The current COVID- induced recession, whether short or longer term in nature, is creating—and will continue to create—potentially interesting opportunities for buyers, and perhaps more-difficult times if you’re a seller.
With this as a backdrop, we’ll offer our perspective on how to explore potential buy-side opportunities and, if you’re a motivated seller, what you’ll likely be asked to consider by prospective buyers, along with how to proceed.
The M&A Landscape, Pre-Pandemic
Up until early March, M&A in the IT solution provider ecosystem was riding a near decade-long upsurge. Offers were nearly all cash, with small escrows to cover representations and warranties, or buyers and sellers were increasingly splitting the cost of rep and warranty insurance and the transactions were truly all cash.
Deals were closing quickly, often in under two months, since buyers were increasingly efficient in getting through due diligence.
Little, if any, of the due diligence contemplated a pandemic and what would happen to the acquired company (and indeed, the buyer) under a pandemic-inspired recession.
The Mid-Pandemic M&A Landscape
The pandemic has had an immediate and profound impact on M&A. Many (perhaps most) of the M&A transactions under letter of intent (LOI) have been put on hold. This is because buyers are increasingly unable to effectively value companies they had under LOI, and also because many buyers now have to husband the very cash they need to close on acquisitions. We’re increasingly seeing buyers asking sellers to put a substantial portion of their total consideration into an earnout or as carried interest in the new company to more effectively protect the buyer.
But some astute buyers understand the old adage “buy low, sell high,” and retain sufficient financial strength to not only continue acquisitions under the current conditions, but to do so aggressively.
Indeed, we’re hearing from many clients who are receiving a sudden increase in calls from prospective buyers. This isn’t surprising, as many buyers have been unable to get solution providers to respond and likely now feel their calls have a higher probability of being returned.
We believe these buyers are correct—there will be bargains. If prudently priced with terms and conditions that protect the buyer more so than the seller, this is unfortunately a unique buying opportunity.
The Service Leadership Index Financial Early Warning Score
A large number of solution providers subscribe to our quarterly Service Leadership Index benchmarking service, so we have a unique window into the health of the industry. We’ve built a metric called Financial Early Warning Score (FEWS) comprised of weighted evaluations of each solution provider’s:
- Earnings before interest, taxes, depreciation and amortization (EBITDA)
- Current ratio (a common balance sheet ratio)
- The proportion of their operating costs covered by the invoices they issue for their monthly recurring revenue contracts
Coming into the pandemic which hit in earnest in Q1, here is the distribution of the FEWS scores across the solution provider industry:
The year 2019 was robust for solution providers in general, building on strong years in 2017 and 2018. How, then, could the fourth quarter of 2019 have the highest number of solution providers in the “Danger” category and fewest in the safest category (“Watch”)?
The answer is mundane: to reduce their tax burdens, solution provider owners commonly take steps to reduce profitability and cash in the last quarter of the year. Two of the three components of the FEWS score are impacted by these. Hence, more appeared in the “Danger” category.
The pandemic began to materially impact the global economy in the first quarter of 2020. How can the FEWS scores in Q1-20 be the best of the five-quarter period? Q1 was a good quarter for many solution providers. To the extent that expected revenue was impacted by COVID, it was often offset by unexpected revenue generated from helping clients urgently adopt work-from-home plans.
Yet, despite the strength of 2019 and Q1-20, a third of solution providers have little in the way of a safety buffer to manage into and through a recession.
As such, those not generating positive net income from March onward need to get positive cash flow as quickly as possible, potentially within weeks. They simply don’t have time to sell their way to profitability. They’ll also need to enact payroll and other cuts just as quickly, likely including reductions in selling, general and administrative expenses, and labor.
We’re already seeing motivated sellers. So, do you want to be a buyer? Should you consider selling again? How best to proceed in either case?
It’s critical to distinguish between a high(er) Operational Maturity Level (OML) business that got into a cash crunch and needs to sell, versus a low(er) OML business that is consistently underperforming financially.
Deciding if the Target is a Falling Knife, and if so, Why it is Falling
Even with a significantly lower revenue outlook for a potential acquisition, how can you be assured that your revenue plan is sufficient?
It’s critical to distinguish between a high(er) Operational Maturity Level (OML) business that got into a cash crunch and needs to sell, versus a low(er) OML business that is consistently underperforming financially.
Start with understanding the business’ financial performance over the past few years. If they were performing well in terms of revenue growth, gross margin performance and bottom-line performance, but entered the year with unusually low cash reserve and got into a cash crunch, here’s what we’d expect them to tell you:
- “Here’s why we have an operationally strong business (i.e., higher OML)”
- “We decided to aggressively invest in X” (this could be operations, new lines of business, a new geography, sales and marketing, etc.)
