06 Sep The Impact of Profit on M&A
How does profitability impact M&A? Where does your firm stand with end of year profit with Q4 approaching? One of the most important principles of your IT services firm should be profit and in this episode we’re diving into why it so important.
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EPISODE TRANSCRIPT:
Mike Harvath 00:03
Hello, this is Mike Harvath with this week’s Shoot the Moon podcast broadcasting live and direct from Revenue Rocket world headquarters on Bloomington, Minnesota. Revenue Rocket is the world’s premier growth strategy and m&a advisor for IT services firms. We are here today with my partners Ryan Barnett and Matt Lockhart to talk about profitability and how it impacts m&a. Ryan, Matt, welcome.
Matt Lockhart 00:33
Well, a super timely topic, for sure. As we’re, as we’re kind of wrapping up, the third quarter firms ought to be certainly thinking about where they’re standing in terms of end of year profit, and how that could enable an opportunity for a merger and acquisition.
Ryan Barnett 00:56
Yeah, and this is a topic that is, is if we look at topics we’ve talked about before, this is one that we get asked about a lot. And and when we look at growth strategy, consulting, we often talk about governing principles of firm. And one of the most important is in order if you’re running an IT services business, it has to have profit, and the biggest thing there is if profit is really the right to continue to employment, they have to have enough money on the table to continue to pay bills, to make to continue to drive the company forward, and it’s vital just for the growth and success in the company. We have often seen product lead growth or companies that kind of feel they’re in a product mentality in which growth at any cost is an option. And we find that in our market, that that can be really debilitating. So today just want to kind of talk a bit about profit in the light of mergers and acquisition, and how it might impact timing, how it might impact your ability to sell how it might be used selling in. So, Mike, I know I just talked a little bit about why a profit is important, but I’d love to to, if you have any more expounding on that and any kind of rules that we’ve seen for profitability in firms I’d love to hear it.
Mike Harvath 02:17
Yeah, for sure. You know, I think what’s important to understand, if you’re selling your firm, and you look at your profit, you have to look at it through the lens of a buyer, right? A buyer is going to acquire your firm for a specific price. And they have to get to a return rate, a reasonable return rate on that investment, or they’re not gonna make it. And typically that return rate and timing of that return are really important. Most firms that do acquisition, say, hey, we need a five, six, or maybe outside of seven year return on that investment, right, the profitability from our acquired business needs to be a creative, one to our profit early, but also the whole investment that was paid, should be paid back within that time horizon. That’s really, really hard to do when you’re a low profit business, or even a single profit EBITA business. You know, the goal would be to drive your business to top quartile profitability, that line crosses for most IT services companies at about 13 to 15% EBIT a little bit of a moving target because as your manager, your top quartile, sometimes it goes as high as 17%. So your profit should be in that range, ideally, to be able to craft a reasonable return on investment for the buyer, and most importantly, drive a market price or multiple for your business that could meet your expectations of value. When you’re low single digit EBITA, and certainly we have guys that run their business like that they feel they don’t want to quote unquote, pay taxes or, you know, whatever they try to drive and wring out all of the profitability of the business. You know, we just can’t get oftentimes get to a reasonable price point for the seller, that will also align to a reasonable return on investment buyer.
Ryan Barnett 04:35
That makes a lot of sense, the ROI and the timeframe and the internal rate of return are all heavy influences on the valuation and how a company may be perceived. When we look at companies and looking to bring them to market, I think it’s important to remember that most deals are based on a Multiple of profit in just that simple statement is, is very important to understand.
Mike Harvath 05:08
I will also add, and I’ll certainly Matt you can chime in on this, but, you know, most private to private transactions are reported if the reported in the press at all around valuation are reported as a function of revenue, and it’s easy to get lost. And the reason it’s reported as a percentage of revenue or a multiple of revenue is because that’s the numbers that are known, and in private to private deals, people don’t want to disclose the profitability of a company they just acquired, or the seller doesn’t want to disclose how profitable they are, even though that is the index for how these deals are valued. And so it’s sometimes you know, we’ll talk to potential sellers that say, Well, my firm should be worth two times revenue, or 1.4 80%, or whatever. But within this is that, you know, and typically those conversations are happening with companies that have low profit, is that that isn’t how their value their value based on a multiple profit. So it just so happens that aligns to, to what was paid, because that multiple of profit was such that, you know, was supported by the by the, or the, that lines for that revenue multiple because it was supported by generally a high profit business, and that multiple profit just happens to correlate to what’s reported around a multiple revenue.
