23 Aug IT Services Sellers: Evaluating the Size of a Buyer
Tune in as the Revenue Rocket team discusses what a seller should consider when evaluating a buyer!
Mike Harvath 00:04
Hello, this is Mike Havarth with this week Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket headquarters in Bloomington, Minnesota. And today, I have my partner Ryan Barnett with me. And we’re going to talk about how big a company can I afford to buy it from a buyer. And talk a little bit about how to evaluate the market in sort of this tumultuous time. As you know, Revenue Rocket is the world’s premier growth strategy and M&A advisor and IT services companies. And we’re going to share a little bit of that experience with you today. Over to you Ryan!
Ryan Barnett 00:49
Thanks, Mike. I like that international theme to it, we’re kicking off yet another non US based client here soon and it’s fun to do work around the globe. And I think our audience I hopefully is around the globe as well. But today, Mike you’d mentioned what’s a good number for a buyer to take a look at. I also want to examine the lens of what a seller should consider when evaluating buyers of their business. I think there’s some surprising rules of thumb that we’ve seen, that allow sellers to actually consider firms that are much closer to their revenue and their size than they imagined. So with that, I’d love to just kind of set this up as the topic. When you look at buyers of IT services business, we typically group them into a few different categories. One is strategic in which are companies that are looking to grow their company through acquisition, get revenue targets to get more geographic expansion to get more service coverage with like minded firms. And typically we would group and another group of financial buyers, they look through the lens a little bit differently. So when you’re, as a seller, considering a financial buyer, it’s going to be a bit different than with a strategic buyer. And with today’s discussion, like actually like to start with some of those financial buyers that are out there, as it’s a little bit different on how a seller should evaluate a financial buyer. And Mike, I’d like to get hear your input and can you just help me understand the types of financial buyers that are out there?
Mike Harvath 02:38
Yeah, for sure. With the typical private equity buyers either buying a platform, or talk an acquisition to a company that they already own material stake in, and they’re typically buying those businesses to hold them for up to five to seven years and sell them for a profit. So it is certainly a relatively short term in the context of sort of a corporate lifetime of buy and hold strategy. And I guess you could even call it a buy and flip strategy. But you know, it’s over five, seven years, typically. And so if you’re a salaried, you’re gonna want to understand, you know, some stuff about that, like, how are they capitalized? And do you fit the portfolio, what they want to buy, and, you know, kind of what’s in there for you as it relates to if you’re going to roll equity, they’re usually going to ask you to roll some equity into the equity of that particular platform. So that you can, as I say, the famous, you know, get the second bite of the apple. Also, there’s, you know, family offices, right, family offices operate a little differently. They look a lot like a private equity firm from an investment perspective. However, they usually buy all of your company, they don’t ask you to roll equity. They usually are much more of a buy and hold type strategy. Many of them declare that they’re buy and hold type buyers, because they’re actually buying the cash flow and the value of the cash flows over the long term, putting their capital to work to get a return on, on cash, if you will, or return on capital. And IT services companies that run well tend to spin off a lot of cash, so tends to be a pretty good investment over the long haul. And obviously, you know, we’ve talked about, you know, other flavors of buyers. But from a financial perspective, certainly financial buyers fall into those categories.
Ryan Barnett 04:43
And the other one we’ve seen a bit of is that I would call it a search funder or someone who’s looking for as an independent sponsors. It’s a little different than that they’re trying to build that and buy that business but there’s a category of individuals out there that are also interesting, a bit mix between a strategic and a financial buyer.
Mike Harvath 05:08
Yeah, good point, right. I mean, you know, search funders come in all different shapes and sizes, everything from recent graduates from from business school to people that have worked in, you know, the financial side of the industry, either for a PE firm or for an M&A broker, to people that come from industry who have been pretty successful in their own right, and then now they want to acquire business. And we’ve had a separate podcast about search funders in detail. So I’d encourage you guys to take a listen to that if you’d love to learn more about it.
Ryan Barnett 05:45
Mike, if we take the lens of a seller here, and a seller is looking to to, they’re willing to work with a financial buyer? What should they be looking for, when it comes to the financial viability and in hitting the number that they’re looking for?
