By George Sierchio
Mergers and acquisitions have been a hot topic in the IT services space for quite a while now, and it will continue that way for years to come. M&A is alluring, intriguing, risky, rewarding, and much more art than it is science and legalese.
Let’s jump into some abbreviated guidelines to help you buy an IT services business.
THE WHY AND THE WHAT
Before you start your search, you need to know why you’re diving into this endeavor and what you’re looking to get from the process. The leading reason is to get “bigger” via top line revenue growth. However, don’t stop there. There needs to be more to it than that for a game plan. Consider other strategies such as increasing profitability through consolidations, adding new service capabilities, talent acquisition, new vertical knowledge, geographic expansion, etc.
What this target business needs to look like to answer your why from above is next. This is your candidate criteria. It can’t cast too wide of a net, and you don’t want to be looking for unicorns. Some criteria ideas would be location, capabilities, specific talent/certifications, acceptable total revenue/recurring revenue/ profit margins ranges, what customers should look like and their profitability. You should also be OK with something that fits most criteria. A perfect fit can’t be needed to pull the trigger on a deal, or you will never get one done.
IT’S NOT EVER FREE
It will cost money to purchase a business in terms of a down payment as well as additional costs in the form of professional services (advisors, lawyers, CPAs) and integration costs. Not to mention lots of time costs for you and your internal staff.
Understanding how much available funding you may need and can get your hands on is important to think of up front. You must know where you are getting it all from and prepare to make it available to use before you need it. Business cash in the bank, personal liquid assets, lines of credit, family/friends/investors, bank loans, and non-bank lenders are all options.
Of all the avenues a bank is the most difficult. Thinking you are going to stroll into a bank and walk out with a loan because “money is cheap” these days will likely end in disappointment. If you’re not a large company with business or personal assets (not a good idea) to back up a loan and you’re buying a service-oriented business with limited tangible assets, money is not easy or without extreme covenants, even if it is “cheap.” In the rare instance you secure a bank loan, a seller will want to know that you have already been approved and that the overall deal structure makes sense as banks don’t loan 100 percent of a purchase price and often put many strings on the deal structure.
FINDING AND ENGAGING CANDIDATES
So far you still haven’t looked for a candidate, but you are prepared to do so. There are many ways to search for candidates and typically not many shortcuts. It takes a long time, especially if it’s an owner or an internal person with a day job doing it part-time. Best methods are through user groups, peer groups, and IT industry associations. Working from an already established relationship or common connection is the key.
You can also get the searching and introductions done through tapping sell-side brokers, although this is not recommended unless they are a rare firm specializing in the IT services space. The better route is a buy-side M&A firm, with expertise in the IT industry, where you also receive good advice.
Once you connect, it’s all about relationship building and learning about each company and the exchange of information to make that happen. This process can’t be cut short. Think opportunity and fit first, money last. Discussing purchase price and deal structure while still in the dating process is often the kiss of death.
DOING ENOUGH DILIGENCE
With enough courting accomplished, you can get a nondisclosure agreement in place, if you did not already do so, and ask for more serious diligence. That includes sharing financials (best looked at monthly), information on employees (no names), customers, (no names), and sales.
This will allow you to create a transaction model to determine a purchase price and deal structure that meets your needs for an accretive deal (i.e., it has monthly cash flow after paying deal debt) with a return of your cash within a reasonable investment horizon (i.e., the time it takes to pay the deal off). All deals include risk to the buyer. The goal is a fair price and structure that balances the risk to ensure results through goal alignment.
Now you have what you need to use your modeling in crafting a letter of intent (LOI) to turn your candidate into a seller. Insisting on being able to do good pre-LOI diligence means you have done enough to put forth an offer you can stand behind versus one you know will be changing post-LOI. That’s called “retrading” a deal, and it does not go over well with a seller, even if it was they who withheld the information you needed to put forth a good LOI.
There are many ways to write up an LOI. The goal is to produce something that is a rough outline of main items that will go into the ultimate purchase agreement and the timeline in which you are looking to get the deal done. The seller is pledging to dedicate themselves to the presented deal during that time frame as well. Most paragraphs in an LOI are “nonbinding,” but a good LOI is made to be honored by the buyer and seller as agreed. Either party going into an LOI with a nonbinding attitude (see retrading above) is the wrong approach. Everyone should be excited to hit the gas once an accord is reached and the LOI is signed.
DOCUMENTATION, MORE DILIGENCE, AND PLANNING
Excellent work! You now have a seller. A lot has transpired, but in terms of closing the deal, this is where the rubber meets the road. Purchase and ancillary documentation will be drafted, negotiated, and reworked in what should be an effort to stay within the spirit of a fair deal agreed to in the LOI. Your attorney, CPA/tax advisor, and M&A advisors should be working with you, not against you, to make this transaction happen, while also protecting you. All advisors should be well-versed in M&A commensurate with the size of deal you are doing and at least the service industry if not IT services specifically.
While documentation is being prepared, diligence will continue. If you did a lot of diligence to create the LOI there is less, but still lots, to look at in terms of details to make sure what you thought you were buying pre-LOI is in fact what you are buying. If things have changed or you discover something unexpected, you may need to adjust the documentation for protection or perhaps even adjust the price and payment structure; if not, walk away from the deal.
During this phase you will also be working with the seller and your internal team on transitioning and integrating the business. This cannot be put off until after the closing! There is much to do in terms of communication and planning around employees, customers, vendors, processes, and systems.
This is when we can say congrats! With the paperwork signed and funds exchanged, you have a closed transaction. Now it’s time to get to work on your action items made while planning your transition and integration.
THAT’S A WRAP
M&A deals of any size are full of as much risk as reward, and it’s not for everyone. Even with a pot of gold at your disposal, it’s not so easy or guaranteed. Most will ultimately never pursue M&A in earnest. Of those that do, very few will buy a business of much significance or value add, if they get through the process at all. Hopefully these guidelines will prepare you to be in the ranks that successfully buy a good company and do great things with your investment.
GEORGE SIERCHIO is EVP and senior partner at Cogent Growth Partners, leading over 25 buy-side transactions in the IT services space.