Matt Lockhart 06:46
Yeah, well, let’s, let’s kind of dig in there just a little bit. And I think there’s an opportunity to, to, you know, do some clarification, yeah, there are deals that are traded on, you know, multiples of revenue. And, but those are very specialized, you know, situations, it could be that somebody has, you know, really, really unique intellectual property, they’ve got a product and, or a product and a service that is very, very unique. And there’s a ton of value, because there’s an opportunity to grab market share, based upon the uniqueness of that of that offering. And so, you know, in those cases, that it could be applicable to trade on the top line revenue. But again, very, very specialized in those scenarios. And I think that oftentimes, an IT services firm could, you know, say, Well, geez, you know, I heard about this, you know, XYZ company that traded on, you know, a multiple of revenue, it’s just a misnomer, because, you know, 90% of transactions that are in the IT services space, aren’t quite honestly aren’t that specialized, that can command being traded on a multiple of revenue. So that means that for 90%, of the transactions that we see, they are traded on a multiple of EBITA. Right. And so it’s just, I think it’s just worth kind of being real clear and clarified on the the aspect of how most opportunities are looked at in terms of value. Yeah, I think it’s a fascinating topic, frankly. Because everything that you just don’t want to just absolutely correct. And I think, you know, also for IT services companies that are in the low 20s percent, or mid 20s percent EBITA, from a profitability perspective, they can be in a kind of a multiple of revenue, certainly above one time revenue. And, you know, in some cases as much as two times revenue, but, you know, that’s a really very, very special, profitable, high growth company, typically, with a lot of secret sauce that’s achieving that sort of benchmark. And you just keep that in mind. And, you know, certainly more profits better than less. In the context of mergers and acquisitions. It gives you more choices, as a seller gives you more interest as a seller. buyers love to buy highly profitable companies typically, because they know that they’re staffed appropriately in the IT services world that they’re managed effectively the controls are in place, and that they’re, if you couple that with a kind of an up into the right growth trajectory, we have aware, of course, buyers like to buy winners.
Ryan Barnett 10:09
I think they, it’s a lot, it’s much harder to sell a company that doesn’t have profits. When we’ve worked with buyers, there’s some companies that will look at distressed assets, or they’ll look at fixer uppers. But for the most part, companies being accreted to earnings is a foundational item for for acquisition. Just to to, to note that. We want to switch gears a little bit, when we work with many companies on the buyer side, and we look for companies that are represented by other brokers, it’s very common for us to see profit just happened to appear in the last year. And with a history of profits that had been no less so. I’d love to get either of your perspective on the length of profitability that’s needed or or being aware or cautious of, of kind of false measures to boost up profitability. Any guidance or thoughts around that Mike or Matt?
Matt Lockhart 11:13
Well, I mean, there’s got to be at least if it you know, it sort of plays into a little bit, the structure that could be applied to a deal, right, so if a firm has one, maybe two years of of profit and or growing profit, well, they certainly better be able to demonstrate the the foundation that enables that profit to continue both of the growth and the profit, as Mike pointed out, but if they, the less historical, you know, means that if a firm wants to sell and and you know, get a get a number, they’re going to be have to demonstrate the continuity of that profit, and they’re going to need to earn it out. Right, they’re going to need to, to, to put a higher degree of structure in an urn out to the to be, you know, for a buyer to be able to bank on the continuity of that profit. So, you know, I think, Mike, I don’t know, a minimum of three year track record of profit growth, you know, should be in place. And, you know, obviously, you know, the, the more historical, the better as it pertains to being able to maximize the sort of the cash portion of the deal.
Mike Harvath 12:39
Yeah, I think for sure, I mean, the more of that you can show there, as it relates to profitability, trajectory and growth trajectory. I think it’s important, you know, you can, we talked a lot about a rule of 45 that talks, so there’s a trade off for growth and profit. And if you have hyper profitability, but no growth, there’s going to be, you know, that’s in question as well, right? There’s got to be reasonable balance between the growth and profitability of the business so that a buyer can get comfortable, that it’s a healthy going concern that’s growing. With that, then I think there, they’d be prepared. But you know, certainly a multiple year view of that is critical. Some folks had a pretty, you know, material dip at COVID. There’s, we can explain some of that, in that scenario, but you got to look at a broader trend line. And, you know, the farther we get away from the impacts of COVID, less of an impact and, frankly, less an opportunity for, for why you may have seen a hit and profitability or growth, but I certainly think at least three years is critical.
Ryan Barnett 13:53
Yeah that really, really helps give a timeframe to it. Switching gears a little bit, we talk with sellers often that they have a number in their head, and they understand that the profitability is at not at a an ideal number, and they’re less inclined to consider selling the company until they can get that profitability up. I’d love to get your opinion on, is that the right thing to do? Should a company in trench and work on profit? Or other scenarios or options that you could perhaps grow with together and maybe sell in and look at ways to take an earn out and kind of prove the growth just give some guidance? And granted, every scenario is going to be a bit different. But are there some scenarios that you’ve seen, when someone’s asking that question s hould they at least take the call of the broker and go through the discussion or do you hold on wait?