Mike Harvath 06:06
Well, certainly, you know, cash is king, right? So the financial buyer should be able to easily show capacity to do the deal. And a pitfall with financial buyers, as some of them are independent sponsors looking to use your deal to raise capital. And that is a risk. Because they may not be able to raise the capital, they may or may not be able to raise the capital. But if you find that they’re quote, unquote, an independent sponsor, per se, and they want to sign you up, to use us as bait for various private equity firms or other family offices or other investors, I would say seller beware, because the challenge that rescue run in that case, the additional risk is that they can’t raise the money, they don’t have the committed capital. And that’s going to be a problem. And so I think their track record, if you’re going to sell to a financial buyer is critically important. How many deals have they done? Right, historically? How many deals have they done? Sort of in your industry? Right? And IT services? Have they done any? Are you considered a platform or a tuck in? How did those other sellers fare, you should ask to talk to those people. And they do have to show a capacity for getting the transaction done. And generally, that comes from a note from the people that are providing capital. Oftentimes, if it’s a PE fund, they may be using both debt or leverage and cash from reserves to do the deal. And, you know, you need to kind of understand what the source of funds are and get some confirmation that they can actually fund the deal. And we recommend when we represent sellers, we do that early on in the process. So that you’re not getting dragged around by, you know, either an independent sponsor, or someone who’s you know, doesn’t have the money, it’s kind of a dreamer. Certainly asking those questions up front as qualifying questions is super important. And making sure that you get satisfactory answers to know if you’re gonna go into a diligence effort with them. You know, in the end, they can actually fund it.
Ryan Barnett 08:27
Hear that, right, we want to look for words like committed fund, or someone’s on their fourth or fifth fund, and they have portfolio companies that are similar worth, that’s gonna be more, it’d be better than someone who’s looking to expand capital or looking to use debt or looking to use alternative means of financing other than what’s already committed.
Mike Harvath 08:52
Yeah, absolutely. And why that’s super important now is because, you know, with capital markets and the cost of capital going up, you know, it becomes tougher to get that financing not certainly not impossible for these kinds of firms, because they have long standing relationships with lenders, and they work it into their model. Certainly won’t, I think materially slow them down. We have a lot of reasons to think that certainly they could be some slowdown, and we’ve seen some already although, you know, we’ve seen some high points where, you know, the markets picking back up, which, you know, again, sort of swings the pendulum may be back the other way, but people having experience in doing these deals, if they’re a financial buyer, is really critical. Because the way they fund them the way they get committed capital, who they involve in the transactions need to be partners with relationships that have been successful together. And certainly that can be vetted prior to you know, get down the track to file with them.
Ryan Barnett 10:02
Great, thanks, thanks for for defining that. If we switch to the other side, let’s talk about strategic buyers for a bit. Mike, just do a good job of defining that strategic buyer. And why does strategic buyers consider acquisitions?
Mike Harvath 10:21
Well, strategic buyer in the traditional sense is one that generally is an operator of a business, who’s looking to grow through acquisition. And they’re typically looking for very specific capabilities, and or staff and or sort of geographic expansion opportunities, or customer list expansion opportunities that will help them expand the business. And, and those buyers are different. And the reason I say that is because they’re typically come with much more knowledge about core. The levers to pull, and IT services, right, the opportunity to grow, most of these buyers will find you if you’re a seller, because of what you built, right, they’ll be looking specifically for you. Doesn’t mean that, you know, if you use, you know, a skilled and talented broker that the broker can’t find those strategics either, because they certainly do. And we do as a matter of fact, every day on behalf of our clients, but it is someone who’s operating that company in your space. In some ways, you could think of them as a competitor. In some cases, sometimes they’re an adjacent business, meaning it’s a business line expansion. For that acquire, you’re in an adjacency, where either you both serve the same kind of customers with different service assets. We’ve certainly seen a lot of that in recent years. But there’s someone who’s going to buy and integrate and run your business without the goal of selling it or flipping it. It is again, a buy and hold strategy sort of long term, one in which the enhanced offering and team and staff are of huge value to growing the overall enterprise, not just the value. And I don’t mean to make the sound like it’s not valuable, I certainly want the value of the cash flows as well. But it’s far more than the value of just the cash flows.
Ryan Barnett 12:41
Then yeah, when you think about this, this is day one plus one equals three type scenario.
