Valuation is a big part of the story when selling your MSP. For most business owners, their MSP represents not only their biggest asset, but something they've put decades of blood, sweat and tears into building. So it's natural that they want to know what it's worth. This article, and MSP Valuations overall, is designed to give business owners practical guidance on this topic.

But before we dive in, we want to make one point that some may view as controversial: for most owners of successful MSPs, valuation should not be the most important consideration in selling their business. If you own a successful MSP, chances are you have already done very well financially and a +/-10% difference in the sale price of your company just isn't going to have a material impact on your happiness. We've seen far too many owners get caught up in optimizing their acquisition price, only to feel terrible about the decision a year later when their company is gutted. Make sure you feel good about what the acquirer plans to do with your business after you sell it. Trust us: that will be more impactful to your life than the last dollar.

Now, back to our regularly scheduled programming.

Unpacking EBITDA

Most MSP transactions are valued on a multiple of Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). You may have heard Warren Buffett and Charlie Munger criticize EBITDA, and in most cases they are right. But in an asset light business like an MSP, where there is very little depreciation, EBITDA really does translate well to the pre-tax operating cash flow, so it is a fair metric to use when determining valuation.

When an acquirer is valuing an MSP, they will often make normalizing adjustments to accurately reflect the structural cash flow of the business. The most common normalization adjustment in MSP acquisitions is around owner compensation. Most owners compensate themselves in a variety of ways, from traditional W-2 wages to running personal expenses through the business. A buyer will typically add back all forms of owner compensation to EBITDA and then deduct a market level of compensation for a CEO of a business in that size range. For MSPs below $5m of revenue, CEO compensation runs in the $200-250k range, and for MSPs above $5m of revenue it's $250-300k, or even more for larger businesses. When you are calculating your Adjusted EBITDA, it's critical to normalize owner compensation in this way so that you are using the right measuring stick.

Adjusted EBITDA is typically calculated for the most recent trailing twelve-month period to capture the latest trends in the business.

Valuation and what moves it

MSP valuations typically fall within a range of 4-8x EBITDA, with the difference in multiple being driven by business size, growth rate, quality of revenue, and customer diversification.

Firstly, on business size, all else being equal, larger MSPs command higher multiples than smaller ones. There are two reasons for this. The first is that smaller MSPs tend to be more fragile and dependent on the owner or another key person. Larger businesses tend to be more resilient and require less day-to-day involvement from the owner. The second reason relates to supply and demand. The majority of MSPs are below $3m of revenue, but the minimum revenue threshold for most well-funded buyers is at least $3m and in many cases $10m+. This means that all the demand for MSP acquisitions is aimed at the larger firms, even though smaller MSPs make up most of the industry, and that creates a gap in EBITDA multiples between larger and smaller MSPs. The difference can be material, with smaller MSPs with under $500k in EBITDA transacting at the lower end of the 4-8x range, whereas larger MSPs with $1-2m+ in EBITDA transact at the higher end.

Secondly, on growth rate, all else being equal, a business that is growing faster is worth more than a business that is growing slower or not growing at all. We often get asked if we look at future growth projections when valuing an MSP, and the answer to that is no. The value of growth is captured in the multiple that we pay for a business. For example, if we pay 4x for a flat business that remains flat in perpetuity, we are getting a 25% yield on our investment. If we pay 8x for a business, it needs to double EBITDA to get to the same 25% yield as the flat business that is purchased at 4x. If you want a premium multiple, show the buyer a compelling case that your business will double its profits organically over the next 3-5 years.

Thirdly, not all revenue is valued the same. Recurring managed services revenue where you are delivering a service to the customer on a recurring basis is the most valuable form of revenue in an MSP, by far. Recurring cloud resale is valuable in the sense that it is recurring, but the margins are low and can be changed by the vendor. Non-recurring resale and non-recurring services are less valuable and businesses that have 40%+ of their revenue coming from this type of work will have a more difficult time selling their business and will get a discounted multiple of EBITDA.

Finally, customer diversification is a critical factor in mitigating risk to a buyer, so it contributes meaningfully to valuation. If your top customer is over 20% of revenue and your top 5 customers are over 50% of revenue, expect a lower valuation and expect to have significant scrutiny by any buyer on the contract terms and health of those customer relationships. Any customer with over 10% of revenue will generally get scrutiny, but 20% is typically the point at which the buyer is taking significant risk.

Different buyers value things differently, but there is broad consensus on the four factors above. If you build an MSP above $500k of EBITDA, with consistent growth, the majority of revenue from managed services and a diversified customer base, you are all but assured a healthy valuation when you go to sell your business.

Deal structure

We quoted the 4-8x EBITDA range above, but the multiple doesn't tell the whole story. Deal structure matters a great deal. Cash at close is the simplest part of the purchase price to value.

Earnouts are a component of almost every acquisition and are generally based on EBITDA or recurring revenue growth targets. Earnouts are a useful tool to bridge valuation gaps between buyers and sellers and can help buyers get comfortable with paying a higher price for a business because the seller is incentivized to grow it. This can lead to a seller earning a higher valuation because of the lower risk of the buyer. There isn't clear publicly available data on what percentage of earnouts achieved, so the best thing a founder can do is to ask the prospective buyer for that exact percentage. If a buyer is evasive or hesitant to share that information, you probably have the wrong buyer. At Evergreen, we proudly share that 96% of our earnouts have been achieved.

Last, but not least, is rollover equity, which is the concept that you take a portion of your purchase price in shares of the acquirer or retain a percentage ownership stake in your own business. This can be an enormously valuable component of a deal. At Evergreen we have had several sellers that earned more from selling their Evergreen stock than they did when they sold their own company. On the other hand, equity can turn out to be worthless if the company you roll into performs poorly, and we have seen many cases in which rollover equity holders have gotten wiped out completely.

A common mistake owners make is to value all rollover equity the same. With the range of outcomes being so wide, it is critical to do your homework on the equity returns track record of the buyer that you are rolling equity with. Ask for the historical financial performance of the company you are rolling into and if your buyer hasn't been in the MSP space, ask for the historical returns of their previous investments. Generally, you are better off investing your money with people with a strong historical track record.

You can also infer how valuable a buyer's rollover equity is by how willing they are to give it to you. If your buyer mandates equity rollover or is eager to have you take 20%+ of your sale proceeds in equity, chances are they don't believe it will appreciate very much.

Where to go from here

Hopefully this information is helpful to you as you build your business towards an eventual exit. If you are looking to get an estimate on the value of your MSP, we encourage you to use our free valuation calculator, which is based on over 130 real MSP transaction data points. Our team is also always happy to have a low-pressure conversation with you, whether you are looking to sell your MSP soon or just planning many years ahead. Finally, we put on our Elevate event annually in the US, Europe, and Australia, where we dive into proven tactics for increasing the value of your MSP. We encourage you to attend and hope to see you there.

We will end by reiterating the point from the second paragraph above, which is that valuation should not be the be-all end-all when it comes to selling your business. What happens to your company, to your team, and to your clients is ultimately going to have the biggest impact on how you feel about your exit. When you sell your business, you have a choice between maximizing valuation at all costs or taking care of your employees and customers. You own your business and are free to sell it in whatever way you want. But, if you ask a buyer to accept an inflated EBITDA number based on cost cuts or "synergies," don't be surprised if your MSP is gutted and you regret going through the sale.