an owner. Or pay some bonuses, or pay a commission on that money.
I'll give you a really good example. Nobody would pay a commission on an annual payment, a prepayment, because you haven't delivered the services yet, and that client could still cancel. You might owe them a refund. There's a lot of people that don't book it that way. So that's a really good example of what we see as a difference, but where business owners just don't understand the difference between GAAP accounting and cash accounting.
Jessica C. Davis
Interesting. How many MSPs that you work with make that mistake?
Rick Murphy
Almost all of them.
Bruce Teichman
I was going to say a pretty high number, 80%.
Rick Murphy
I'm going to go greater than 80% think would be making this. And mistake is not how they look at it.
Jessica C. Davis
Yeah, that's the wrong word.
Rick Murphy
I could put it in a different way, but I don't want to create any issues. But the idea that you're thinking about tax accounting when you're operating your business is not how you should think about accounting. You should be thinking about accounting in terms of how your business is profiting? How's your business doing? Are you controlling expenses? How am I making money? And if you're not making money, why am I not making money? How could I make more money? And again, I'm sharing that with your team or whatever else you're going to do with that is where GAAP accounting can be really helpful because I understand it ties it back to cashflow.
Most people, again, when they're looking at P&L, their cashflow is just looking at their bank account. Do I have any money in the bank? How much money do I have in the bank? They're really proud of that. I can keep money in the bank. But money in the bank's not cashflow. It's a result of cashflow. But again, did you pay the bills you're supposed to be paying? Does that money come from prepayments and other things that should be on deferred revenue?
That money should be in a savings account or someplace else. You can't put it in your regular checking account and accidentally spend it on a new, whatever you want to do with it. EBITDA hides that. It is a proxy for free cash flow in the absence of debt and other issues. If the company doesn't have a lot of debt, which most of them don't, if you're not buying a bunch of equipment, you don't own it, you don't have to refresh a data center. A lot of these companies are fairly nimble in that way. EBITDA is a proxy for free cash flow, is a conversation starter, but again, it doesn't take into consideration your balance sheet, which is why it's not GAAP compliant.
Jessica C. Davis
Makes sense. Well, thank you for that perspective, you guys. Really appreciate it. And while I have you here, just wanted to also check in with you both. 2024 is kind of a different kind of year so far. We've still got some inflation. I don't have a good sense of how the deal flow is going so far this year, but I wondered if you might provide your perspective on our deals picking up this year. Where are we going with that? What's your sense of 2024 so far?
Rick Murphy
2024 has definitely been a different year. It’s just a lot of talk about interest rates, but we don't really see it affecting a whole bunch. The people that rely on a lot of lending to get deals done, well, that's slowed them down a little bit. It's cost them more money. They're being a little more circumspect on price point. I think it's probably taken the top off the market in a bit in terms of some egregiously overpaying deals I've heard of in the past, although we haven't participated in them.
I think that every deal is taking a little bit longer to get done, whether it's because the people that are doing the purchasing, a PE company, for example, a private equity company, for example, who might be using some lending leverage as part of the transaction costs in a transaction, their lender might have different covenants than those covenants used to be a year ago, two years ago, when money was a lot cheaper.
If you think about the interest rates themselves and just the same exact covenants that were previous covenants without adjusting those covenants, higher interest rates actually don't work. I have to renegotiate the covenants. So that takes time. There’s got to be a good purpose behind it. The length of the due diligence process has increased. We're seeing deals are taking longer. We're getting deals also done with customers, with candidate companies that we've talked to years ago, because they just weren't ready yet, or they just weren't big enough for their own desires to move on.
It is still a seller's market, in my opinion. Bruce, you can speak to that. I think that it's a good time to be a seller. And it's also a good time to be a buyer because you've got good companies that have matured, and you've got an operational maturity level that is significant that's worth adding onto your business. So we are also running to everybody wanting to be a buyer. That has definitely been happening more so than I can remember in even the near past. Every company I've talked to wants to learn how to buy companies, even though some of them shouldn't be.
Jessica C. Davis
We're going to circle back on that one and talk about that one next time around, you guys. Everybody wants to be a buyer. How can you be a buyer? That's a great topic.
Bruce Teichman
The other thing I'd add just in terms of state of the market this year compared to last year is that for those that are relying on borrowing it's slowed them down a little bit, but by and large, we haven't seen that much of a change. From a valuation perspective the MSPs over the last several years have been upticking a little bit on what somebody is willing to pay. And that I think has definitely leveled off, probably started middle of last year. It's just not climbing anymore. But it didn't drop so much. And I think the reason it didn't drop, nothing to do with interest rates, is that, you know, there are just less quality MSPs.
It's sort of a supply and demand over the last five years as many of those better larger organizations have been already acquired you know they're part of some portfolio whether it's a strategic buyer or private equity. There's just less quality out there and I think the buyers are looking for that. to go back to and maybe it is a little bit the interest rates and the cost right there being more scrutinizing. And they're looking for those better businesses And because there's less of them. So the other thing though, if you're not, if you're not very sophisticated, if you're not making good margins or, or, uh, growing, you know, quarter over quarter, pretty, you know, regularly, you know, up into the right, as they say, um, I think the market is, has lowered for those guys, right? Like, you know, it stayed high for the good quality firms because they're, they're just in demand, right? It's not rocket science, but that's definitely happened.
To Rick's point, so many buyers are getting so many knocks on the door. So picture you're in the foyer negotiating to sell your house with somebody and literally on all the windows around the room everyone's knocking and it's someone that may be unqualified but you're in terms of negotiating with who's in front of you it's slowing things down and sometimes to the point of interfering with deals getting done.
Jessica C. Davis
And there's another topic for our next time around, which is how do you become a quality MSP, I think.
Rick Murphy
Yep. I think so too.
Bruce Teichman
That's a great topic.
Jessica C. Davis
All right. So tune in next time for when we talk about those great topics coming up. Thanks so much to Rick and to Bruce for talking to us today about what's going on in the market.
