There's a lot that goes into a business acquisition and it's important to have the right advisors to take you through the acquisition process. More importantly, there are a number of key changes you can make to your business now that make you much more attractive for acquisition in the future. The possibility of being acquired is exciting for many MSPs, but it's important to start setting yourself up for success today
On this week's episode of MSPradio, we welcome back Tom Fafinski of Virtus Law, who will tell us about the anatomy of a business acquisition and what MSPs can start doing today to set themselves up for a successful acquisition in the future.
Also, be sure to take a listen to Tom's previous MSPradio episode, Proven Tips for Improve Your Master Service Agreements.
Tune in this week and subscribe to our podcast on iTunes.
Nate: Hey folks welcome back to another episode of MSP Radio. As always I’m your host Nate Teplow and today we’re going to be talking about acquisitions, this is a very excited topic for MSPs. I think a lot of MSPs get into the game and acquisition is how they kind of exit. So it’s an exciting thing for MSPs and you really need to start planning early and setting yourself up for success if you want to eventually be acquired down the line.
So before we get into it I would like to remind you to subscribe to our podcast on iTunes. If you are listening online you can subscribe to our podcast and get these episodes straight to your iTunes account. We’re also available via the stitcher application for android users. Follow us on Twitter using the handle at follow Continuum and you can let us know what you think of the radio show with the #MSP Radio.
So as I mentioned we will be talking about acquisitions today and we are actually going to be were coming back a previous guest on MSP Radio, his name he is Tom Fafinski He is the cofounder of Virtus Law. So Tom, welcome back to MSP Radio.
Tom: Thanks for having me Nate.
Nate: Yeah, absolutely. So Tom joined us a few months ago and he spoke about keys to successful master services agreements. It’s been a great episode for us I think it’s been almost listened to episode since it aired back in I think it was early September. So Tom is very knowledgeable, he works frequently with MSPs providing legal services for them. And he will be discussing the anatomy of the business acquisition and some of the keys to setting yourself up for success.
So Tom, first off again welcome back, excited to have you again. Tell us a little bit about the current landscape in terms of acquisitions. What are some of your clients going through when it comes to acquisitions and the marketplace?
Tom: What we are seeing well, thank you by the way for having me back, I appreciate the opportunity. What we’re seeing in the market is, and we’re not going out there shopping deals we are just providing legal representation when a deal comes to fruition. We are seeing a lot of activity compared to like in 2010. I mean the activity was near nonexistent and it seems like the last 2 years have been making up for that. There is a lot of demand for it; there is a rush to the market and growth by the companies that have decided that they want to make a mark in this area.
And what I mean by that is instead of building out a new area. For instance if a company is in one metropolitan area and seeks to move to an adjacent metropolitan area, rather than doing a build out organically of that adjacent metropolitan area, they will say, “You know what, I think we are going to go buy somebody in that area. We will move the administrative burdens associated with having 2 administrations and launch with a head start in that new geographic expansion.” That’s a Geo expansion strategy. So that’s happening.
And then we see other folks that have made a decision, other companies that have made the decision that they are looking at services they provide and the risk of it becoming commoditized which is a big danger in an industry is to have commoditized service offering. And they are trying to fight the commoditized nation by making a specialist play where they are actually going to go, they’re going to stay within their market but they are going to go and acquire a particular discipline or an industry vertical that is what they believe in.
For example there are law firms, MSPs that specialize in servicing law firms, some that specialize in servicing accounting firms or chartered schools or banks. And what you see is they will go acquire that expertise rather than trying to develop it organically. So you have these multiple pressures for businesses to be acquired at a time when from an economic standpoint, there’s a lot of money sitting on the sidelines.
If you are a healthy company right now, it’s never been easier to get financing. If you are good company and you have lots of liquidity and lots of collateral to deal with. Banks are giving away money at less of a spread because there is so much competition to try to find this good work.
And so you’ve got all these things happening, all at the same time which is for a seller, just a wonderful scenario just to be in. On top of it, I failed to mention, that private equity has moved into the space and private equity groups are companies that create a fund. And the fund is constituted by money from private individuals, from pensions, from investors that are looking for a return without having to be engaged in the activity and the fund raise is all this money and then he goes to market partners with managers.
We’ve seen this phenomenon of private equity moving into this space probably 2 years ago or a year and a half ago when it really started to move so I know that’s a really long answer to your short question of what is the current landscape but it is also for everybody involved. It’s great for the buyers because man is cheap, funds are accessible, they can remove the administrative costs, they can facilitate their expansion, they can remove the risk of commoditization, they can do a Geo expansion if they want to do a Geo expansion and it’s great for buyers because they are getting… There is a lot of demand out there for their stuff so they get the price.
