Mergers and Acquisitions Implications for VARs, SIs and MSPs

BY CRISTIAN ANASTASIU

How are the various business models typical for the IT channel companies defined today and how can they position themselves if they are planning a Mergers & Acquisitions event in the next 6 to 18 months – be it a sale of the business or an acquisition?

In the last two decades, the IT infrastructure channel industry has evolved significantly from the resale niche that dominated the 1980’s. Following a measured progression from the VARs of the 90’s and System Integrators of the early 2000’s, MSPs and Cloud Services exploded onto the scene. In some cases, companies have transitioned from one business model to the next and blurred these lines, but many have found it hard to do.  

Business Models

Channel companies generally fall into categories based on the product resale revenue vs professional services revenue vs recurring services revenue, while many are still a combination of two or more models. Typical metrics are:

• Reseller: more than 95% product resale
• Value Added Reseller (VAR): more than 80% product resale
• Systems Integrator (SI): up to 50% services revenue, some of it recurring
• Managed Services Provider (MSP): more than 60% recurring service revenue
• Cloud Provider: little product resale, more than 80% recurring service revenue

What were the M&A trends and valuations in 2019?

• The valuations for MSPs and Cloud providers continued to grow, and successful companies (based on profitability, growth rate, etc.) were valued on a multiple of revenues basis. The time to successfully close a transaction involving such a company was often less than 6 months, below the overall market and the industry averages. Sellers received multiple competitive bids. The higher and the stickier the revenues, the higher the multiple was.
• The valuations for VARs and Systems Integrators were flat at best, with a typical sale process taking anywhere from 9 to 12 months or longer. There had to be a perfect fit with the buyer in order for the seller to fetch acceptable multiples. Typical valuations were in the low to mid-single digit ebitda multiples.

Let’s first walk through what seems to distinguish these companies, and then explore the best M&A options. 

Besides the obvious product vs. service revenue mix, the characterization of these companies is distinct on a variety of levels:

1. Size 

• VARs and Systems Integrators, with their focus on product sales, were able to scale faster and have been around for a longer period of time.  Many of today’s VARs and SIs are companies with north of $50 million in revenue, with several players in the multi-billion dollars range and active globally.
• In comparison, MSPs are generally companies in the $1 – $5 million revenue range with a few larger exceptions. They are sometimes centered around a few local key customers.  These customers are historically small and mid-sized businesses where it’s strategically beneficial to outsource the IT services rather than organically grow those departments in house. Currently there are thousands of MSPs active nationwide.

2. Customer Profile

Larger enterprise customers have been slow to transition to the outsourced model for a number of reasons: their requirements are too complex, IT is strategic to them, outsourcing would lead to some IT staff losing their jobs, etc.  As a result, VARs and Systems Integrators, who served large accounts, were not given the opportunity to develop a managed services practice (because their customers had no need for managed services).  And for those VARs and SIs that tried to add services to their repertoire, a key mistake was trying to sell to all the needs of each customer rather than standardizing their service and streamlining their staff. Consequently, many missed the opportunity to create a profitable and repeatable service model.  

3. Founder Background

The founder’s background plays a major role in the company culture and their abilities to scale or transform their businesses.  

1. VARs and Systems Integrators have traditionally been founded by salespeople or at times, two or three partners with complementary backgrounds (sales – engineering – operations – finance).   Some of these founders and their company became experts at solving new problems, based on new technologies and products offered by the manufacturers. This project-based model was a great fit for their skill and inclination. Once the problem was solved and the project was completed, they rushed towards a new challenge, a new customer, a new project, without focusing on offering services around what they had installed. Developing a managed services practice requires process, discipline, repetitive activities – generally something more creative organizations are less interested in.
2. MSPs and Cloud Providers have more often been founded by technical people with limited sales or management experience. The profile of the sales organizations at MSPs and Cloud Providers is mostly technical, while some of the sales people are from outside the industry (insurance, healthcare, etc.). Historically MSPs have had a sales handicap vs SIs when it comes to winning new customers. Many new projects still start with a product buildout, and services follow once the products have been installed. Due to the lack of relationships with manufacturers (Cisco, Dell, HP, Avaya, etc.), where many new opportunities originate, it can be more difficult for MSPs to get leads about future projects. This is especially true since they have a small and more technical sales force; by the time services becomes a topic for a given project the SI has already established a relationship with that customer and is well positioned.