- “Tax planning and/or owner-related dividend requirements took most/all of our cash reserves”
Why weren’t these otherwise-able owners/executives who saw the COVID recession coming able to cut deep enough and quickly enough? What you’re looking for are owner/executives who can build a great business, but now find themselves unable to lead decisively in a crisis—whether they’re able to discern this about themselves or not. Alternatively, you may have an owner who has decided that there’s strength in joining with another company.
In contrast, the underperforming owners/executives will have a track record of financial underachievement. They may be unable to provide clear or compelling reasons for this, or for why they are now unprofitable, out of cash and unable to identify (much less execute) the necessary steps to survive. We should note these can be difficult to integrate.
The Buyer/Seller “Whiteboard Day”
A good way to test your acquisition synergy theories—and vet out a number of culture and business operations factors—is the “whiteboard day” between the buying and selling CEOs.
- In preparation:
- List five of the seller’s typical customers (not biggest or smallest) on the board but remove names.
- Do the same for the buyer.
- During the meeting:
- Price the seller’s five clients with the buyer’s standard pricing model for the same services.
- Price the buyer’s five clients with the seller’s standard pricing model for the same services.
- If offers (packages, features) are 90% similar, that’s good.
- If the seller’s pricing turns out to be higher, that’s also good.
- If both parties’ pricing is the same, but it’s set at low OML pricing, that’s bad.
- If the buyer’s pricing is more than 5% higher than seller’s, that’s bad for two reasons:
- Most of the seller’s customers will not convert to the buyer’s pricing, saddling the buyer with the same suboptimal profit model.
- The buyer’s salespeople will conclude that the seller’s (lower) pricing is good enough (“Why else would we buy them?”) and attempt to sell future deals at that lower pricing.
- For the same 10 anonymous accounts identified above, run through the following questions:
- How did we attract them?
- How did we get a proposal to them?
- How did we pitch it?
- Why did we win?
- How did we onboard them?
- How do we manage the accounts?
- For the last three accounts the seller lost due to their own mistakes (not including any of the five used in the above exercises):
- What were the mistakes?
- How did they happen?
- What steps were taken to try to rescue each account?
This “whiteboard day” exercise will teach both parties much about each other’s approach to the business and to customers. The goal is finding the highest likelihood of success as well as ease of integration at the lowest cost in the shortest period of time.
What follows next are guidelines and tips for buyer CEOs seeking successful integrations.
- Tough love is best; slow integrations most often do not work well.
- During preacquisition time, set measurable goals for 3, 6, 9 and 12 months, and for 2 and 3 years. Measure progress versus those goals and adjust accordingly.
- The acquiring CEO must be a visible and continual leader, especially post-acquisition:
- Over-communicate. Otherwise, employees will tend to assume the worst.
- Always remember that people—even if they love and trust you—can only change so fast. Circumstances may require you to move quickly, but just as quickly you should re-establish a sense of the familiar and stable.
- Make sure the messages your employees (and your customers, prospects and business partners) take home to their families are sober, but positive and practical.
- Get out in front of customers, prospects and business partners with information.
- As the CEO speaking to people from the acquired company:
- Don’t say, “Welcome new people, we’re excited to have you. We’re going to pick the best of each company’s best practices and combine them into an even-stronger company. 1 + 1 = 3!”
- Do say, “Welcome new people, we’re excited to have you. I’m confident that once you learn how we do things, you’ll be great contributors, as I know you have been in getting here!”
- The first phrase unintentionally sets up a competition to prove which company’s best practices are, well, the best. The acquiring CEO will end up being a tie-breaker on many issues, which is not a win/win position for a leader to be in.
Performing the Search, Making an Offer and Closing the Deal
Once you decide on the profile of the solution provider that you’re looking for, you then need to target prospective sellers and get them to engage with you.
Think of the required effort as a marketing campaign. You’ll need to build a database of the prospects in your target geography that are most likely to meet your criteria. Next, create an outreach campaign to get these prospects to engage with you, and then execute the campaign.
Once you have a prospect engaged, how should you think about pricing and terms, now that we’re in a recession? We recommend you focus on a fair price; even in these recessionary conditions there could be multiple buyers in larger metros and for solution providers of significant size. That said, you will likely find prospective sellers with cash flow (or EBITDA) that has slid significantly and may perhaps even be negative. In this case, you’ll need to consider offering a price based on a multiple on monthly recurring revenue (MRR). Prior to the current crises, the most you might pay as a multiple of MRR would be in the range of 1.5 times.
Summary
As a buyer, the current environment will undoubtedly present you with a number of opportunities to acquire solution providers. But caution is the order of the day; you may be catching a falling knife of some size, speed, weight and sharpness.
As a seller, be prepared for a lower price on terms that protect buyers from a potential drop in your revenue (e.g., for an MSP upwards of 25%). As such, do your best to get multiple buyers engaged, as that will improve your chances of an acceptable outcome.
This is an abridged version of a newsletter published by Service Leadership in July 2020. Read the full newsletter at www.service-leadership.com/news-events/news/2020/q3.
