Preparing to Sell an IT Services Business

The owners of an IT services business may reach the point where they want to sell the business. Selling any business is an involved process, and it can be further complicated as a company grows and becomes more successful or experiences setbacks. Preparation and planning are critical to getting the best outcome.

Before starting the process, the first question to answer is: why sell?

Motivations to sell

There are three reasons most owners want to sell: liquidity, growth, or to transition to something different. Sometimes it's a combination of those reasons. Understanding the motivation to sell is vital because it helps determine the types of buyers to consider and how to approach the process.

Liquidity

At the risk of stating the obvious, if the owners want to make money by selling the business, the business has to be valuable enough for a buyer to pay for in cash or some other liquid asset (e.g., public stock).

In this scenario, strategic buyers - that is, other companies that want to acquire some combination of your talent, revenue, or other operational value - are the most likely to be a match. These buyers can use a combination of cash and stock (if they are publicly listed), creating a liquidity event for the seller(s).

Private equity firms can also be buyers, but they typically are looking for some or all of the management to continue working in the business. Often a significant portion of the proceeds from a sale to private equity is in stock that may not be liquid (there's a reason it's called private equity). The equity component incentivizes management to stay involved with the business and drive growth. This creates the possibility of two liquidity events: one when the sale occurs and a second, future sale after the company grows. The second liquidity event can often be larger than the first, leading to a better financial outcome for owners willing to remain active in the company.

Growth and Operational Excellence

Sometimes services businesses get stuck and need help continuing to grow in size. Other times, a services business may be growing but sees an opportunity to accelerate that growth by combining it with another company or to protect its competitive advantage in a market.

Strategic buyers can help with growth, but it may look different from it would with a private equity buyer. A strategic buyer often wants or needs to fully integrate the acquired business into their own. So, while the components that come from the sold business are still growing, it's happening in a broader, existing organizational context. Occasionally a strategic buyer may keep the acquired company separate. It's rare, and often they end up getting integrated eventually.

Private equity buyers are very good at helping with growth. Although every firm is slightly different, they are generally financially and operationally disciplined. Their goal is to acquire businesses that complement their capabilities and portfolio, increase their value, and sell them.

Another critical aspect of growth is operational excellence. As services businesses grow, the processes, tooling, and sophistication of operations also need to improve. Both strategic buyers and PE buyers can help with this.

Transition to something different

Sometimes owners actively involved in the business want to transition to doing something new/different. They don't want to continue being involved in the business to help grow it. What they've built may need to be more valuable to generate a significant liquidity event, but the company may be doing well enough that it doesn't make sense to shut it down.

This is a tough spot for owners. Finding a buyer for this kind of business is usually tricky. Unless the owners have taken steps to transition out of the company's day-to-day management for some time, buyers may not see enough value to pay for the business.

The takeaway: owners need to be honest with themselves about why they're selling, what they expect to gain, and the range of options available to them as a result.

How services businesses are valued

The simple explanation usually given is that services businesses are valued based on a multiple of revenue or EBITDA.

While this is true, the complete answer is more complicated. Many factors influence the multiples used, including:

• Growth rate: A company with an excellent track record of year-over-year growth is typically worth more. It is sometimes possible to get credit for future growth, effectively making it a “forward multiple” if the backlog is robust and shows an acceleration of the business.

• Nature of services: Modern capabilities using technologies in high demand and not viewed as a commodity will command a higher multiple. Older technology or commoditized services will fetch a lower multiple, all other things being equal.

• Size of the business: Strategic and PE acquirers have a target company size they are looking for, typically measured in revenue. Selling a business with below $10M in revenue can be difficult. It generally gets more straightforward as the revenue of the seller's business increases.

• Geographic considerations: The geographies from which services are delivered, and the geographies of clients, often influence multiples. If the staff of the company selling or the companies they sell to are in a jurisdiction with geo-political risks, that may reduce the multiple or eliminate buyers from consideration.

• Client concentration: If too much revenue comes from one or a small number of customers, the multiple may go down compared to a similar business with less concentration.

• Net revenue retention: How much revenue is "retained" year-over-year with existing clients can be a significant factor in valuation. This metric measures what percentage of your revenue in year N was generated by the same clients in year N-1. High net revenue retention - in the 80% range or higher - is typically much more valuable because it shows durable client relationships.

• Intellectual property: This often comes in the form of accelerators, proprietary processes, or tooling that would be hard to replicate, which can differentiate the services provided to clients. Note that this is not product revenue; having revenue from something other than services often complicates the valuation process and rarely works to the seller’s advantage.

• EBITDA: Lower profitability can be overlooked if other aspects of the business are attractive, but the company needs to demonstrate it can be profitable. High gross margins, a track record of scalable growth, and high net revenue retention are the best combination for overcoming low EBITDA.

Finally, the way the sale occurs influences value. A competitive sales process with multiple prospective buyers will generally increase the value. A sales process with only one buyer has no competitive tension, so the company selling may be valued lower.

The takeaway: Understand the factors that affect valuation so you can maximize the value of the business. For this strategy to be effective, there should be a track record of at least a year of the positive aspects of the business’ performance. Run the business accordingly!

