"A Beginner's Guide to M&A" | FAQs from Hampleton's Webinars (#7)

Since the start of the outbreak in March 2020, Hampleton Partners has provided tech business owners with regular webinar updates regarding M&A prospects in the current climate.

In this blogpost, we have compiled questions asked in our March 2021 webinar on activity in the IT Services sector – and their answers – through which we aim to provide "A Beginner's Guide to M&A".

I’ve heard all sorts of rumours of valuations depending on the sort of firm involved. How much depends on the company in question?

Median valuation multiples can only be a guide, and many factors can influence valuations in different sectors.

If you look at valuations across the board, the range of disclosed valuation metrics in IT and Business Services is huge, from as low as 1.1x and as high as 30.8x on EBITDA. Announced revenue multiples were even greater in variance, as low as 0.1x and as high as 10.9x.

The large range of valuation metrics is due to a variety of factors including growth rates, profitability, geography, domain expertise and service offerings.

For instance, while companies with payment processing services garnered healthy valuations in the 15x EBITDA range, a 42-year-old $47 billion distribution company was purchased for 0.15x revenues.

What’s your view of the sector looking forward further into 2021 and beyond?

2021 is going to continue to be an active year for M&A in IT Services. Custom software development & payment processing major driver of value in IT Services as the post-Covid effect and burgeoning disruption via fintech continues.

We believe too PE investors will continue to consolidate certain markets and larger established vendors will acquire specialised skills not developed organically in-house and their associated revenue streams as product cycles ever-shorten.

Do you see a difference in the attractiveness of the B2B2C vs. the B2B model and if so, how does this translate into M&A valuations in the IT Services sector?

The B2B IT Services market has been very robust and is holding fast against more hybrid models like B2B2C.

When opting for B2B2C, the key issue which will tend to tweak valuations is the total addressable market of the “B2C” component of that particular model; so, if the B2C component at the base of your sales pyramid is very broad, this could attract higher valuations. Conversely, if it isn’t very large, this could negatively affect valuations. In some cases, however, acquirers might consider rolling up both a B2B and a B2C company to consolidate the two in a hybrid model.

Do IT Services valuations depend on the size or revenue of the company?

Size does matter – particularly in the sub-half-a-billion range, i.e. between $5 and $500 million enterprise value.

As a rule, the larger the business, the higher the valuation. The valuation multiple would typically be a multiplier of earnings, i.e. measuring the “amount of money which the business can earn”.

For example: If you’re selling a company that is about $20 million in size and generating $3 million profit in IT Services, you could be looking an EV of around 10x your EBITDA or profit – that is to say, around $30 million.

But if you take the same exact business and it is five times as large, you could be looking at 12x or 14x earnings.

Why? Because larger companies are typically the “gorilla” in their market. In fact most $100-200 million IT Services companies are the champion of something in their geography or segment. For example, they may be the IT Services provider to 8 out of the 10 largest life sciences companies worldwide.

Companies receive a premium for size, therefore, but also for the leadership and other soft components that come with their size.

Do you see a difference in valuation between LOI stage of process and final agreement?

It is common for valuations to be adjusted downwards between the LOI and closing.

When negative elements are uncovered during the due diligence process for the first time, this can negatively affect the valuation multiple. In fact, even if the due diligence reveals something positive which was not disclosed before, this doesn’t play to the seller’s benefit or drive the multiple upwards.

Before reaching the LOI stage, correct process management is crucial. Entrepreneurs who receive LOIs but are not advised by professional M&A advisors are often drawn into a process with a single buyer or investor in a sped up “exclusive” process. Without the correct direction, they may fail to disclose crucial elements along the way, and these elements can later be used to drive the price downwards by the buyer during the due diligence process.

At Hampleton, we run a two-step process which is split between initial bids and final bids.

Between the initial bids and the signing of the LOI, the prospective buyer can carry out a buyer due diligence to obtain relevant data and confirm the price and structure of the deal before setting up the final due diligence.

The final due diligence process should thus only confirms what was originally researched during the buyer due diligence (e.g. share ownership, outstanding lawsuits, legal disputes with customers, etc.).

Issues should not arise at this stage if the process is well run. We believe the price between the LOI and the final agreement should be identical and agreed upon within 60 days.