Macro Trends and Valuations from Recent Deals

Mike Harvath  00:04

Hello, and welcome to this week’s Shoot The Moon podcast, broadcasting live and direct from revenue rocket world headquarters in Bloomington, Minnesota. With me today, on our podcast are my partners, Matt Lockhart and Ryan Barnett. Welcome, Matt, Ryan, how you doing today?

Matt Lockhart  00:23

Hey, Mike. Good do good to be here. Good to be with you, Ryan, what’s going on?

Ryan Barnett  00:28

Hey, guys, appreciate you coming on the call. Revenue Rocket during this 2022 has been an interesting and good year for transactions. And while we are macro economically in an interesting cycle, we’re watching interest rates come up at the moment, we are also seeing deals keeping to give me similar transactional levels. And today, we want to dig into a little bit of what we’ve actually seen in completed deals and 2020 to buy a few different categories. So want to dig into some multiples that we’re seeing and some trends that we’re seeing and what you can expect as buyers and sellers and IT services companies in this market. So Mike, maybe you could just start us off with some general trends in in, in what you’re seeing and kind of a macro level. And then let’s zoom in into some of the industries that we’re talking about.

Mike Harvath  01:26

Yeah, for sure. You know, it’s interesting, because there’s certainly been, you know, if we were to try to predict the future, early in the year, there was some discussion about, you know, maybe the market would be cooling off, and we’d see fewer deals or reductions in EBITA, , you know, purchase price, etc, we certainly did not see that, particularly in q3. And we don’t expect that we will see that sort of in our own book, as well as our view of the market in q4, either. So demand is high. You know, we’re seeing that driven predominantly due to sort of limited sellers and multiple suitors coming in competing offers, on these deals, all the deals that we bring to market, we’re certainly seeing that sort of range. And when we look at multiples, that are different driving factors, of course, on, you know, how strategically relevant the deal is, to a particular buyer, and especially with IP based businesses, those drive, you know, interesting multiples of revenue. In more traditional, you know, managed service providers, app integrators kind of cloud service providers, and, and custom app dev guys, those are much more tied to very specific multiples of EBITA. And we’re seeing ranges that, you know, are pretty much as holding up quite well. And in alignment with where we saw deals, you know, trade in, in 21. And as well. So we think that the m&a market is very healthy right now. It’s a good time still to be a seller right now. I think that will hold together for the foreseeable future. And, you know, with that, I think that I would say that, and I don’t know if you have any comments about this, but I’m, I’m bullish on the future for our industry right now for m&a.

Matt Lockhart  03:27

So, the law of supply and demand, if the supply of a good or service outstrips the demand for it, well, then prices will fall. If demand exceeds supply, then prices will rise, even in what is going to be you know, what is a little bit more of a challenge, credit environment, I think that the law of supply and demand has held true because valuations and prices have not fallen. If anything, they’ve they maybe have continued to to tick up just a little bit, but certainly have not seen any, you know, dramatic decrease because, well, again, that tried to true principle of the law and supply and demand, I think has held true in this space. Now. I mean, is it for everything in in our marketplace that it is as hot No, you know, there’s been a fair amount of consolidation already in some areas that those areas aren’t quite as hot and but but no, I think you’re spot on Mike that it has been in and for the foreseeable future will remain a very active and very healthy environment for it services firms for tech enabled services firms for SAS firms for product firms. Just technology’s a great place to be.

Ryan Barnett  05:11

Yeah, good set up a little bit about here. So these, again, are, these are deals that we’ve looked at in the last in the last year. And if you include all of the deals that we looked at that it had some that are, I would say, there’s a few that are I would call outliers that are outside of the typical norm. We actually saw an average EBIT a multiple about 11.1 times EBIT da, as the total enterprise value, if you kind of take out some of those outliers. It goes down to about 9.2 times EBIT, da. So the in general, those are pretty high rummer. And to give some context, we’re looking at companies that are have on average are about between 10 and $20 million in revenue. Again, there’s some that are higher, that are some that are lower, but gives you context of the size of the deal that this this year has, has put us in. If we dig into this a little bit, I’d love to talk about managed service providers. When we looked at the math of our deals this year, we had on an EBIT a basis, our average deal came in at about 8.4x EBIT, da and our average revenue multiple came about 1.4x microman, I’d love to give some ideas of tradition that seems that feels a little bit higher than than normal. In a traditional year, you may hear ranges that are between six and eight, or you may hear from five to seven somewhere around there for for things to crack over 8.4 I’d love to get perspectives of what are driving some of those valuations and and in what can sellers do to maybe to to think about? What, how they can achieve some of these exit multiples.

