Positioning Your IT Services Firm For An Eventual Exit

Preparing a company for an eventual exit should ideally begin at least two to three years in advance, if not earlier. The most important variables that would-be acquirers will look at are not things that can be significantly improved in a one to two-year time frame. There are certainly less important items that can be improved in shorter order, but the fundamentals that drive higher valuations, increased interest from acquirers, and a better exit scenario all take time.??

Most CEOs and founders have an exit number in mind that they are looking to realize once they decide to sell. So, a sound understanding of valuation multiples will naturally help them plan and put them on the trajectory to achieving that goal.

Most IT Services companies in the lower middle market are valued on an EBITDA multiple. In an M&A Market experiencing normal market conditions, a realistic range of valuation is anywhere from 4x – 10x EBITDA for companies in the lower middle market. As companies mature, that range naturally increases and valuation conversations will often shift to a higher multiple of revenue. But for most IT Services Firms with a revenue run rate of anywhere from $2 million to $30 million, 4x – 10x EBITDA is a good starting point when setting expectations. There are, of course, numerous factors that will determine where in that range a company will fall. Elements including growth rate, services delivered, and technology solutions supported will all impact valuation multiples.

Outside of the services offering and target markets, I typically see five core areas buyers focus on when analyzing a company and deciding on an acquisition price they can get comfortable with. Those five core areas are Net Operating Income, Gross Margin, Customer Concentration, Rate of Recurring Revenue, and Growth Rate.

Net Operating Income:

This is the most obvious and important metric. Net operating income (or EBITDA) is the largest element that will determine the valuation of an IT services firm. As net operating income grows, the valuation multiple will increase as well.??

Where things can get complicated for founding partners is how they allocate expenses across the organization. I will often see partners, owners, and operators, opt not to take a salary and pay themselves in dividend distributions annually below the net operating income line on an income statement. While this makes perfect sense in practice, the problem is after an acquisition occurs, the acquiring organization will inherit market-rate salary expenses for those partners and founders.? Whether or not an organization decides to pay all of the partners below-the-line distributions is less important. What's more important is that founders understand how their net operating income will be viewed by acquirers if they are doing this.

Gross Margin:

A company's gross margin is one of the most important financial metrics there is. A healthy gross margin can be a huge driver of revenue growth because it enables companies to reinvest a healthy amount of capital into customer acquisition-related activities, and it's a leading indicator of the scalability of an organization. Savvy acquirers know this and always look to acquire companies with a gross margin that is at or above industry benchmarks.

In the IT Service and IT consulting world, I typically see gross margins range anywhere from 30% on the low end, up to 50% on the high end with a good best-in-class benchmark of 40% gross margins or higher. So, if your gross margin is below 30%, it should be viewed as a high-priority issue that needs to be addressed. And if you're south of 40%, you should strive to get as close as possible to that number as you can.

Customer Concentration:

One item that will raise serious concerns for potential acquirers is customer concentration issues. Anytime I see an IT services firm that realizes a significant portion of their revenue from their top one to three customers, it raises concern for me because I know buyers will have reservations, and it could negatively impact deal structure and valuation.

In an ideal world, revenue would be distributed fairly evenly across your entire customer base. In practice, that's not always feasible, and understandably so. Over-reliance on one customer for the vast majority of a company's revenue is highly risky. It's highly risky not only for the company, but for the acquirer as well. When I come across companies where 35% to 50% of their revenue is coming from one customer, my advice is always to address that before trying to sell their organization.

Rate of Recurring Revenue:

One of the reasons investors love SaaS companies is because of the predictability and scalability of their recurring revenue base. Since most IT services and IT consulting firms are doing project-based work, a pure recurring revenue model isn't in the cards. And that's OK and I would never encourage a company to unnaturally shift their billing model or delivery model to try to capture more contractually booked recurring revenue.??

Acquirers who are active in the IT services and IT consulting space understand this. What they will look for is the rate of recurring revenue.? In other words, what percentage of your customer base will come back to the well on a year-in and year-out basis and commit to more work. While it's still project-based work and not contractually booked, recurring revenue showing a stickiness to your customer base on a year-over-year basis goes a long way in getting acquirers comfortable with the long-term viability and scalability of your company.

Growth Rate:

Whenever a CEO or founder asks me what they can do to best prepare for an exit, my response is always the same: If there was one thing above all else they should focus on, it is revenue growth. After all, customer acquisition and revenue usually cures all. Demonstrating a consistent growth rate year after year goes a very long way in building buyer confidence, and a willingness to pay a higher multiple.??

As important as the growth rate is, it's an area where I see most IT services and IT consulting companies in the lower middle market fail. The reasons behind why they're failing to consistently grow are an entirely different topic that warrants its own discussion. Even showing a modest compound annual growth rate of 15% or higher over multiple years will put your company in the top 20% of firms in the lower middle market.

By now, it should be obvious that optimizing these five variables is not a short-term effort and requires a longer-term multi-year effort. No business is perfect, and acquirers will almost always find red flags. But making the decision to commit to improving these variables will not only better position a company for an exit over the long term, but will also build a very healthy and profitable organization.

I'm the Founder of Drive Equity Advisors, an investment bank specializing in M&A advisory for sellers and acquirers of IT and management consulting firms in the digital transformation space. You can learn more about the work we do at driveequityadvisors.com