What’s in a Name? Channel Partner Types/Positioning for M&A

BY CRISTIAN ANASTASIU

What’s in a name? Plenty when it comes to a channel partner’s business model and positioning for a planned merger and acquisition. Particularly if they’re planning a mergers and acquisitions event in the next six 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 1980s. Following a measured progression from the value-added resellers (VARs) of the ’90s and system integrators (SIs) of the early 2000s, managed service providers (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 product resale revenue vs. professional services revenue vs. recurring services revenue, although many are still a combination of two or more models. Typical metrics are:

• Reseller: more than 95% product resale.
• VAR: more than 80% product resale.
• Systems integrator: up to 50% services revenue, some of it recurring.
• 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 revenue basis. The time to successfully close a transaction involving such a company was often less than 6 months, which is below the overall market and industry averages. Sellers received multiple competitive bids. The higher and stickier the revenue, the higher the multiple.
• The valuations for VARs and SIs were flat at best, with a typical sale taking anywhere from nine to 12 months or longer. There had to be a perfect fit with the buyer for the seller to fetch acceptable multiples. Typical valuations were in the low- to mid-single digit earnings before interest, taxes, depreciation and amortization (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, these companies have distinct characterizations on several levels:

1. Size

• VARs and SIs, 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 multibillion dollars range and active globally.
• In comparison, MSPs are generally companies in the $1 to $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 midsized businesses where it’s strategically beneficial to outsource 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 SIs who served large accounts weren’t 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.

VARs and SIs have traditionally been founded by salespeople or, at times, two or three partners with complementary backgrounds (sales, engineering, operations and finance). Some of these founders and their company became experts at solving new problems, based on new technologies and products offered by 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 toward 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 and repetitive activities – generally something less interesting to more creative organizations.

MSPs and cloud providers have more often been founded by technical people with limited sales or management experience. The profile of their sales organizations is mostly technical, while some of the salespeople are from outside the industry (insurance, health care, 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 is well-positioned because it has already established a relationship with that customer.

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 often 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.
• whether 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 explore mergers and acquisitions implications for channel partner firms and how these companies can prepare for an M&A.

Preparing for an exit, as with preparing for everything else in life, requires a goal as well as a plan. Is the goal to fetch a certain dollar amount when selling or to sell at a certain time?

Often, especially if valuation expectations aren’t realistic, both goals cannot be achieved concurrently, so you must make a choice.

Given the higher demand and valuations for managed service providers (MSPs) and cloud providers, should value added resellers (VARs) and systems integrators (SIs) endeavor to transform their companies 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 its revenue mix to match the recurring revenue component typical of an MSP, with more than 60% of its total revenue being recurring. If a VAR or SI with $30 million in revenue adds $3 million of managed services, while impressive, it’s still a VAR or system integrator with only 10% or less recurring revenue.

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

If an M&A event is planned within the next six to 18 months, we don’t recommend any significant changes in company strategy because of the potential downside if the transformation isn’t successfully completed.

M&A Timeline Options

If the timeline until a merger or acquisition 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 [state, local and education (SLED) government agencies, health care, 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 its business in the ’80s in the refurbished equipment space but successfully developed into a services company. The secret: It left the refurbished equipment business completely, focusing exclusively on services.
• Organically transitioning the business.

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 to grow revenue and maximize the price when selling the company. The merger of equals is an alternative approach we have seen in recent months. That’s 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 one plans the merger and how well it executes the integration.

Purchase Price

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’s 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 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.