Mike Harvath  07:06

Yeah, I mean, you know, I would say that, you know, running a solid growing business, and we’ve talked about this a lot in podcasts in the past is the ticket to get a premium multiple, I think the ditches for multiples and core IT services businesses historically been sort of in that six to 8x EBIT, uh, you know, for IP based businesses, I’d say it’s a SAS firm, you know, those numbers can be a multiple revenue. And typically, I’ll hover around two to three times revenue, depending on sort of the company’s profitability and growth trajectory. But I would say that, in general, to get a premium multiple, we’ve seen that with with deals, it has to do, you know, as Matt mentioned, before, it kind of was supply and demand, certainly, that drives a lot of pricing competition, and it drives the offers and the multiples up. But it also has to do with there’s just, you know, in my opinion, better run companies, some of these guys that are going to market are pretty well run. And that was certainly the case with our clients tended to operate in, in if certainly the top quartile of both revenue growth and profit realization. But in some cases in the top, you know, low single digit percentile of their peers in profit realization, you know, if you’re running a firm, and it’s north of 20%, EBITA, and you’re growing it, you’re gonna be in a position a great position to command a premium. And that is certainly something to think about if your desire is to exit at some point, you know, you want to optimize that business for profitability and growth, so that your buyer can have a clear path or their return rate. And ultimately, you know, for buyers, it’s just a lower wrist acquisition, it’s one that sometimes we use the term fixer upper right. It’s not a situation where a buyer is going to come in and make material changes to the business to optimize it for profit, so they can achieve their growth rates. They don’t have to turn a lot of wrenches on the business and change things and reduce costs and all that if you’re already optimized. And so, in many ways, it’s much easier to think about transacting a deal because you know that there’s going to be less changes to the business once it’s acquired, and certainly much more of the same, because you’ve already optimized it for growth and profit. And it drives up value. Matt, what’s your thoughts?

Matt Lockhart  09:45

I think it’s a well run business that is sustainable, that has the foundations of great customers and great service is always going to be very attractive, right. And we’ve done a lot of work this year with a number of firms and our readiness programs to get people ready to do just that. And so it’s not, I think that you bring that up as a really good point, Mike, because it’s not just being in the right space. I’m sure, we’re all thrilled with the space that we’re in. But you’ve got to, to do the strategic items that make you more attractive to the right, ideal buyers, right, you know, other things that we’ve seen that have given a bit of a leg up across spaces, but in particular, in the MSP space, is having a level of vertical concentration, right, be it in regulated industry, or not, just having the ability to demonstrate value, add an expertise to a customer set, in addition to being a very well run business, in addition to being in the right space, is a, you know, it’s a winning proposition. So we know that there’s so many different factors that enable, you know, sort of that optimized outcome. But starting with the foundations of, you’re running a great business that can sustain and has happy customers. Yeah, that’s always a pretty good place to start.

Ryan Barnett  11:37

That’s great insight to profit is really important to business, some of the businesses that we worked with had profit margins, even a margins over 20%, consistently, kind of five years over that rate. It said, when you can have consistent recurring revenue and a consistent basis, buyers are willing to pay for it. And that’s what we saw with this last quarter. To turn gears a little bit love to talk a bit about custom application development firms. So, Matt, you were a bit of a lead here. And some of these, on the math side, we saw really some interesting numbers about 2.5x revenue, and 10.4x EBIT, da love to get your perspective on perhaps the category of what were driving those rates, and where companies may want to take a look and get insight into this category.

