05 May IT Consulting: Industry Multiples, Earnouts & Owner Expectations
Of late, we’ve worked on several projects in the IT consulting/IT staffing industries. Here in the Seattle area a great number of such companies exist, many of whom get their feet wet as Microsoft vendors, but then who grow via internal sales and marketing teams. In this post, I want to discuss a couple of recent deals, including their similarities and some of the differences and how we’ve worked to overcome differences between buyers and sellers to make things happen.
Services vs. Products
Regardless of the technical nature of IT services, consulting and staffing, at the end of the day they’re just s services business. There’s no products or IP, no consumer-focused product and no way to plugin a traditional manager to the business. The downside is that there are fewer managers who can truly run an Information Technology or software consulting company than could effectively run a niche manufacturer, a consumer products company or even a website business.
As a result, the list of potential buyers doesn’t include every single XYZ private equity group in the market. No, the list of potential buyers are typically outside of private equity firms and are generally much smaller. Shorter lists means finding potential buyers is–of necessity–a much more focused activity. Entering into a strategic auction process requires more work in bringing some of the best buyers to the table.
A Thought on Multiples
In many instances, the value is in the eye of the beholder. Like we’ve stated before, many business owners have unrealistic valuation expectations for their companies. There is a major disconnect between buyers and sellers in terms of value. Typically buyers buy more frequently, than sellers sell. The power is therefore more often in the hands of the would-be buyers than the potentially acquired.
The real question is, just what have we been seeing for multiples with these types of companies. Initial offers have been in the ballpark of roughly 3x to 4x of EBITDA with negotiated strategics coming up to just below 6x (but these cases are very rare). However, the higher the valuation the greater percentage is usually included in an earnout contingency. And we all know earnouts can act as a double-edged sword.
Negotiation Points & Merger Integration
When the negotiation dust settles, the typical areas of strife all revolve around the following three key points (the rest are ancillary details that are easily bypassed or fixed):
- What is the decided-upon multiple of the LTM EBITDA? The last couple we’ve seen usually come in at 3.5x. When the dust finally settles, they usually end up between 4x and 5x. This isn’t from specific market data, but personal experience.
- If there is disagreement in the multiple, can it be increased by adding more to an earnout? If so, what percentage of the deal can be negotiated into the earnout. On the buy-side we’ve seen earnout offers as high as 50%–an indication the buyers see risk in buying a business that may be too tied to a single founder. The last couple of deals we’ve done had final negotiated earnouts of 15% and 25% respectively.
- How long will the owner be available on a consulting basis post-merger?
With all the risks and negotiations aside, there are consistent and highly active acquirers within the software consulting and IT staffing space who’re looking for growth via strategic acquisition. Many acquirers are also extremely good at the post-merger integration process, which itself is probably the most risky component for business buyers (hence the large percentage of earnout contingencies).