Nate: That’s great, it sounds like a nice little collision of trends in the marketplace that I me when you have private equity groups and banks and companies looking to acquire expertise, all kind of rushing to the same industry it means just a lot of opportunity and good situation if you are in managed services provider.
Tom: Absolutely, it really, really truly is. Because at MSP could be really attractive on that Geo expansion where somebody is just trying to move into the market and pick up existing footprints or foundation but it’s also great if they can niche in a particular area where the MSP is being provided within a particular industry so that’s the opportunity.
Nate: Yeah, that’s great, that’s great to hear. Something we talk about frequently on the radio show is… And it just other content we produce here at Continuum, is finding your area of expertise and specialize in and how to identify the target market. And this is another reason to specialize and find a specific area of expertise is because those companies looking to acquire, they would rather get somebody with expertise in a certain vertical rather than just a broad random range of clients.
Tom: You know, I am practicing what I preach too. We have decided to niche and we’ve… You can niche in more than one particular industry, you can’t do much more than 3 though. But we’ve niched 2 and so rather than become a generalist business firm that has the surf everybody doing everything; we made the decision that we’re going to focus on technology companies.
And we can’t feed that appetite just in a Twin Cities market so we have expanded our markets across the nation just as long as the technology arena because we have a lot of expertise in that area and done a lot of work in that area. So I’m practicing what I preach. I believe in it, I believe in it not just for MSPs but I believe in it across the board. If you are not going to go to market in a huge capacity like I have everything to everybody and we have an abundance of resources like IBM type of thing, just to pick a name, if you are going to shy away then you would say we’ve got to niche like this and become experts.
Nate: Yeah absolutely, it’s a good practice for any business. So take me through it, is that the high level standard process of an acquisition? What are some of the key steps in the acquisition process?
Tom: That’s such a great question. What people normally come in with, they just don’t understand how that process works. So the very first thing we have to do is we have to decide what type of structure of business acquisition is it going to be. Are we going to do an asset purchase transaction which is a clean slate transaction? You just buying assets and one of those assets is good will or the book of business that they have. Or are we going to actually do an equity purchase where we are going to own the shares of or units of ownership in that business which is important in a rollup type scenario. So if you have a private equity player out there that wants to do a rollup, they are more interested in, sometimes not always but sometimes are more interested in acquiring the equity rather than the assets because by buying the stocks or the shares, they control the assets but they also get historical financial data that they can combine and demonstrate that they have been in business for a lot longer.
So if you have a business that’s been in business for over 10 years and private equity is new to the game and they take that 10 year company and they merge it with a 15 year company and a 5 year company and a 2-year company and they are doing this rollup, they get to boast be in business 15 years because that legal entity actually has been in that merger setting. So that’s kind of the very first, sometimes it’s a merger too where that’s the kind of 3rd subset which is really not happening as much in what I’m saying is with an asset purchase or an equity purchase those are the 3 deal structures.
And then you go, you move to something called the letter of intent. And there are 2 types of letter of intent actions. One is a letter of intent that looks a lot like a purchase agreement or it’s very robust and it includes lots of terms. It’s not binding; people are going to use it as a launching pad to a final close. And that is something that deal guys like to introduce because it’s a quicker close. The parties are getting together some basic business terms but then it’s expanded beyond that. The more common that I have found has been you do a letter of intent and between the business folks, there’s a little bit of lawyer involvement but mostly it’s let’s figure out what is the payment price, what are the deferred payments? How much we’re going to get upfront? What type of security we’re going to get? Is there going to be an earn-out? What type of employment is involved? Are we selling portions of the assets or all of the assets?
And we’re looking at that type of letter of intent between business folks. What they are really looking to do is just try to get some basic things down that they can agree to and if they can get these things agreed to then they will go to the next step. And the next step is whether it’s a share purchase or a unit purchase agreement or the more common asset purchase agreement where all of these terms are passed out along with a bunch of legal terms.
So letter of intent asset purchase agreement; once that as a purchase agreement is in place really the transaction is done pending due diligence. Now there is this due diligence period this due diligence period is where you go confirm the representations made in the asset purchase agreement. You make sure the financials are accurate; you are looking at the assets to make sure that the assets are physically in good condition, that the contracts are sign able for instance; I think we’re going to talk about that a little bit later on. We want to do a little bit of signing contracts.
So those types of representations and warranties that are going to be committed to and adhere to are proven out. And then you go to final close and the final close is really just you know, hey, we made these obligations to each other, everybody is worked out…. We’re going to work out the contingencies of all outcome and we are either going to waive the contingencies as we’ve satisfied them like we’ve gotten the financing we need to fund the transaction and then we’re going to go to close. And the close is really more ceremonial of this type of structure.
Tom: Another long answer to a short question.