Ways to find a buyer

There are three ways sellers typically find a buyer:

1. Cold inbound from a prospective buyer

2. Organically, through networking with the leadership of businesses that could potentially acquire them

3. Working with an investment bank to run a sales process where the bankers use their network of prospective buyers

Cold inbound is rare, but it does happen. These types of transactions are usually not the best outcome for the seller because there is no competitive tension to maximize the value of the business. Also, because the buyers and sellers meet initially in the context of a potential sale, it can be hard to judge if there is a good cultural fit. Owners can't assume this will happen, so if they want to have any control of their destiny, they must look at other options to find a buyer.

Organic connections that lead to sales are better than cold inbound because the buyers and sellers have gotten more familiar with one another outside the context of a sales transaction. Finding any buyer organically through one’s network can be challenging. Even if you find a prospective buyer, it can be hard to create competitive tension in these transactions. There are only so many prospective parties that most companies can bring to the table.

A sales process run by an investment bank typically maximizes the value of the company being sold and the likelihood of a successful transaction. Sell-side investment bankers generally have done dozens of transactions and have a broad network of prospective buyers.

While an investment bank may have the best outcome, it does come at a cost. The seller pays the bank for its services, and the sales process can be very demanding. Selling a business to cold inbound or organic connections can be simpler, but the process is usually out of the seller's control.

The takeaway: even if owners may never want to sell or know they're not ready to sell yet, developing a network of prospective buyers and investment bankers is helpful. You'll get to know who you like in a lower-pressure setting, and they'll already know about your business when it comes time to sell.

Consider what type of buyer is suitable for the business and the sellers

Given all the factors above, consider what type of buyer would be attracted to the company and what type of business meets the sellers' goals.

So much of a sales process revolves around the price that it can be easy to lose track of an important fact: at the end of the process, the leadership of the company being sold will stand in front of their employees to tell them what happened. Essentially, the owners or leadership are picking their employees' next employer.

For anyone involved in the business after the transaction closes, the culture of the buyer matters. Making a decision based solely on price is easy - it's a quantitative exercise. After money changes hands, though, it's all about the people. The cultural component is a much more qualitative consideration. You should like each other!

The takeaway: Sellers should have some opinion about the ideal buyer for their business. Strategic vs. PE, the type of company culture that will be a fit with management and employees, and what type of combination is the most likely to motivate people to succeed are essential.

Make sure you're ready for the type of sales process you intend to run

Selling a company is not easy. Most founders or CEOs who have been through the process will tell you it is one of the hardest things they have ever done. The company's leadership involved in the sales process should be prepared because it will be stressful, distracting, and time-consuming. Success is not guaranteed. Many transactions fall apart between when a letter of intent is signed to literally minutes before the closing.

All transactions require some level of due diligence. How intensive that process is will vary, but it always involves sharing details about legal agreements, finances, taxes, and every aspect of business operations.

A sales process where a buyer and seller work together directly without bankers may be shorter and more straightforward but still very demanding. Less due diligence may be required if the buyer is a private company. A public company has obligations that require a much deeper level of due diligence.

The due diligence process is critical to closing the transaction successfully. It requires supplying lots of documentation and answering many questions the sellers may not anticipate. The process is (slightly) less stressful if you have as much documentation as possible ready in advance. Investment bankers help tremendously with this part of the process because they know the information needed for diligence and can anticipate buyers' questions.

The takeaway: sellers should make sure they are prepared for the sales process mentally and in terms of having business matters buttoned up. Needing to find critical business documents, dealing with major legal matters, or being distracted by significant family or personal issues is a recipe for disaster.

Determine who will be involved in the process (and who won't)

It's crucial to figure out in advance who will be involved in the sales process. The most senior management in the company typically must be involved. There will be conversations requiring senior management participation, and they will normally need to support due diligence requests.

Beyond senior leadership, owners need to consider how widely known to make the sales process. Telling employees may create counterproductive stress. Not every attempt at a sale will result in a transaction happening, so it can create pressure for no reason.

Also, once you begin serious discussions with a prospective buyer, NDAs are required for everyone involved. The people who can know about the sales process at this stage are usually very limited, especially if the buyer is a public company, because the details of a potential transaction may be material, non-public information. Employees who know a sale is being considered will want information that management can rarely provide. This can create even more stress.

If you tell employees, it's also very likely that customers will find out. If customers find out one of their vendors may be sold, it can create unnecessary stress. The reality is that buyers and sellers are highly motivated to make sure business with customers is maintained due to an acquisition. Still, customers may worry and change their buying patterns during a sales process, leading to additional complications for the sellers.

Sellers will need support in a few areas that typically require third parties. Lawyers familiar with the company's legal matters and these business transactions are critical. Accountants and tax professionals familiar with the company's financial records and tax filings are also needed.

The takeaway: consider how widely known the sales process will be within the company. Generally, the fewer people involved, the better. Sellers will benefit from having employees and as much management as possible focused on "business-as-usual" operations. The fewer people that know reduce the chances of sensitive information leaking to customers. Also, the buyer will likely require the sellers to restrict information about the sale.

Get started

All this preparation is just the beginning. I’ll be covering the actual sales process in a later post!