Mike Harvath 12:48
Yep, you can cross selling upselling each other’s customers, you can leverage. And I often use this analogy, like, you know, a great strategic buyer allows you to go to a place that you can’t get on your own. Right, just because they bring capabilities and synergies that you either it will take you so long to Bill, or so much investment to build that it’s untenable or it just because of the passage of time and the market opportunities, you wouldn’t be able to capture it based on kind of where the market is today. So you know it certainly, you can go together to a place you couldn’t go apart. And that certainly adds a lot of value to the transaction.
Ryan Barnett 13:33
If you think about a strategic buyer, Mike, how do they typically fund a deal?
Mike Harvath 13:43
They’ll typically fund a deal. One of a couple of ways. As you know, if you listen to this podcast, right, like the time there’s lots of currencies to be utilized in M&A transaction, certainly there’s cash. There’s earnout, which is really gain share, if you will, where you take the business post transaction. There’s a seller note, as a seller, you can become the bank, if you will, and provide financing to the buyer. And those are usually very effective, provided they’re collateralized properly. And you know, there’s outside debt financing, as well as an equity role. So you know, debt financing, bank financing is a great source for strategics to utilize them, and often many of them do. You have lots and lots of clients that we’ve helped by companies over the years that have used debt financing successfully, to acquire businesses. And then equity roll really is about rolling at your equity into the bigger firms combined into the equity. And no again, this is not vastly different than in a private equity sort of environment. Basically You’re saying, hey, I want to be part of something bigger, I’m gonna participate as a partner in that bigger entity. And, you know, at some point when the larger entity is sold, or has a liquidity event of some sort, let’s call it a recapitalisation with a private equity firm have their own relationship, that you will get essentially bought out or paid out of that equity.
Ryan Barnett 15:24
That makes sense. So there’s a variety of ways in which a firm can raise capital. As a seller, you have to evaluate the reasonable portions of which and if you’re selling or selling out, I really encourage you, listeners to listen to that podcast of if you’re selling, selling in, you may want those you want those equity type opportunities. There’s a lot of options there. If we think about really, the size of a company, one of the things I think our sellers get surprised with is, it sometimes it’s actually even the smaller companies get more surprised? Is the size of the buyer. And Mike, when companies are considering an acquisition, especially if it’s supportive to be a creative to revenue and earnings? What is the buyer looking for as far as size relative to their own size? Are buyers looking to chew off everything? A little bit? To help me understand that?
Mike Harvath 16:37
Well, it’s an interesting question, because, you know, certainly, it has been a little bit all over the board historically, for us, like we’ve helped individuals buy up to $15 million businesses, right? We certainly have helped sellers sell to companies of the same size, or even just slightly larger than themselves. So I think you have to evaluate the situation, each situation is a little bit different. When you look at access to capital, particularly on I would say on smaller transactions, and I would define smaller transactions as being, you know, sort of under I don’t know, six, seven $8 million in enterprise value. There’s certainly a ton of financing sources available to any company, including the SBA you know, there’s loan limits, and a few other things that go into place in the SBA program that move around a little bit, but we’ve certainly had a lot of deals, or we’ve represented sellers with a buyer is going to get and utilize an SBA loan. And depending on the buyers credit worthiness, and sort of, you know, personal net worth, they may be able to acquire a business just out of either retained earnings, or their own investment capital, or a conventional loan from a bank or some combination. And so I wouldn’t on its face as a seller rule out talking to someone who’s interested in acquiring your business, it’s just super important that you qualify sort of source of the funds that will be needed to do the deal. And so you know, there might be a really great business case for you to merge with a company or be acquired by a company of the same size, because there’s this huge one plus one equals three upside opportunity. And if that buyer has access to capital, which you can confirm, then there shouldn’t be that shouldn’t be a consideration. I know, there’s certainly a lot of assumptions to be made about, you know, can that company afford to buy me if you’re a seller, and you tend to rule out wow, they’re too small, or they’re this or that? I don’t think that’s necessarily appropriate, we think it’d be appropriate to have a dialogue with them, about how you feel about it, and talk to them about what is their plan to fund the transaction very directly. Certainly, as a firm that hopefully you listen to this podcast for a while, if you’re going to market to sell your business, you’ve hired a competent broker to represent you. And better yet, you’ve hired us I don’t know but in but in all seriousness, you know, that broker is going to be able to qualify that buyer on your behalf. To make sure that access to that capital exist, sometimes that can be a little bit of a tricky conversation if you’re doing it on your own behalf with say, a peer organization or someone that might be considered a competitor. But, you know, at the end of the day, I think whether it be a, someone the same size, or even smaller, maybe an even an individual, we’ve seen, certainly individuals who have been operating executives that have all the skills needed to build and grow a business who want to be business owners, you know, raise capital, they’ve, you know, use some of the provisions in the 401k laws to, you know, leverage their investment portfolio to, to kind of pay the down payment for, you know, loan programs to acquire businesses. And then there’s just a ton of ways that individuals that have a little bit of access to capital can use a combination of cash and leverage to buy your firm in its entirety, or maybe you want to be a partner and merge with them, and swap equity. And all of those things are certainly viable options.