Nate: No, that’s interesting stuff and a lot of things you’ve got to bring together in order to put the acquisition process into place. So we’ve got to take a quick commercial break here on MSP Radio. Coming up next we will continue speaking with Tom Fafinski of Virtus Law about the acquisition process and some keys to a successful acquisition and what MSPs can do to set themselves up for success. So we will see you all in a few minutes after this quick commercial break.
Nate: Hey folks, welcome back from our commercial break. You are here on MSP Radio. I am your host Nate Teplow and we are speaking with Tom Fafinski, cofounder of Virtus Law about the anatomy of the business acquisition and some keys to success for MSPs and for the acquiring company.
So Tom you just took us through the steps in the acquisition process. What do you find are some keys to a successful acquisition? I know not all acquisitions are positive and beneficial so what are some of the keys to making that a success?
Tom: Well when we’re talking about MSPs, I’m going to make it specific to MSPs and what the current climate is because there’s different ways of looking at it in different industries. What big focus is for MSPs is it’s really earnings and it’s a term that you will hear, it’s EBITDA, It’s earnings before interest, taxes, depreciation and amortization.
And one that is seeking to do is measure a cash flow projection into the future and companies are trading at a multiple of EBITDA, now often times just referred to as earnings here for ease. So when a private equity group is looking at acquiring a company, they want to see that the company that they are acquiring will prove out from an EBITDA standpoint, from an earnings perspective into the future.
So they are looking for the ability to remove administrative costs because when they are doing a rollup or multiple acquisitions, they are sometimes able to remove that administrative cost and use the current infrastructure and leverage that. So they are looking to do that piece and they are looking at the EBITDA and saying okay well we know that we are going to be able to make that into the future, we are also going to be able to do better if we can remove the administrative costs and in a rollup scenario.
In a geo-expansion, the same thing is coming into play where somebody is in one community and decides to expand into a new community that’s adjacent to it. The infrastructure costs and the business aren’t that much different. By doing the geo-expansion they are able to leverage the current administration like the human resources person and the chief financial officer, the lead technologist. And so what they are doing there is they are saying, “We’re going to look at EBITDA and make sure because we could prove EBITDA by leveraging the existing administrative costs.”
And then you look at the niche expansion where somebody is looking at the same market and they are just focusing in on the niche piece. They are really looking the same thing whether they are able to remove the administrative costs. So we are not dealing with a lot of buyers that are trying to purchase out the competition to avoid the competition from being in the marketplace which has a different type of multiple that they would apply to if they are trying to eliminate competition. Most of this is about increasing their product offerings or the service offerings.
So the focus on EBITDA is really, really extreme. And the multiple and I have seen transactions of 10 times earnings of these things which are fantastic especially if you have expertise.
Nate: Yeah, absolutely. Can you tell us a little bit about the importance of monthly recurring revenue to I guess an MSP and why that’s so important to an end company that’s acquiring because a lot of MSPs here, they sell a little bit of managed services, some monthly recurring revenue but they also take on these one-off projects that might sidetrack them a little bit and it’s a little more random, those spikes in revenues and profits. Tell us a little bit about how MRR plays into this.
Tom: You know, recurring revenue is such… That such a great topic for MSPs because you guys can be accountants and not lawyers – so lawyers in my industry, this is what we fight all the time. We do project-based work and so to do project-based work you go out and you hunt. You strap on your rifle, you go out in the woods and you go looking for a kill. And when that project comes in, you bring it in and the people back at the office, they harvest it and cut it up and put it out and then you are done with that project and it’s unlikely to recur.
So let’s take an example in estate planning, somebody comes to you with an estate plan. They want you to do an estate plan for them, you send it back out, they don’t really have other estate planning work that they are going to send it to you or other related work where they would come back.
Whereas accountants, and today is October 15 and it’s the final filing deadline for individuals, I love the accountant model because an accountant, their business comes every year it comes through the door. Every year it is required and regulated and we have governing authorities requiring that the tax returns be filed every year so the accountants just have a great business model; everything is coming back. And not only is it coming back on a recurring basis, it’s recurring every year so they are predictable.
So what we try to do as a law firm is we’ve tried to borrow from your industry, the managed service provider industry, we borrowed that same concept and we actually do it in our law firm where we are offering recurring services. We will do all of your legal work for X dollars, that’s predictable, it’s a monthly fee and there is a reason for that. It’s smart, it’s smart from a business standpoint, it’s also smart from a sales standpoint.
If a buyer wants to buy your company and they see that your revenue is recurring every year and automatically renews, every month and they know that there is a year of horizon or maybe it’s six-month provision that they are going to exit from it, it’s even better if you can tie up the equipment a little bit too where you are actually leasing some equipment to them or at least controlling the lease of the equipment to them. A buyer looks at that and they say, “That stability in revenue coming in, we will pay a premium for it. We will pay the premium for it because it’s more probable that it will be successful.”