Matt Lockhart  12:36

Yeah, I mean, I think that we had a podcast at the beginning of the year that reminded people that Software is eating the world, right. And so, and that’s just gonna continue forward. And you couple that with what has been an ongoing backlog of of modernizing, you know, software within enterprise environments. You’ve also got a growing digital native populace that wants to interact via their phones or via their computers. And so you know, is there just there’s a whole bunch of software to be written. And then you saw some, and we’ve seen this in a number of our programs, where you’ve got firms that are outside of the North American marketplace, that are looking for strategic opportunities here on shore, because they recognize that, you know, obviously, the North American market is, is the predominant market for the services. And it matters to have capabilities Close to close to customers. In addition, you know, we’ve seen things happen on the reverse, right, where we’ve seen, you know, strong North American firms that are looking for capabilities elsewhere, and are looking to open up new markets elsewhere. And so, there’s just a whole bunch of opportunities that are very strategic in nature, that I think, Hey, I’ve added to what is already challenge from the demand side. And so you’re just seeing, you know, really super healthy multiples, and there is no reason to think that that’s going to change, you know, anytime soon. Now, going back to the principles that we started with, gotta be very well run, got to demonstrate the ability to continue to grow. Having a really strong sales and marketing go to market is going to be absolutely key for custom app dev firms, because differentiation is super hard in that space. And then the pluses that we’ve talked about before certainly exist in this space as well.

Ryan Barnett  15:13

No great insight. That’s really helpful. If we switch gears over to cloud service providers, we saw a very interesting trend here. I think part of this could have been related to just the profitability of the some of the deals that we’re seeing. But we saw 3x revenue and about 7x EBITA, that, I would say that one thing was a new normal with this was some very cash heavy related deals. So there’s no limited earn outs on that on the sides of these deals. Mike, I’d love to hear your perspectives on cloud service providers and, and why we’re seeing some of these these multiples.

Mike Harvath  15:57

Yeah, it’s a fascinating sector. I mean, I would tell you that there’s a huge demand now for cloud service providers. And there’s a lot of consolidation going on in that space. And we certainly have seen CNET drive deals as we’ve seen a drive consideration as it relates to more cash upfront, and we’ve certainly seen it, you know, doing interesting things with multiples. You know, we think that trend will continue, we think a lot of folks have built some really interesting and compelling and very profitable club businesses. And it’s, I think, for some of these buyers, it’s getting harder to get customers to switch off some of these providers. So they’re switching cost and cost of sales has gone up. So many of them have pivoted to more of an acquisitive strategy to grow or add fuel to the growth of that business. And applying their kind of rule of thumb around how they think about getting them moved over. Because it’s such a sticky business, it’s hard to unseat incumbents, within customers in this space. So certainly, we expect that trend to continue, may even accelerate. And if we have a little bit of pressure on the economy, because people who are customers of cloud service provider businesses certainly don’t want to upset the applecart with anything they have going on and take down the risk of a migration to a new provider, they’ll probably I suspect be more conservative with their kind of their their service providers and just want to stay close. So the counter to that is that that I think it’ll end up driving more consolidation, because of the customer acquisition, you know, the customers willingness to not transfer just organically, but really, it will need to be transferred through some sort of inquisitive approach. So it’s sort of an interesting market to watch. We’ve experienced very, very interesting buyers coming in. And certainly there’s a material number of financial buyers in the space that are that are either buying platforms or are building out platforms they’ve already acquired. And private equity is very active here. That’s been our experience, certainly. And we expect that trend to continue for the foreseeable future.

Ryan Barnett  18:23

On that note, my, when we look at our deals, approximately 45 ish percent had PII or some kind of PII funding, I would say that the still there’s still strategic operators at the table, but the funding is coming from these firms. PE firms are definitely interested. We definitely see increased P firms in managed services deals. Anytime you get that recurring revenue, over 60 70%. financial buyers tend to rear their heads and start to look at this. What’s been interesting is that multiples have kept tire typically, when we see financial advisors in the past, some of those multiples creep down, I think, in this case with the the fact that they’re buying with strategics at the table or working with an operating company, I kept these multiples at a higher ratio tip gets off.