4. Age

Many VAR and SI founders are approaching retirement age while the average age of MSP owners is generally lower. Although there is and will continue to be strategically motivated consolidation in the MSP space, we expect more VARs and SIs to be ready to sell, relative to their total number, in the coming years.

5. Sales

Experienced buyers of IT companies oftentimes use a simple yet effective method to better assess a company’s culture: the sales commission plan.  The comp plan is a critical element when evaluating a fit between two companies, because changing a comp plan too drastically is something any experienced sales manager prefers to avoid.  The comp plan reveals a lot about:

• company goals
• if a company is more sales, marketing or technically focused
• if it values more winning new customers vs developing existing ones
• if it is more team or individual centered
• how it hires and develops top performers, etc.

While comp plans can vary from company to company, the differences will be more obvious between the different business models.

Continuing on, we will explore how these companies can position themselves if they are planning a Mergers & Acquisitions event in the next 6 to 18 months – be it a sale of the business or an acquisition.

Preparing for an Exit

Like with everything else, preparing for an exit requires a goal and a plan. When setting the goal, is it:

a) To fetch a certain dollar amount when selling or

b) To sell at a certain point in time?

Oftentimes, especially if valuation expectations are not realistic, both goals cannot be achieved concurrently, so a choice has to be made.

Given the higher demand and valuations for MSPs and cloud providers, should VARs and Systems Integrators endeavor to transform their companies in order to increase the purchase price when selling? Should MSPs try to grow faster by adding product resale to their offerings?

First, “transforming” means for a VAR or SI to fundamentally change their revenue mix to match the percentages listed at the beginning of this article. If a $30 million in revenue VAR or SI adds $3 million of managed services, while impressive, they are still a system integrator with only 10% or less recurring revenues.

Secondly, the probability of completing a successful transformation will depend on a) the time available until the planned sale and b) how well and firm the transformation is managed.

1. If an M&A event is planned within the next 6 – 18 months, we do not recommend any significant changes in the company strategy because of the potential downside if the transformation was not successfully completed. 

If the time horizon is longer, VARs and SIs have a couple of options:

• Acquire a small MSP to help scale services and cross sell – the challenge is integration, cultural fit, etc.
• Focus on a vertical market (SLED, healthcare, financial services) – we are seeing higher multiples for specialized players
• Use a managed services third party to help jump start and scale your own capabilities
• Continue to be a VAR or SI, the best you can be, focusing on new technologies and higher margin products. Make up in size what you lose in multiples when it comes to the valuation
• Implement a drastic change in the business model.  We recently advised an MSP who started their business in the 80s in the refurbished equipment space but successfully developed into a services company. The secret: they exited the refurbished equipment business completely, focusing exclusively on services
• Organically transitioning the business – see b) below

b. Transitioning from a VAR to an MSP is a complex business transformation. When embarking on it, be aware of the risks vs rewards. Will the long-term benefits outweigh the cost? The transformation will have to address and possibly alter the very characteristics that made the company successful in the first place: culture, founder’s strengths, customer base, employee mix and skill set, etc. How committed and dedicated is the owner to push this change through?

As to MSPs’ options to scale, we don’t see increasing the product resale component as a viable strategy in order to grow revenues and maximize the price when selling the company. An alternative approach we have seen in recent months is the merger of equals, the combination of two and sometimes more MSPs, since a larger company is typically valued on a higher multiple basis. The success of this strategy will depend on how well the merger is planned and how well the integration is executed.

Ultimately the purchase price will be maximized by the fit between buyer and seller. Key questions we ask business owners when analyzing their company at the beginning of a sale process are: “How high is your opportunity funnel conversion rate? Why are you losing new business?” The answer will help identify the profile of buyers who would be able to eliminate or minimize that weakness. Buyers are looking for ways to improve a seller’s business and enable incremental growth, which is what the buyer is bringing to the table … other than money. It is a factor that will justify a higher purchase price.

In summary, while part of the same ecosystem, IT Services companies in the channel infrastructure space have a few intrinsic and very distinct characteristics depending on their business model and history. Understanding those differences will help business owners and their management teams successfully plan and execute an M&A transaction.