Nate: Yeah, if you’re going to buy a company, you want predictability, you want stability and those MRR contracts are important for that.
Tom: Absolutely! Whether it’s a geo-expansion or an expansion by creating a niche of expertise, that is… I’m in you’re not just buying the talent, you are buying the people that are paying for the talent too, those customer relationships.
Nate: Yeah, absolutely. So leading into that, our last episode we talked about an assignment clause and how important that is to include in your Master services agreements. Can you tell us why this is so important especially when it comes to acquisitions?
Tom: The biggest probably the biggest issue that I see in the contracts that we are asked to comment on is a lack of this assignment provision. The MSP isn’t… there is no term in the contract that allows the MSP to transfer to a subsequent MSP or a successor MSP.
If you are going to sell your business, ever, you’ve got to have this provision and most people have some plan of selling their business at some point. If the contract is assigned and there is no right by the customer to cancel the contract at that time, a premium gets paid for it because there is a higher probability of stickiness. In fact, it’s 100% sticky because you could legally compel the customer to stay with you. If you don’t have the provision, there is no stickiness. The customer can leave if they want and you know what? Customers sometimes do.
So here is what happens. If you have a transaction with somebody and they don’t have this ability to assign their contracts, the customer, the MSP’s customer success, “Well, I’ve got to make a change anyways. I was looking at Steve down the street and Steve has been pitching me for a long time but I have had a good relationship with this company, the existing company and I’m not going to make the change. But if I’ve got to make a change, if it’s got to be to a stranger or the Steve down the street that’s been calling me for a year and a half, I will go down there, I will move down the street.”
So for the customer that isn’t fully sure, experiencing a change, they would be more likely to leave and less likely to stay. Now compare that with the customer that has to stay for at least 6 months or has to stay for 3 more months until the end of their contract. If they have to stay anyway and they have to acclimate to the new MSP, well they are less likely to go through that twice. So if the customer, they are looking to have less pain in their life, if you take away that pain and make them only do it once, they are more likely to stick with the acquiring company so really, really important to keep that comedy that assignability clause inside your contracts because if you don’t have it, you really don’t have anything to sell.
Nate: Yeah. And it is something you should start doing now whether you’re going to sell your business in 3, 4, 5 years, you’ve got to start building those clauses in now to set yourself up for the success in the future.
Tom: Absolutely because if you are the customer and you see that, if you say, “Hey, I’ve got the version of our new contract and you’ve inserted this provision, I don’t want that provision. What’s going on, are you selling?” “No, no, no, no! I just heard this radio show,” or, “We have a vendor that is suggesting we do this.” You need more time to get that if you don’t want it to happen when you are saying, “Yeah, we are exiting in 2 years.”
Tom: Customers have long memory. If you say that you are not planning on selling and you have inserted this contract provision because you are planning on selling, they will remember that and they won’t want to do business with the successor company.
Lots of times what we are seeing in this industry is an earn-out provision. So this happens Nate whenever there is a compression on capital gains with earned income, there is less pressure for the buyer to pay the seller something that can be treated as capital gains so capital gains generally has gone from 15 to 20%. And so the gap is narrowing in terms of earned income versus capital gains. So what a seller is… If the seller believes in their business, they are more likely to do a earn-out and say, “Okay, I will get paid this amount for sure but if post-acquisition, if performance is enhanced and increases in year 1, year 2, year 3, I’m going to get additional bonuses that are going to be tied to this acquisition,” and they are called earn-outs.
A buyer is more willing to pay more in that type of success scenario. So if they are successful and we are looking historically, we’re not looking at hopefully, we are looking at we know it’s been successful, they are more likely to say, “Fine, we will give the buyer additional money,” and they will agree to it up front so they stickiness of customers is really important if you have a earn-out and almost all the transactions we’re doing right now have some form of earn-out.
Nate: Yeah, that’s really interesting. Well, Tom I hate to cut you off, this is a great conversation we’re having here but we are coming up towards the end of our show but really interesting stuff here. Again acquisitions are a big topic in the MSP industry and again it’s something you really have to set yourself up for that success in the future and start thinking about 3, 4, 5 years before you actually plan on being acquired. So Tom thank you very much for joining me here on MSP Radio today.
Tom: Thank you sir!
Nate: Absolutely so again Tom Fafinski from Virtus Law. If our listeners want to learn more about what you do and your areas of expertise where can they go?
Tom: Virtus Law.com or you just call us at 612-888-1000.
Nate: Great, well thank you Tom and I definitely recommend to our listeners to check out his previous episode on master services agreements if you haven’t heard it yet, it’s a great show. And thank you to all our listeners for tuning in this week to MSP Radio. I hope you enjoyed our conversation with Tom Fafinski and we will hopefully see you all next week on MSP Radio!
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