Mike Harvath  19:17

Yeah, I think it would make they’re just Ryan is that, you know, in the cloud services market, you know, there there are larger strategics as well, that are exceptionally well funded because the profit profiles of culture with businesses. And so some of those guys are certainly doing acquisitions. I don’t want to get sound in my comment that it’s only PE funded deals. It’s not, you know, your stats of our own experience show that, you know, 55% of them were not being funded and 45% were. But and I think that’s predominantly because there’s an extremely healthy, larger cloud businesses that are doing acquisitions AND/OR they’re doing bolt ons or line extensions to things like manna service. And so, you know, there’s some kind of additional extensions that are looking for one plus one equals three as well.

Matt Lockhart  20:15

You know, one thing that you sort of brought up there, Mike, that I do think is, is relevant in our experiences that we’ve seen more and more firms, as the as the space is continuing to be a very competitive space, right, for tech enabled services firms. Well, run companies are recognizing more and more, that having an inorganic growth strategy is absolutely critical to their ability for ongoing growth. Now, you sort of pointed it out in the context of, of, you know, continuing with new customer acquisition, and that’s certainly the case, you know, but it can also, you know, shorten the cycle to add in capabilities and the like. So, you know, I do think that one of the things that we’ve seen here in the past year has been more firms who haven’t traditionally looked at in organic growth, doing that. More so and making it truly a strategic imperative.

Ryan Barnett  21:27

I agree, Matt, I agree. I love to wrap this up with a discussion here about some of the the profit versus and revenue multiples. What we’ve seen here is some very profitable companies. I’d love to get both your opinions on where are there some cases in which we see some of these multiples change, and that revenue starts to become a bigger contributor to the enterprise value multiples than than the profit. And I’d love to have some healthy debate on on where that where you see that occur.

Mike Harvath  22:13

On revenue, multiples versus EBITA of multiples on how they’re how we’re going to proceed with that. I mean, how companies see that from a buyer’s perspective, so we’re, we’re going here, Ryan?

Ryan Barnett  22:25

Yeah, correct. I’d love to see that. And, Matt, I’d love to hear the counterpoint of where where you’re seeing some particular industries of where maybe there’s a bet on recurring revenue, or a bet on a product or something else where the profits starts to become less of a contributor compared to revenue?

Mike Harvath  22:47

Yeah, you know, I think as I think about it, you know, in a traditional managed service provider application implementer, or, you know, maybe a custom dev guy, and to maybe a little bit of a lesser extent, a cloud service provider, it’s all about EBIT on multiples, and less, much less about revenue multiples. Now, you see deals reported as revenue multiples, because the firm’s where that is reported, they don’t disclose profit. So the only multiple you can, you can report on us revenue. And you’ll see them sometimes exceptionally high revenue multiples of 1.5 to one or two to one, or in some cases over two to one. And the reason that is on the revenue multiple side of a more traditional IT services businesses, because they’re exceptionally high profit. You know, profit is king in those markets. And, you know, if you’re 23 24% 20 in some cases, 26% EBIT, uh, you can pretty quickly do the math that, you know, at the multiples we’re talking about, you’re going to have a very material revenue multiple. It’s not to be, you know, you shouldn’t read it, though, that all those businesses are trading at those revenue multiples, regardless of profit, because that’s not how it works. Now, the case of SaaS companies are companies that have a lot of recurring revenue, or maybe they’re a hybrid, they got a SaaS product they built, and they’ve surrounded it with professional services to implement. And they have kind of a, what we’ll call a tech enabled service with a big percentage of the revenue being recurring due to their SAS subscriptions. Oftentimes, that is focused more on a multiple of revenue and less focus on profit. Profit is still exceptionally important. You know, we see those deals typically trade at 2x or 3x revenue. But profit becomes less critical. Now profit, you have to be profitable, I think to get in those ranges, particularly for firms under 50 million in revenue. I think you have to be able to show a trajectory to optimize top line and profitability. I think sometimes SAS firms or businesses that are built around IP think that they should trade in these multiples, even though they’re not profitable or have never been profitable. And, you know, that’s not the market today. I mean, I know some deals have traded like that in the past, but it’s certainly not the market that we see today, or one that is representative of a current market. To play in that, you know, we oftentimes get asked, Well, where does the recurring revenue threshold need to be to sort of get into these higher multiples that are less focused on profitability, and, and the magic number seems to be about 60%. So, you know, if you have a recurring SAS business with at least 60% of that revenue coming as SAS Type revenue, and the rest was, let’s say, if project based implementation, or some of it could be associated with legacy maintenance and support or some other subscription based services agreement to keep things running, then you can you can be in those, those ranges. If the IP is less than that as a percentage of revenue, then, you know, these attributes associated with more focus on profit and multiples of EBITA come into play. Matt, I don’t know your thoughts about this? Yeah, I mean, a couple of things, right? There’s always outliers that can enable a, what would what we would sort of typically consider an out of bounds, valuation based upon profit, super uniqueness of capability. And to your point of demonstration of explosive, you know, recurring revenue growth and or overall revenue growth, you know, size, obviously can play into it, you know, but there’s a shoot a scenario that we’ve been working through here where firm wanted a discussion based upon a multiple of revenue, which is fine, because in actuality, the EBIT to multiple, you know, worked out within acceptable, you know, bands, right. But then there are also those cases, you know, sort of going back where that capability is so distinct, where it’s really on the, the sort of the fringes of the laws of supply and demand, you know, we’re a firm that is obviously demonstrating can, you know, real strong growth, real strong customer base, they may not have the profit realization today, and they want to sell in with an organization, and they can trade up on, you know, a revenue multiple. And it’s, it’s just that, I think, to your point, that shouldn’t be the expectation, unless we’re talking SAS base firm that is growing strongly. And as all, you know, recurring revenue.