Ryan Barnett 20:57
I think that’s a great point. And one of the things if it’s not clear through this is that it’s tough to do an acquisition. And if you’re buying any firm, there’s a fair amount of work and due diligence and strategy that’s needed in order to successfully complete an acquisition. So if that’s the case, you are going to try to want to take the biggest bite that you can. And try to be a big swing, I think sellers really struggle to understand that concept, if you’re a really tiny fish, and you’re in your swimming in a pond full of sharks, you’re just not going to be big enough to get gather the attention and find the strategic value that’s needed. So having someone a little closer to you in size can actually be a much better fit than someone that is a behemoth in the industry.
Mike Harvath 22:03
Yeah, and I would also add that, you know, it’s a risk mitigation play for that buyer, right. And yeah, they’re gonna take on some risk. But, you know, maybe you’re gonna take on some risk to the seller to particularly if there’s an earn out or seller note involved, but in the end, you know, a combined company, especially if ones are of similar size, are going to be further you know, further fortified against, you know, ups and downs in the market. And the larger the combined business is, I often use the term thick ice, you have to be able to weather, you know, the storms, and also take advantage of, you know, upside potential in the market. It just is factual. So, you know, being part of something bigger, even if it’s just something that’s maybe twice your size. Once you combine, you know, one plus one equals three will be a risk mitigation strategy in its own right.
Ryan Barnett 23:11
Good, good. Well said. If I say kind of summarize the discussion here today, if you’re looking at a financial buyer, the size of the acquisition is as often going to be determined by the size of the funds and access to capital, I think a little more blunt in the end, as a as a reminder to sellers, many funds will talk about their investment criteria. And it really helps to understand, within that target, whether too big or too small, I think is critical. Establishing proof of funds within and making sure that the fund is well done, I think is critical as well. The other portion, if you’re considering a strategic buyer, they can often be similar to your size. And especially if you’re looking to grow in and sell in, it’s critical to understand that someone near your size may be much better than someone that’s 10 times your size, that to one plus one equals three. That really helps move the lever on the accretive to earnings and credit to revenue side. With that, Mike anything else you’d like to cover?
Mike Harvath 24:40
No, I think you know, when you think about it, you know, it’s somewhat counterintuitive that, you know, firms of similar sizes are much more likely that fellows will speak than one so maybe someones 10 or 20 or 30 times your size looking to buy you. The acquisitions are hard, right? To your point, right? To get a very challenging to get done, it’s just as hard to get a very small deal done as it is to get a larger deal done. If someone’s going to make the investment in the resources needed to get that transaction done, and, you know, brokers and broker fees, and like legal and finance and tech support, all stuff is needed, as a buyer, they want to buy as large a firm as they can, they’re really, you know, make to leverage that investment. And versus you might think, well, you know, maybe a company would buy a firm the size or smaller all the time, because they want kind of a low risk play. And that is a consideration for some buyers. But I would tell you, it’s much more likely that a buyer of any size wants to buy the largest firm they can in order to get the most leverage against the investment that’s needed just around the mechanics to get the deal done. And so you know, if you’re a seller, don’t be put off by that or turn those deals away. I don’t think if that makes sense. I think it makes sense for you to look at them and qualify them carefully.
Ryan Barnett 26:16
Well said well said. Well, Mike, that’s all I have the questions for you today.
Mike Harvath 26:22
All right, great. With that, I will tie a ribbon on it for this week at revenue rocket. With this podcast. We encourage you to tune in next week, where I’ll talk about more exciting topics around growth strategy and buy side and sell side M&A or IT services companies. Thanks and make it a great week.