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How to navigate M&A in the MSP space

MSP M&A can feel like a chess match: Each party wants to win with little, if any, consideration for their opponent. Here are tips to approach information gathering for an M&A.

For managed service providers considering a merger and acquisition -- whether as a purchaser or as the company being acquired -- remember Gordon Gekko from the film Wall Street when he said, "The most valuable commodity I know of is information." Truer words could not be spoken when it comes to negotiating a sale, merger or acquisition.

The process begins with an impetus that leads MSP owners or buyers to contemplate an M&A. For example, the MSP owner might have a partner without a buyout agreement or wish to retire and doesn't have an exit strategy other than sale. Whatever the reason that has brought them to the table, they must gather full and complete information to make an informed decision.

Whether an MSP joins forces with another business entity, buys another or sells, information is the key to success in all M&A, and the information gathering process never ends. Information is gained through due diligence, the cornerstone of any successful deal. Approach due diligence for what it is: an investigation of both parties to determine if an M&A is the right move and if it will be productive and sustainable in the long term. Due diligence is the process of knowing what the MSP has if it's the seller, knowing what the MSP is getting if it's the buyer, and knowing who the MSP is joining in the case of a merger.

The M&A process is an opportunity for MSPs to not only examine potential new partners, but also to reexamine their own company -- including its competencies, weaknesses, culture and processes. MSPs may be surprised that they have more value than the other party and perhaps that may lead in a different direction. Could the seller become the buyer?

Zina L. Hassel, CEO, ZLH Enterprises Zina L. Hassel

MSPs can use public information and talk to professional associates to research their potential buyer, partner or acquisition. Early on in the M&A process, the MSP should execute a nondisclosure agreement and must sign a letter of intent (LOI). The LOI will summarize the material terms of the prospective deal. It also signals the beginning of negotiations for the definitive purchase agreement and allows the parties to begin due diligence.

Questions MSPs must answer to get to this step include the following:

  • How will they get everything in order so that prime multiples can be gained?
  • Is the purchaser looking at top-line revenue or earnings before interest, taxes, depreciation and amortization (EBITDA) numbers?
  • Does the MSP carry a lot of inventory?
  • How have the earnings changed year over year?
  • Is most of the company's revenue derived from time and material or contracted work?
  • Can the MSP sustain the numbers it presents at the negotiating table?

Human capital and HR due diligence

Employees are the greatest asset of an MSP, in addition to the signed contracts in the company's portfolio. In the world of MSPs, providers cannot understate the value of employees and the quality of the service they provide. Human capital can make or break the negotiation and the success of any merger or acquisition. Make sure the face of the MSP is recognizable and in good shape. Positive reviews and accolades are a plus.

Properly performing due diligence enables the MSP to look at the strength of its workforce to determine if it can handle the coming change to the business structure, what can be done to reduce friction and how to create synergy among a new team.

Communication is key

During the M&A investigation, a potential partner will look at whether the MSP's managers ensure that employees work at their level of potential capability. Can employees handle more responsibilities and the opportunity to grow? If so, how will managers help employees adapt? Through this process, MSPs should address whether managers' assigned duties are consistent with their values and interests. If so, they are more likely to embrace the coming change, stay with the company and maintain productivity.

It's important to assess whether key managers will be encouraged to develop in their role, if they are coached by their leadership and whether they are content with their careers and compensation. This includes looking at PTO and benefit packages. Midlevel managers are the force delivering the organization's operating goals; without them, the transition and ultimate outcomes in any M&A could prove disastrous.

Maintaining morale, retention and productivity

Regardless of the MSP's position as buyer, seller or leader of a merging company, talent retention is crucial. Assessing who comprises the MSP's star team and communicating with them early about the company's M&A goals increases the likelihood that they will feel secure in keeping their position and in embracing the change that is coming, as well as instilling a sense that they are important.

The impetus for all M&A decisions vary, but they all ultimately involve the same outcome: increasing revenue by increasing competencies and efficiency.

The risk, otherwise, is that fear and insecurity will take over and they will seek new and secure employment with a competitor. Retention of the MSP's best people must be of paramount concern. The MSP may have to earn out some of the sale price by hitting sales or other KPI metrics, and employees will help the company get there.

Reasons to make a move

The impetus for all M&A decisions vary, but they all ultimately involve the same outcome: increasing revenue by increasing competencies and efficiency. Here are three reasons an MSP might take part in an M&A:

  • expansion of service offerings, where each company's services are similar to their own but also where new synergy is likely to create new and improved services;
  • geographic expansion creating a greater and broader market share and the ability to target new customers; and
  • realizing economies of scale by consolidating departments and removing redundancies, such as human resources or accounting.

Time to negotiate the price

For the financial agreement to work and to ensure its success, both parties must have a clear understanding of the other's assets and potential future earnings. This includes knowledge of the types of contracts held by the MSP or the company an MSP is acquiring, such as short-term vs. long-term contracts and prospects for future business development. For buyers, the goal is to provide less cash initially and base future capital payout on profit contingencies. The strength and number of recurring contracts is the chief concern under this typical scenario. On the other side, the seller will likely bolster the promise of future earnings and try to leverage past performance during initial cash-upfront negotiations.

This is where each company's goals are in polar opposition. The only way to manage risk and strengthen negotiating power is through continuous due diligence. The MSP must keep asking questions until it is fully satisfied that they have sufficient information to make that decision.

About the author
Zina L. Hassel is CEO of ZLH Enterprises, a technology company with roots in telecommunications that provides white-glove concierge tech services. Hassel is also a member of The ASCII Group Inc., a North American IT community for MSPs, solution providers and systems integrators.

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