Ryan Barnett  28:23

Yeah, I think both of those perspectives are, are very helpful to wrap this up. We, these are, again, real world multiples that we’re seeing here this year. And, again, that average is it has been, it’s been consistent. And it’s that we’re seeing that multiple 9.2 against across all of our categories. If you include some of the little multiplier kind of outliers, that creeps up to about 11.1 for the companies that we’ve been dealing with in the IP services space, some things that you can do, our profit is king, it’s going to continue to be at at that attracts multiple suitors. And that is helpful to overall increasing your, your, your your enterprise value. I think buyers, you have to realize that coming in at a Forex event, a multiple is not going to be table stakes, or it’s not going to get you the stakes to even get to add to the table. So watch out where you can go, your revenue rocket we are, we do have a valuation calculator. It’s actually updated and launching here this week. And I’d love for you to take a look at that revenue. rocket.com/valuation Mesh calculator is a great tool to see where your company may fit today. So we encourage you to take a look and see and we’re happy to walk you through the results of that calculator. With that, I’ll turn it over to Mike for our micromanaging class thoughts and wrapping it up.

Matt Lockhart  29:59

Time to do your deal, Mike, time to do your deal!

Mike Harvath  30:03

There you go guys. Yeah, I think what’s interesting, you know, just a couple of comments that there’s been a lot of saber rattling about how the economy is going to crater and how deals are gonna fall off the shelf. And you know how multiples are gonna go down? I would just say today, we certainly haven’t seen that happen, having lived through three recessions here, revenue rocket, we certainly saw, you know, real world recession, and some of the worst in our industry in early 2000s. And then again in 2008, slow down, but deals still occurred, we still facilitated deals during those times at fair multiples. Because great companies will always be in demand, ones that are run well, with high profit will always be in demand. And some could argue because of the scarcity of sellers that even during that period, more buyers will come into the market and create even more demand thinking or perceiving that maybe multiples will be going down. We don’t anticipate that to occur as it relates to multiples going down. Certainly more buyers might come in we saw that in the last two different recessions. We saw more buyers come to the market, which actually fueled valuations and didn’t discount them. So I think the future is bright. If you’re running a good tech services, business and Polanco evaluate an exit on the coming years, I think you’ll certainly have a lot of options if you’re well run and profitable. So that will tie a ribbon on it for this week. For the revenue rocket Shoot the Moon podcast we encourage you to tune in next week, we explore and unpack various topics on optimizing your growth and conducting m&a deals in the IT services space. Thanks and make it a great week