Mike Harvath 15:00
I think some of that depends on what the intent of the seller is, right. So if the intent of the seller is to quote unquote, sell in, be part of the going concern plus transaction, then certainly, you know, they should take the call, and they should discuss how, you know, I might be turning some wrenches on the business to optimize profitability and growth right now. And that they want to be able to take advantage of that before they’re fully out or fully exited. Now, there’s ways to do that, right, you can roll equity and sell that equity later, you’d become part of the new company, there’s ways to, you know, structure, what we call gain, share arrangements, and then gain, share and earn out arrangements, you certainly can participate in that growth and that profitability that’s forthcoming. And oftentimes, if you’ve made material investments that haven’t just hit yet, or haven’t fully been realized, you know, that is the right strategy. Maybe right, because of, you know, kind of where the businesses today for you to exit with taking some risks in the consideration on the transaction. So you can take advantage of investments or changes you’ve made in the business moving forward, it’s definitely going to be required by buyers, if they see that there’s softness in your numbers, they’re going to ask that, especially if you’re forecasting kind of big growth hockey stick high profit numbers, that you take some risks and participate in that on a go forward basis. So, you know, I think it’s the right strategy. And matter of fact, as a, as an aside, sellers that take advantage of sort of earnouts, you know, meet or exceed those are not targets, you know, 84-85% of the time. So, you know, they are paid out at a pretty high rate. And, you know, so the risk of burnouts really is not as much as many people perceive them to be.
Ryan Barnett 17:07
Right, I think there is a balance there. Absolutely.
Matt Lockhart 17:12
You know, one thing you brought up, Mike is, firms that pretty clearly seem to be seem to have optimized profit. Now, obviously, any seller is going to, you know, do oftentimes do the right thing with regards to expenditures that, you know, may not be paying off in the near term, and the reduction of those expenditures, but in other cases, firms make some material changes to their, you know, operating model, and reduce things that are really quite necessary to continue to grow the business. And they do so, you know, because they think that a buyer is gonna go, wow, look at, look at these, you know, these exploding profit margins and you know, pay up, right. Yet the reality is, is that if the, if the foundation has been changed and or compromised, so that firm isn’t in a position to continue to grow and, and as a going concern, well, you know, people are fooling themselves.
Ryan Barnett 18:34
Totally agree Matt, totally agree that the, there’s absolute balance here. I, for for me, I think we’ve hit a lot of the points. If you’re I think if you’re a company, that’s a few years out, there are opportunities for you to improve profit in general. Mike, Matt, either one here, have you seen some successes or what would you recommend for a firm that’s maybe taking a year off and trying to a year before sale or maybe two, to help focus on improving that profit?
Mike Harvath 19:11
Well, I would add that, you know, certainly getting some outside help, is probably a good idea. Right? I’ll put a little plug here for, you know, our team, as it relates to kind of Strategy Optimization advisory work that we do- you know, we help lots and lots of tech services firms kind of optimize their strategy for revenue growth, and most importantly, profitability. And there’s some dials that you can turn there. They may not be immediately evident to you as an operator. And I think by getting some outside counsel on that, and taking that advice, you know, whether that be from us or someone else in the space who specializes in IT services firms would be good would be would be time well spent and an investment that would return, you know, many, many times the level of, you know, ROI, the return on investments very high, because if you can optimize that profit, it turns into a direct correlation of the multiple EBITA on a sale. So, you know, that preparation on outside counsel is critical. And certainly, you know, your accounting firm typically can help depending on what they do, if they have an advisory function. But I think what’s more important is that the investments made in profit optimization, come not just from cutting costs, but come from expanding, sort of your market share and your growth. And that combination of balancing revenue growth with profitability, is what’s critical. And if you’re going to make investments to do that, that if they’re done right, you’ll get a great return on investment on that time and energy spent.
Matt Lockhart 21:12
You know, something, and it’s not simple, I shouldn’t say, I was gonna say something as simple, but something as fundamental as getting a valuation done, you know, if you’re, if you’re thinking that your time horizon is within a year or two, getting a current valuation, and, you know, one just to set the mark in terms of where you’re at against the market, but two, to understand the process. And because the, you know, looking at, you know, our method of a balance value calculation is looking at the historicals plus future, and understanding all of those in inputs could be, you know, super valuable for a future seller. And, you know, from that, then, you know, as Mike said, there’s opportunities for guidance around, you know, optimization, both on the growth front as well as on the on the profit side.
Ryan Barnett 22:12
That’s very helpful. Mike, Matt, that’s all the questions I have for you today. Turn it over to you to wrap it up.
Mike Harvath 22:18
Sounds good. Ryan. Thanks a lot. As we bring this particular podcast to close we’ll tie a ribbon on as they say. End the summer of 2022, I certainly look forward to all tuning in next week, as we explore other kind of growth strategy and m&a topics that are relevant to the IT services market. Thanks and make it a great week.