Most company valuations, including IT managed service providers (MSPs), are based on the earnings (profit) they generate. The earnings metric commonly used is EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization. This is a convenient proxy for cash flow and can be used to compare companies with different capital structures, tax rates, and depreciation policies. Most small to medium IT service companies are valued between 4X and 8X EBITDA. However, this is a wide range and doesn’t tell the whole story of how an MSP, VAR, or any IT service company, is really valued.
Recurring revenue is king when it comes to valuing managed service providers. That’s why the MSP model, with its emphasis on recurring revenue and a long customer lifecycle, tends to have higher valuations, per dollar of revenue, than other types of IT service companies. For MSPs that have additional revenue streams, their professional services are valued lower than recurring revenue, and their product sales are valued the least.
Besides Earnings, What Drives Higher Valuations?
Yes, making more money each year will significantly improve your valuation. However, there are other factors to consider. One is the size and scale of your business. Valuations don’t go up smoothly as a company grows revenue and profits. The value curve actually looks like stair steps. In other words, as companies become larger and reach new revenue and profit milestones, their valuation multiples increase. So a company with $25 million in revenue and $5 million EBITDA has a significantly higher valuation multiple than a company with $2.5 million in revenue and $500,000 in earnings. Larger companies have proved that they can scale, add management depth, continue to gain new customers, and minimize customer churn. If the company can provide services over a larger geographic area (regionally, nationally, or globally) it will tend to have a higher valuation than a local provider.
Companies with specialized services and deep industry experience also have higher valuations than companies that are less differentiated. If you’re seeking to raise your valuation, consider focusing on some market segments that are growing rapidly and are willing to pay for your type of service. In a high growth market, some value gets created due the scarcity of certain products or services. That’s why some MSPs are adding consulting and advisory services in vertical markets in order to become trusted advisors and build deeper client relationships.
How Can You Get the Highest Valuation?
To increase your company valuation above the normal range of multiples (above 8X) may require more than growth. It will probably require some differentiators such as intellectual property or unique knowledge and processes.
It’s also relevant to consider what not to do to increase your value. One tip is to not become dependent on a few key customers. A diversified customer base reduces the risk to future earnings, and that will be reflected in the amount if someone tries to acquire your company. This is one of several risk reduction techniques that can help maximize your company value. Contact us if you would like to discuss your unique valuation and value enhancement needs.
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